Cash and cash equivalents are the backbones of every business entity. There is nothing possible without cash. So it is essential to keep a record of all the cash inflow to the organization, and outflow from the organization should be kept properly.
In small business entities, there are no such restrictions on the format of cash flow. But for large companies and organizations, there is a proper format to be followed.
The format is described in IAS-7 and GAAP (FAS95). For every business entity, the statement of cash flow should be made according to these standards.
The main purpose of making a cash flow statement is to provide the information and compare the cash receipts and cash payments during a time period in which the entity runs its business.
It also serves the same purpose as preparing other financial statements to let the users understand the entity’s financial situation, financial performance and position, and cash flow.
Classification of Statement of Cash flow:
According to IAS-7, the cash flow of every organization flows under the three main heads. It means all the transactions should be classified under these three activities.
- Operating Activities
- Investing Activities
- Financing Activities
These are the main activities in an organization that are why changes come in cash and cash equivalents.
Each activity provides different information on the entity’s cash flow with a different purpose. Operating activities will let the users know whether the entity has positive or negative cash flow and the movement of each item of working capital.
The purpose of preparing cash in the investing activities is to let the users know the items that the entity has the hug investment in and the items that the entity relax to invest in.
Importance of Statement of Cash Flow:
Organizations use accrual methods of accounting to record their transactions. And all the financial statements are based on this information.
Besides the cash flow statement, no financial report provides the actual information about the cash inflows and outflows.
Let’s suppose an organization runs its business with a high inventory of fixed assets and high credit sales.
By analyzing the balance sheet and Profit & Loss statement, you can say that the company is very stable.
But on the other hand, there is not enough cash available to meet the organization’s expenses, which may result in bankruptcy or a decline in the company’s business. Let’s study an example to understand it fully.
XYZ is running its business in New York City. The balance sheet shows Assets side $400,000 with a cash balance of $2000 and receivables amounting to $70,000. At the same time, the liability side shows a payable net of $40,000.
Projected sales for the next month are amounting to $60,000 with an expected $50,000 credit sales. There is no chance of converting current receivables into cash.
If we analyze the above information, we will say that the company is very profitable with high sales. But when you make Cash current cash flow and projected cash flow for the next month, there will not be enough money to pay current payables of $40,000.
So the managers have to adopt some strategy to counter the shortfall of cash. You can get this information only by a statement of cash flow.
Cash flow for Decision Making:
In the previous example, we study how the cash flow statement is important for the company’s management to decide and plan for the next business period. The cash flow statement is also important for the following persons.
- To Investors:
To all the persons or organizations who want to invest in an organization. As it shows the company’s position to pay their current and long-term payables. Investors value statement of cash flow the most when looking to invest in companies.
- To Creditors:
This report is always helpful to the creditors of a company. Because they use this report to decide whether it is feasible to go extent the company’s credit limit or should it be limited as the company cash flow shows negativity. So as part of the financial statements, It is equally important to all the stakeholders of an organization.