Financial management principles and practices

Accounting

The Cash Flow Statement

A financial analysis looks at many aspects of a business. The greatest emphasis is usually placed on the income statements, also referred to as the profit and loss statement, and the balance sheet. However, the cash flow statement is also important, playing a complementary role showing the cash flows of the firm; showing the cash which is coming into the firm and the cash which is leaving the firm. It may be argued that this is an important as it shows the actual movements, rather than the theoretical earnings. The use accounting conventions means that costs and/or revenues may be included on accounts for different periods. For example, if a capital investment is made which is expected to have a productive life of five years, under the matching convention the cost of the equipment is written off over that fives year, so the costs match the revenues that are produced (Kimmel et al., 2010). This means in the first year the expense shown on the income statement will be much less that the actual cash leaving the firm, and in subsequent years the expenses shown on the income statement will be greater than the actual cash leaving the firm (Kimmel et al., 2010). All of the cash flows are recognized, but they are not always in the same year they occur. The same is true for revenue recognition; revenue is recognized as it is earned, not as it is received (Kimmel et al., 2010). The cash flown statement rectifies this, the purpose is not to show earnings, but the actual cash flows.

The cash flow statement looks at three different areas where cash may enter or leave the firm; operations, investment and financing. The operations section refers to the cash flow that comes into or goes out of the company as a direct result of the business's core operations (Stickney et al., 2009). The revenues generated by the business will not usually match the net income shown on the income statements. The income is adjusted so that it shows the actual cash movements to eliminate the non-cash items which were included where adding or deducting differences in the cash and the non-cash items. For example, one adjustment is adding back the depreciation which may have been included on the income statement. Another example of an adjustment is the allowance in the changes for the accounts receivable, where the amount increases from one period to the next there will be a deduction from the net revenue: where there is a decrease between periods there will be an addition to the net revenue (Stickney et al., 2009). Similar adjustments are made for items, such as expenses, taxes etc. (Stickney et al., 2009).

The second section shows the cash inflows and outflows from investing. The figures shown are the changes that have occurred on the previous year. For example, if the firm makes a capital investment, the cost of that investment will be an outflow. If there is revenue created by an investment, such as the sale of the asset, this will be a cash inflow (Stickney et al., 2009).

The third section is the financing. The main components are the changes in debt; increased debt creates a cash inflow, whereas paying off debt creates an outflow. Any capital that comes into the firm or leaves the firm is included in this section. If dividends are paid, they will be a cash outflow in the financing section. The cash flow statement will end with a net total of the cash flow from all areas and a calculation of the difference between the current and the previous period.