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Introduction
Now that we have covered the profit & loss statement and the balance sheet, it is time to focus on the cash flow statement. The cash flow statement is a very simple yet powerful financial statement. As its name suggests, it simply provides details of all the cash transactions incurred during a period. For investors to understand this financial statement, it is crucial to understand more about its history, structure, and contents.
What is a cash flow statement? Why do we need a cash flow statement?
After the profit and loss statement and the balance sheet, the cash flow statement is the third and final component of the modern accounting framework. By aggregating the cash that comes in and goes out under different heads, the cash flow statement gives its readers one crucial number: net cash flow. This is the change in the total cash available with a company during the accounting period.
But to understand why investors need to know the net cash flow, one needs to step back and understand the profit and loss statement. As any person reading a profit and loss statement probably knows by now, a company that claims to have a revenue of Rs 100 in a particular year need not have received the entire Rs 100 in reality. This seemingly illogical outcome is not by accident but by design. It turns out that there are certain advantages of not basing an entire accounting system solely on when the cash was actually received. This principle is called accrual-based accounting and it is the bedrock of modern financial accounting standards.
But unfortunately, just like how there are two sides to a coin, there is also a disadvantage of using an accrual-based accounting system. The disadvantage is that it creates a gap between the quantity of net profit stated in the profit and loss statement and the net cash profit (as is reflected in the bank account). And it is in understanding this crucial gap (between the profit and loss statement and the actual bank balance in a company) that the cash flow statement becomes vital. It is the only statement that does not work based on accrual accounting and can focus on the concrete quantity of cash transactions.
How is it structured?
A cash flow statement consists of three sub-statements, which are: Cash Flow from Operations, Cash Flow from Investing and Cash Flow from Financing. The basic premise is that all activities of a company can be segmented into three broad buckets, i.e., operation, investment, and financing. And when the sum of the aggregate cash flows in each of these buckets is taken into account, it would give the investor the net cash flow (inflow/outflow) during the reporting period.
How is it useful?
In simple words, the cash flow statement acts as a check on the management's ability to get away with creative accounting choices. By shunning the accrual system and emphasising cash transactions, investors can easily identify any shenanigans that the company may have used to dress up its numbers.
For example, if a company decides to sell its goods and services to customers on credit aggressively (Buy Now Pay Later), it would be detectable as there would be no impact on the cash flow statement. However, the profit and loss statement would show an increase in revenue. Similarly, the cash flow statement will also be able to identify any underreporting of expenses compared to the actual cash paid.
Another valuable feature of the cash flow statement is that it enhances the comparability of operating performance amongst different businesses (in varied sectors) because it eliminates the effects of varied accounting treatments that are prescribed for similar transactions.
Key takeaways
When used in conjunction with the rest of the financial statements, the cash flow statement provides valuable information about a company's operations. Investors must always keep a close eye on this financial statement, which is disclosed every six months (as per current regulations).
We will give more information about each sub-statement so that readers can appreciate the finer nuances and use them to make better investment decisions.
A summary of the cash flow statement for every listed company is freely accessible on Value Research Online. Details are available under the 'Financials' tab.
Also in the series:
Cash flows: Operating activities
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