In accounting there are generally four different kinds of financial statements namely the balance sheet, the income statement, the cash flow statement, and the fund flow statement. Here, we delve into the last two.
The Cash flow statement represents the actual inflow, and outflow of cash, and the increased or decreased position of cash and cash equivalents in a business. In a way, it is useful in assessing the company’s ability to meet its short-term obligations. Cash equivalent means highly liquid current assets that can be readily converted into cash without any loss in value or time.
A cash flow statement can provide details about operation-related spending, including purchases of inventory, extending credit to customers, and buying capital equipment. Further, cash flow provides insights into short-term liquidity and cash management. It is best used to understand the liquidity position of a business. For example, in a restaurant inflow of cash will be daily, and at the same time inventories exhausted daily, and at the most, some provisions may not last long for over a month. Such items which will be quickly converted into cash can be treated as the cash equivalent. At the end of the day and on a specific day, the restaurant owner finds out the increased or decreased position of the cash and different variables. This will help the owner to understand the overall performance of the business regarding the inflow and outflow of cash. The increase or decrease of cash in hand position helps the owner to decide how much cash balance shall be maintained for routine business transactions as well as meeting upcoming payments or anticipating cash requirements. Historical cash flow information can help owners forecast future cash flows, and assess the accuracy of past forecasts.
Impact of depreciation on cash flow:
Operating cash flow starts with net income, and then adds depreciation or amortization, net change in operating working capital, and other operating cash flow adjustments. The result is a higher amount of cash on the cash flow statement because these non-cash expenses are added back into the operating cash flow. Thus, depreciation does not have a direct impact on cash flow, but it does have an indirect effect on cash flow because it lowers the company’s tax liabilities, since depreciation and amortization on tangible and intangible assets respectively, reduces net income in the income statement.
Working Capital Assessment:
The working capital (WC) of a company is calculated by deducting current liabilities (CL) from current assets (CA). The equation for working capital is WC= CA-CL. Any changes in current assets (other than cash) and current liabilities (other than debt) affect the cash balance in operating activities. For example, when a company buys more inventories, it results in current assets increase. However, spending on inventories is cash outflow. The value of inventory is subtracted from net income because it is a cash outflow. Similarly, when receivable increases, it indicates the company sold its goods on credit. There was no cash transaction even though revenue was recognized, so an increase in accounts receivable is also subtracted from net income. On the other hand, if a current liability, like accounts payable, increases this is considered a cash inflow. This is because the company has yet to pay cash for something it purchased on credit. This increase is then added to net income (a decrease would be subtracted).
Importance of cash flow statement:
Since the income statement and balance sheet are based on accrual accounting, those financials don’t directly measure what happens to cash over a period. Therefore, companies typically provide a cash flow statement for management, analysts, and investors to review.
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