Overview of Cash Flow Statement
A cash flow statement is a financial statement that exhibits the flow of incoming and outgoing cash in an enterprise. This statement is used to assess the ability to generate and utilize cash by assessing business gains from continuous progress and external sources for cash inflow as well as a cash outflow in terms of payments made and other input charges in the business. In short, a cash flow statement records the cash flow in a business.
How do you Classify Cash Flow Statements?
Cash flow statements can be classified into the following categories:
Cash Flow Generated from Operating Activities: activities that generate significant revenue
Cash Flow from Investing Activities: acquisitions and disposals of long term assets and investments
Cash Flow from Financing Activities: activities that result in changing of size, composition and borrowing activities of a firm from other sources
What are the Objectives of Cash Flow Statements?
The cash flow statement assesses net changes in both cash and cash equivalent thus helping in the assessment of income generated through operations, financing, investing and other activities. It helps a business firm to formulate a budget plan and associated policies by assessing the cash flow statement. It also helps in managing cash efficiently.
How to Calculate Cash Flow Statements?
A cash flow statement is calculated by using two main methods: direct method and indirect method. It is important to make adjustments in the net income of a firm by adding or deducting differences in expenses, revenue, credit transactions and other non-cash things as they are evaluated in the income statement and balance sheet.
Direct Method
In the direct method of calculation, employee benefits expenses paid, cash received from trade receivables, etc., are transformed into a cash basis as items are reported on accrual data in the statement.
Indirect Method
The indirect method of cash flow statement calculation is based on the amount of net profit and loss. This includes the statements of various operational activities of a firm. It is also calculated on an accrual basis, thus, taking non-operating items into account such as interest paid, the goodwill that is written off, depreciation, etc.
Advantages
A cash flow statement helps a business owner assess net assets.
It helps in evaluating the cash-generating capability of a firm.
Aids in planning policies for profit-maximizing.
Understanding and assessing the cash flow of a firm helps in optimizing profit and sustainability.
Helps investors get an idea and judge the risk of investing in the firm.
Helps creditors understand a firm's resources in terms of liquidity and other assets as well as plan a budget for the firm's operational budget and other expenses and debts.
Limitations
Although there are huge advantages that a cash flow statement offers, there are some limitations too.
It is mostly based on secondary data
It does not take non-cash transactions into account
It does not adhere to the fundamental accounting principles
It is not a substitute for the income statement of a business
It is not totally useful in gauging the profitability of a business.
Need more help? Visit Vedantu's website and get more information and study material on this topic which you can download in PDF format for free of cost! You can also download the app and access these free resources whenever you want! Download now.
FAQs on Cash Flow Statement: Preparation and Use
1. What is a Cash Flow Statement?
A Cash Flow Statement is a financial statement that summarises the movement of cash and cash equivalents coming into and going out of a company over a specific period. It provides crucial information about a company's ability to generate cash and its needs to utilise that cash, complementing the Balance Sheet and the Profit and Loss Account.
2. What is the main purpose of preparing a Cash Flow Statement?
The primary purpose of a Cash Flow Statement is to provide insights into a company's liquidity and solvency. It helps stakeholders like investors and creditors assess the company's ability to generate positive future cash flows, meet its obligations (like paying dividends and interest), and understand the reasons for differences between net income and net cash flow.
3. How are business activities classified in a Cash Flow Statement according to Accounting Standard (AS) 3?
According to Accounting Standard (AS) 3 (Revised), cash flows are classified into three main activities to provide information that allows users to assess the impact of those activities on the financial position of an enterprise. These are:
Operating Activities: The principal revenue-producing activities of the enterprise.
Investing Activities: The acquisition and disposal of long-term assets and other investments not included in cash equivalents.
Financing Activities: Activities that result in changes in the size and composition of the owner's capital and borrowings.
4. What are some examples of cash flows from Operating, Investing, and Financing activities?
Examples for each activity include:
Operating Activities: Cash receipts from the sale of goods or services, and cash payments to suppliers for goods and to employees for salaries.
Investing Activities: Cash payments to acquire fixed assets like machinery, and cash receipts from the sale of these assets or other long-term investments.
Financing Activities: Cash proceeds from issuing shares or debentures, and cash repayments of amounts borrowed (e.g., loan repayment).
5. What is the key difference between Net Profit and Cash Flow from Operating Activities?
The key difference is that Net Profit is calculated on an accrual basis, including non-cash items like depreciation and credit transactions. In contrast, Cash Flow from Operating Activities reflects the actual cash generated or used. To get from net profit to operating cash flow, adjustments are made to remove the effects of non-cash transactions (e.g., depreciation, goodwill amortisation) and changes in working capital (e.g., debtors, creditors).
6. Why is the Indirect Method predominantly used for preparing the Cash Flow from Operating Activities in the CBSE 2025-26 curriculum?
The Indirect Method is favoured in the CBSE curriculum because it provides a useful reconciliation between the Net Profit (from the Profit & Loss Account) and the actual cash generated from operations. This method highlights the differences between net income and net cash flow, offering deeper insights into a company's earnings quality and working capital management, which is a key analytical objective for students.
7. How can a company report a high net profit but still face a cash shortage?
A company can be profitable on paper but cash-poor due to several reasons that a Cash Flow Statement reveals. For example, if a company makes most of its sales on long credit terms, its revenue and profit will be high, but the actual cash from customers may not have been received. Similarly, significant cash might be tied up in purchasing large amounts of inventory or paying off short-term loans, leading to a cash crunch despite high reported profits.
8. Why is depreciation, a non-cash expense, added back when calculating cash flow from operating activities?
Depreciation is added back because it is a non-cash charge that was deducted to calculate net profit. Since no actual cash left the business for this expense during the period, its effect must be reversed to determine the true cash flow from operations. The actual cash outflow occurred when the asset was originally purchased, which is recorded under investing activities.
9. How are interest and dividends treated in the Cash Flow Statement for a non-financial company?
For a non-financial company, as per AS-3:
Interest and Dividends Received are typically classified as cash flow from Investing Activities because they represent returns on investments.
Interest Paid is classified as a cash flow from Financing Activities as it is considered a cost of obtaining finance.
Dividends Paid are also classified as a cash flow from Financing Activities as they are a cost associated with raising equity capital.
10. What does a negative cash flow from investing activities usually signify about a company?
A negative cash flow from investing activities is often not a bad sign. It typically indicates that the company is making significant investments in long-term assets, such as property, plant, and equipment. This cash outflow suggests that the company is expanding its operations and investing in its future growth potential, which is generally viewed positively by long-term investors.
