Analysis of cash flows

See operating, financing and investing activities for a technical explanation of the components of a cash flow statement.

The cash flow statement is an addition to the balances sheets in the statement of financial position and the income statement or may be call it a ‘bridge’ statement in between those two main statements. The balance sheet is a position as at a certain date for current and non-current assets, less current and non-current liabilities, resulting a residual component of equity. The income statement shows the amounts earned in a year using the matching principle (sales match cost of sales, depreciation and amortisation match productive life) and accrual concept of accounting (expense and income allocation to the period they belong to).

The cash flow statement shows how a company raised money (cash) and how it spent those funds during a given period. It’s a tool that measures a company’s ability to cover its expenses in the near term. The cash flow statement is categorised into:

Operating activitiesAnalysis of cash flows

Operating activities are the cash inflows and outflows directly related to the daily operation of your business. When a customer buys your product or service, that’s your inflow. When you pay employees, vendors, insurance or miscellaneous taxes, these expenditures all fall under outflows.

The income statement items are reconciled from net income based on accrual accounting to cash flows from operating activities based on cash accounting.

Investing activities

Purchasing a new piece of equipment or expanding to a new location are examples of investing activities. These tend to be big purchases, and considered as long-term investments of assets.

Financing activities

Financing activities have to do with cash investments or borrowing money. As an example, if you’ve decided to take out a $50,000 term loan, the incoming cash will be counted as an inflow. Your payments on that loan will be considered as an outflow.

Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilise this important financial statement. Analysis of operating, financing and investing cash flows

Here are a few ways the statement of cash flows is used.

  • The cash from operating activities is compared to the company’s net income. If the cash from operating activities is consistently greater than the net income, the company’s net income or earnings are said to be of a “high quality”. If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
  • Some investors believe that “cash is king”. The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
  • Other investors appreciate a company using cash in investing activities – the company seems to have ideas how to spend the cash into growing the business.
  • Shareholders appreciate that the company they own can borrow money from banks and other financiers to add additional cash into investing activities to grow the company even more, or to repay the owners parts of equity to increase the advantage of financial leverage.
  • Many often used financial models are based upon cash flow. Analysis of operating, financing and investing cash flows

Analysis of operating, financing and investing cash flows

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