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Cash Flow Statement

A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only those sources of funds are taken which provide cash and only the uses of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored. A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash.

Objectives of Cash Flow Statement

A Cash Flow Statement provides very useful help to financial management of a business enterprise. It summarises the sources from where the cash may be obtained and the specific uses to which the cash may be applied during a particular period of time. A Cash Flow Statement has the following uses: 1 Helpful in short-term financial planning: Cash Flow Statement provides useful information to a business enterprise to make decision for its short-term financial planning. 2 Helpful in preparing Cash Budget: A Cash Budget is an estimate of cash receipts and disbursement for a future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A comparison of cash budget and cash flow statement reveals the extent to which the sources of the business were generated and used as per the plans of the business. 3 Helps to understand liquidity: Liquidity means ability of a business enterprise to pay off its liabilities when due. Cash Flow Statement helps to know about the sources where from the cash will be available to pay off the liabilities. 4 Prediction of sickness: With the help of preparing cash from operation a business enterprise may come to know about cash losses in operation. It helps to predict this type of sickness. 5 Dividend decisions: Dividend is paid within 42 days, when company declares it. Cash Flow Statement helps the management to know about the sources of cash to pay off dividend.

Operating Cash Flow - OCF

The cash generated from the operations of a company, generally defined as revenues less all operating expenses, but calculated through a series of adjustments to net income. The OCF can be found on the statement of cash flows. Also known as "cash flow provided by operations" or "cash flow from operating activities". One method of calculated OCF is:

Operating cash flow is the cash that a company generates through running its business. It's arguably a better measure of a business's profits than earnings because a company can show positive net earnings (on the income statement) and still not be able to pay its debts. It's cash flow that pays the bills!

You can also use OCF as a check on the quality of a company's earnings. If a firm reports record earnings but negative cash, it may be using aggressive accounting techniques. For 2 reasons Operating cash flow is the lifeblood of a company and the most important barometer that investors have. operating cash flow is a better metric of a company's financial health than net income. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, 'cash is king' and a company that does not generate cash over the long term is on its deathbed. By operating cash flow we don't mean EBITD (earnings before interest taxes and depreciation). While EBITD is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows. Overview of the Statement of Cash Flows The statement of cash flows for non-financial companies consists of three main parts: Operating flows The net cash generated from operations (net income and changes in working capital). Investing flows The net result of capital expenditures, investments, acquisitions, etc. Financing flows The net result of raising cash to fund the other flows or repaying debt. By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.

Accrual Accounting vs. Cash Flows

The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows: Cash is used to make inventory. Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay). Cash is received when the customer pays (which also reduces receivables). There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned.

For example, a company may legitimately record a Rs 100 Crores sale but, because that sale allowed the customer to pay within 30 days, the Rs 100 Crores in sales does not mean the company made Rs 100 Crores cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the Rs 100 Crores is still in accounts receivable. Harder to Fudge Operating Cash Flows Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits. An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "cancels" sales from the following periods (as inventories are sent back). (Note: While consignment sales are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.) The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash leakages (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem. Cash Exaggerations While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves). Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but it is also a legitimate financing strategy. The challenge is being able to determine management's intent. Cash Is King A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs. The Bottom Line Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.

Sources and Uses of Cash

The major sources of cash are as under: Cash from Operation Issue of Equity Share Capital for cash Issue of Preference Share Capital for cash Raising long term loans for cash Sale of Investments Sale of Fixed Assets Premium on Issue of Shares / Debentures etc. The major uses of cash are as under: Redemption of Preference Share Capital for cash Redemption of Debentures/ Repayment of Long-term Loans Purchase of Investment Purchase of Fixed Assets Premium on Redemption of Preference Share/Debentures Dividend Paid Taxes Paid etc.

Difference between a cash flow statement and a funds flow Statement.

Difference between Funds Flow Statement and Cash Flow Statement Basis of Difference Funds Flow Statement Cash Flow Statement Basis of Analysis: Funds flow statement is based on broader concept i.e. working capital. Cash flow statement is based on narrow concept i.e. cash, which is only one of the elements of working capital. Source: Funds flow statement tells about the various sources from where the funds generated with various uses to which they are put. Cash flow statement stars with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses. Usefulness Funds flow statement is more useful in assessing the long-range financial strategy. Cash flow statement is useful in understanding the short-term phenomena affecting the liquidity of the business. Schedule of Changes in Working Capital In funds flow statement changes in current assets and current liabilities are shown through the schedule of changes in working capital. In cash flow statement changes in current assets and current liabilities are shown in the cash flow statement itself. Causes Funds flow statement shows the causes of changes in net working capital. Cash flow statement shows the causes the changes in cash.

Principle of Accounting Funds flow statement is consonant with the accrual basis of accounting. In cash flow statement data obtained on accrual basis are converted into cash basis. DuPont Analysis A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as "DuPont identity". DuPont analysis tells us that ROE is affected by three things: - Operating efficiency, which is measured by profit margin - Asset use efficiency, which is measured by total asset turnover - Financial leverage, which is measured by the equity multiplier ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity) DuPont Analysis It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is underperforming.

Funds from business Operations

The profit loss figure, as shown in the profit and loss account of the firm, per se does not indicate the quantum of working capital provided by business operations because the revenues and expenses shown do not run parallel to the flow of working capital. The profit and loss account contains a variety of write offs and other adjustments, which do not involve any corresponding movement of funds. Therefore, appropriate adjustments are to be made to the profit disclosed by the profit and loss account to arrive at the funds from business operations. For this purpose: (i) all such expenses which have been deducted from revenue but do not reduce working capital are to be added back, (ii) such items which have been added to revenue but have not contributed to the working capital are to be subtracted, and (iii) all such revenues which are not directly caused by business operations should also be deducted and shown separately in the statement. The items requiring adjustment are listed in Exhibit: Method 1 - Adjustment to profit

(a) (b)


Net Income or Loss as shown by the profit and loss account. Add: Depreciation Expenses Amortization of goodwill, patents and other intangible assets; Amortization of discount on debentures or shares issue expenses; Amortization of extraordinary losses occurred in previous years; Loss on sale of non-current assets; Less: Amortization of premium received on debentures; Profit on sale of equipment; Profit on revaluation of non-current assets; Dividends and interest on investment (reported separately)

An alternative method of Estimating Funds from operations: The alternative method of measuring Funds provided by business operations, in actual practice, is by recasting the profit and loss account itself. To be specific, the profit and loss account should be prepared afresh so as to incorporate. (i) (ii) Only business revenue providing working capital on the income side (leaving the items which are to be deducted) Only those operating expenses which involves the use of working capital (leaving the items which are to be added)

The balancing figure of such a statement would represent, then, the amount of net working capital provided (or used) in the business operations. Funds from business operations can also be obtained from the statement of retained earnings. In order to ascertain funds from business.

Method 2- Adjusted Profit and Loss A/c (a) (b) Sales Revenues Less: Expenses using working capital: Cost of goods sold (excluding depreciation) Wages and salary expenses Manufacturing expenses Advertising expenses Insurance expenses Office expenses Other operating expenses Interest Income taxes (A-B)= Funds From Operations

Method 3 Retained earnings account as base: Operation with the help of the statement of retained earning; the following procedure should be adopted (i) (ii) (iii) (iv) Balance of profit at the end of the year requires adjustment We should add back the amount of transfer to the general reserve or any other reserve indication appropriation out of profits as these transactions merely involve the reclassification of items and do not involve any corresponding use of working capital. Payment of dividends (as it separately shown under use of the statement) should be added back. Finally, we should deduct the balance of profit at the beginning of the year.