You must have heard that albeit being profitable, the businesses could not go on as they just run out of cash. This may sound ridiculous at first sight, but managing cash flow effectively is important for the survival of the business.
It is important for all levels of the organization, either small or large. And believe it or not, failure of business due to cash crunch would be the stupidest idea to let yourself and your business down.
Managing cash flow means managing working capital funds in and out of your business. This includes the aspects related to accounts receivable, accounts payable, office expenses, and so on. Tracking cash flow should be done periodically based on the size of the organization.
It is advised that businesses should track the cash flows on monthly basis due to the small number of ins and outs of funds.
The following are the advantages and limitations that key stakeholders could obtain from the statement of cash flow.
But before discussing about the advantages and limitation, let do the general discussion on statement of cashflow.
In general, the statement of cash flow that prepared in accordance with IFRS or IFRS for SMEs has three main sections. The first section is cash flow from operating activities that list down all of the cash outflow and inflow in the operation. For example, movement in the inventories or movement in trade receivable and payable.
The second section is the cash flow from investing activities that list down all of the movements related to investing activities like purchasing of fixed assets or invest in the new subsidiaries.
The third section is the cash flow from financing activities where the cash movement mainly involves the financing activities like a dividend payment, borrowing, or loan to the shareholder or related parties.
Now, let discuss about the key advantages and disadvantages of statement of cash flow.
The advantages of cash flow statement are as follows:
- Assess the Liquidity Status of Company: The Cash Flow statement helps in knowing the liquidity/actual cash position of the company with regards to which profit and loss and funds flow statement fails to specify. If the liquidity status is known, required funds can be raised through external sources, and if there are excesses of funds, these can be used for the growth of the business. If there is any discrepancy in cash position, it can be gauged through analysis of the cash flow statement. The Cash Flow statement helps to define the optimum cash position for the firm. If optimum cash balance can be determined, the firm can ascertain the excess or shortage of cash. Funds can borrow or invest accordingly after knowing the cash position of the firm.
- Assist in Planning, Budgeting, and Controlling: The financial planning and analysis are done with the help of the cash flow statement. It helps the top-level management to coordinate financial operations properly. Cash management is possible through the preparation of cash flow statements. The management can then prepare an estimate about various inflows of cash and outflows of cash so that it becomes helpful to take future actions.
- Performance Appraisal: The management can evaluate the performances regarding the cash by comparing actual cash statement with projected cash flow statements. If any variance is found, it should be rectified accordingly.
- Movement of Cash: Cash flow statement represents the ins and outs of cash, meaning the flows of cash on the basis of which future estimates can be made.
The limitations of cash flow statement are as follows:
- Fails to Present Net Profit: The cash flow statement fails to present the net income of a firm for the period as it ignores non-cash items which are considered by Profit and Loss Statement. The cash flow statement does not help to assess profitability as it neither considers cost nor revenues. However, it can be used as a supplement to the income statement.
- Not a substitute to Funds Flow Statement or Income Statement: The functions which are performed by funds flow statement or income statement cannot be done by cash flow statement.
- Industry Comparison not possible: As the cash flow statement does not measure the efficiency of the firm, intercomparison with other inter-industry is not possible. A firm having less capital investment shall have less cash flow than the firm which more capital investment resulting in higher cash flows.
- Does not Properly Assess Liquidity position: In a practical scenario, the cash flow statement does not assess the liquidity or solvency position of the firm as it presents a cash position only on a particular date. It only helps to know what amount of obligation can be met. In nutshell, it does not represent the real liquidity position.