What is a financial report or a financial statement?
The financial statement is a document or report contains data of the information which are pulled off from different accounting ledgers and present to the company owners to review. Cash flow statement is also one of the documents which helps stakeholders to analyze a company’s current position.
A cash flow statement also provides a very helpful data to calculate a company’s valuation rather than speculation to avoid inflation or recession based on the business activities.
Cash flow statement is one of the financial reports which is prepared to find real cash available in business from the different sources. Cash flow statement is a vital document for the stockholders to understand how the business is progressing.
Positive cash flow does not mean, company organically has a positive balance rather the financing may be a source currently supporting business to survive.
The cash flow statement highlights weakness and progressive areas of cash crises, and we need comparative statements of the income statement and balance sheet. Comparative statement is a history of a company shows whether the business is declining or inclining.
There are two methods available to prepare a cash flow statement, indirect cash flow and direct cash flow. We will discuss here the indirect cash flow method which is divided into three divisions.
- Operating Activities
- Investing Activities
- Financing Activities
How to calculate cash through the operating activities?
The operating activities division informs cash inflow and outflow from the primary operation. For example, a tire shop receives income from the redemption of bonds, which will be allocated into the investing activities section rather than operative because it is not the primary income of the tire shop. The primary source of business here is selling and fixing tires other than it will be classified under the investment activities.
We will share below few accounts which sparks under operating activities of cash flow statement.
Net Income/Loss: A cash flow statement starts from net income and loss.
Inventory in cashflow: The inventory is treated cash outflow which is reduced from the cash though it is equivalent to cash which can be converted into cash.
Accounts Payable in cashflow:
Whereas accounts payable is a cash inflow because cash is still in the hand rather it was spent like inventory. Basically, the concept of cash flow is to find out how much cash is available now, regardless it is to be paid in near future.
Depreciation (Non-Cash Expense): Since it is a noncash expense, we therefore adjust into operating activities and increase cash of business.
What entails in investing activities?
Investment is an asset tangible or intangible, which is bought to earn income in the future, which includes stocks, bonds, real estate and mutual funds, commodities, annuities, and options.
Income receives from one of the above sources is classified under the investing activities rather than the operating activities. A business fixed assets or non-current assets, whether tangible or intangible is framed under the investment activities section of the cash flow statement, except “Goodwill” which is part of the operating activities.
Outflow in cash is mentioned under bracket whereas the inflow of cash is left open generally.
A few examples of the investment activities are being highlighted below for a reference:
Furniture Purchased: Money was spent to buy furniture for business which is recorded in the investing activities section of the cash flow statement.
Furniture Sold: Money received on the sale of the furniture which will be recorded under the investing activities as well. Any item which has a life over a year is classified under the noncurrent or long-term assets.
Advancing of loan: Interest or dividend received on investments are part of the investment activity. The investment maturity date must be over a year.
Rental Income: If the rental income is not the primary function of a business than it is sealed under the investing activities.
Income on acquiring bonds or stocks: A bondholder receives money as interest, or a dividend is classified under the investing activities as inflow whereas money paid to acquire bond also show into investing activities as cash outflow.
What do we include in the financing activities of cash flow statement?
Financing activities are the exact opposite of the investment activities. Purchase of stocks are recorded in investment activities, whereas the sale of stock to raise capital is recorded in the financing activities.
Financing activity is crucial for the stockholders, because apparently many businesses seem in profit, but they may be under huge debts.
Money received as loan classifies under the financing activities and it is recorded a company’s liability. We will highlight below a few accounts to understand why redemptions, proceeds, interest, and dividends are recorded under the financing activities.
Before we go into details let me phrase it out in a sentence.:
“Money lends to someone on markup is an investment, whereas money borrows from someone on markup is financing”.
Issuance of Debenture to Acquire Loan: A company acquires a loan against a given guarantee, is part of the financing activity and the document which covers the condition of loan is known a debenture. Money paid on redemption in the form of interest frames under the financing activities.
Issuance of Equity Share: It is one of the sources to raise capital for a company by issuing company’s shares, which is a part of the financing activities. Equity share does not redeem, and the shareholders receive dividends on income.
Issues of Preference share: Investments or the dividend paid on cumulative, non-cumulative, convertible, non-convertible, redeemable and nonredeemable preference shares reported under the financing activities. Preference shares are redeemable, and money paid in the form of interest is classified under the financing activities.
Long-Term Loans and Bank Overdrafts: Loan, bank overdraft, equity also part of the financing activities.
Issuance of bond: The issuance of bond is classified under the financing activities. Interest paid on bond and securities issued by the company is classified under financing section.
We will share a fictional cash flow statement with explanation how each account had affected a company’s cash flow:
The net increase or decrease must be equal to the bank balance, otherwise there is something is wrong in cash flow statement.
Explanation for the above-mentioned cash flow statement of David and Sons LLC:
Apparently, David and Sons LLC had increased in cash flow compared to the prior year, but the cash came from the financing activity which is not a good sign for the company.
- Operating activities of David and Sons LLC is showing that money was lost in operating activities.
- Investment activities of David and Sons LLC showing the money was lost in investing activities as well.
- Financing activities show of David and Sons LLC, that the loan was taken to run the company which is not a good sign for the company and business may consider improving to sale and decreasing to spending.
May be technically the company is growing?
We should also consider the stockholders salary and personal investments when preparing cash flow statement to see the whether the company nosediving or in a zoom zone.
