Introduction:The cash flow statement is intended to convert the accrual basis of accounting used to prepare the income statement and balance sheet back to a cash basis. This may seem redundant, but it is essential.
Cash flow statements are more relevant than ever before and it is one of the most useful financial management tools a company have to run the business. The global financial crisis has shown how essential cash flow is and therefore the cash flow statement. The road to business success is cluttered with bankrupt firms that were actually showing a profit in their last published income statement.Cash flow is the ‘life blood’ of a company.
The cash flow statement reflects a firm’s liquidity. Cash flow is defined as inflow and outflow of cash or liquidised finances. To keep a business running it is essential to have a positive cash flow. The cash flow statement tells readers if the company is making money from its core operations or financing itself through debt. This essay will illustrate the numerous benefits and advantages a cash flow statement can provide to any company. The essay compares the cash flow statement with the other main financial statements and describes the beneficiaries of the cash flow statement.
I will consider the harmonisation with international standards and look at the practitioner’s point of view.Why preparing cash flow statement In recent years, the statement of cash flow obtained more intense attention from readers of financial statements. The cash flow statement gives vital information about the financial performance of a company. The objective of AASB 107 Cash Flow Statements is to provide information about how an entity generates and uses cash and cash equivalents during the reporting period by disclosure of a cash flow statement, which classifies cash flows as operating, investing and financing.
It is applicable for annual reporting periods beginning on or after 1 January 2005 (AASB website).The concept of cash flow is different from income through sales or revenue through any economic activity. Cash flow can be divided in inflow that is money received as a result of a firms operating activities, investment activities and financing activities; and outflow that is money paid out as a result of a firms business activities. A positive cash flow where the cash inflow exceeds the outflow is a sign of financial health. 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. Negative cash flow where a firm keeps spending more cash than it generates can bring a company into serious trouble. Operating activities are transactions related to the calculation of net income. Generally, changes made in cash, accounts receivable, depreciation, inventory, and accounts payable are reflected in cash from operations.
Investing activities are transactions related to long-term assets and includes changes in equipment, assets or investments. Financing activities are transactions related to liabilities and stockholders’ equity. Changes in debt, loans or dividends are accounted for in cash from financing. (Deegan 2007)Comparison to other financial statementsThe cash flow statement is a very valuable complement to the other statements. Like the income statement, the cash flow statement measures financial activity over a period of time.
The income statement provides the user with data about the profitability of the enterprise with details about revenue and the expenses which reduce profit. The balance sheet is a quantitative summary of a company’s financial condition, including assets, liabilities and owner’s equity at a particular date.The statement of retained earnings shows the changes in a company’s retained earnings over the reporting period. The cash flow statement is derived from the income statement and the balance sheet. The balance sheet and the cash flow statement share interdependence, found in the investing and financing section of the cash flow statement and in the assets and liabilities accounts of the balance sheet. Changes in the net cash from operating activities will also affect the balance sheet.
Weiss & Yang (2007) state various weaknesses with the statement of cash flow of which the most important one is stated to be the absence of the concept of free cash flow. Various definitions for the free cash flow are used:1. Cash provided by operations less capital expenditures2. Cash provided by operations less capital expenditures and dividends paid3.
Net income plus depreciation less capital expenditures4. EBITDA less capital expenditures5. EBIT multiplied by 1 minus the tax rate, plus depreciation and amortisation less changes in operating working capital and less capital spending. (Weiss & Yang 2007)Who benefits from the cash flow statement Main beneficiaries of the cash flow information are the company and its decision making management, investors and lenders or creditors.
A company can use a cash flow statement to predict future cash flow and therefore it assists for budgeting. Financial institutions and investors want to see positive cash flow. Investors can get a very clear picture about what matters most for them: cash flow indicates how financially healthy a company is. Basically, it shows how much cash the company generates and how much of that cash stems from core operations.
Making profits is valuable, but only if those profit can be quickly converted into cash. Suppliers, investors, employees, tax authorities require a payment in cash, not profits. The income statement can actually show profits and despite that a firm can face bankruptcy. In fact, profitability can hide cash outflow. Around ¾ of firms in developed countries died not because of profitability but from a lack of cash.
Thus, the ability of managers to make decisions that generate cash over time is critical to a firm’s long-term survival (Hawawini & Viallet 2002). The importance of cash flow statement was once more realised in the 2007 recession cycle.Harmonisation with international standards In the mid 1990s, a study of Dr. Christian Leuz (1999) in Germany showed that within four years only, most sample firms without cash flow statement changed their reporting practice to disclose cash flow statements in line with international reporting practice. This happened in accordance with the influence of the international standards for cash flow statements as well as the German professional recommendation HFA 1995. Like Germany, many countries recognised the need for harmonisation.
As of 2008, more than 113 countries around the world, including all of Europe, require or permit IFRS reporting. Many Australian practitioners and academics questioned the quality of existing or proposed accounting rules. Harmonisation commenced in 2005 and at the time of implementation there were 37 Australian accounting standards and 34 of these were amended with IASB standards. In November 2006 the AASB published the Exposure Draft 151 in which it was planned to remove practically all existing differences between AASB standards and relevant IASB standards (Andrew & Hughes 2007).
AASB 107 is equivalent to IAS 7 Cash Flow Statements issued by the IASB. The harmonisation with these standards was an important step towards the globalisation. International accounting standards are particularly valuable for international operating entities.Direct vs. indirect methodGAAP permits the preparation of the statement on the direct or indirect method.
Smith et al. (1992) stated that approximately 97% of companies surveyed used the indirect method in the USA. It is assumed that the Australian reporting entities performed in a similar way. The indirect method, also called reconciliation method, starts with net income taken from the income statement, which is determined by using accrual accounting and adjusts it for items that reflect differences in net income and actual operating cash flows. The direct method, in contrast, begins from actual cash receipts and cash disbursements, similar to the income statement. The difference on these two methods lies only with the presentation of the operating activities section of the statement.
Both methods result in identical cash flow from operating activities amounts. Most firms choose to create only one format and present it on the face of the cash flow statement. The indirect method is used most commonly because FAS 95 requires an additional report similar to the indirect method if a firm uses the direct method.
