Home » Aron Govil- What Is a Statement of Cash Flows? What Problems Can It Help Solve?

Aron Govil- What Is a Statement of Cash Flows? What Problems Can It Help Solve?

Cash is king, they say. For managers of a company, cash flow is the most important metric that needs to be taken into account when evaluating the business and its performance says Aron Govil. Cash flow is the lifeblood of a company, which cannot survive without it.

At the same time, cash is different from revenue or earnings when they are in the form of cash: they can only be realized when cash changes hands and actually becomes available for use. This is in contrast to revenues and earnings that represent what might happen if certain actions were undertaken in the future but not necessarily translated into immediate liquidity.

Cash flows can help managers account for all events that generate or deplete cash (inflows/outflows) throughout a company’s operations. They provide an indication of how much actual cash was received by a company through its operations, and how much actual cash was spent by a company during its operations.

Cash flows can be broken down into five categories:

  • Operating activities (sales and purchases of goods and services): the actual cash flow resulting from a company’s day-to-day operations.
  • Investing activities (investments in assets, including property, plant, and equipment): the cash outflow on investments made by a company to augment its production capacity or acquire newer technology.
  • Financing activities: the cash inflows/outflows arising from debt/equity raised by a company through loans or issued shares.
  • Taxation: any tax paid or received during an accounting period.
  • Cash effects of changes in liquid financial instruments. This refers to short-term liquid investments that are hold for only a short time. Before they are convert into another form, such as cash or inventories.

Statement of Cash Flows: A Simplified Example

  • To illustrate this concept better, consider a simplified example of a company’s year-end balance sheet and income statement says Aron Govil. See the table below:
  • In order to calculate net income, we must first add back interest expense because it is a financing activity. We must also adjust for taxes owed on earnings since taxes are account as an operating activity. But pay at year end after all revenues have been earn and expenses have been accrue. Then we can arrive at net income by deducting these adjustments from revenue.
  • Now that we understand how net income is arrive at, let’s see how we can substitute net income. With cash flows in order to understand a company’s health better.
  • See here for more information on examining changes in working capital and how it affects liquidity and solvency ratios.
  • Now, if we were to add back depreciation and amortization (both non-cash items) then we arrive at operating cash flow. Notice that the total is the same as net income. Which means that depreciation and amortization are accounting adjustments. That do not result in actual inflows/outflows of cash during an accounting period (all else being equal).
  • If we add back other adjustments such as changes in inventory & prepaid & accruals, then the resulting figure will give us a measure of “operating cash flow”. From here, we can subtract capital expenditures to arrive at free cash flow.

See here for more information on examining changes in working capital and how it affects liquidity and solvency ratios.

In this article, we have shown that by using a statement of cash flows. Analysts are able to calculate the amount of cash used to fund operations during an accounting period. As well as the financing activities/investing activity/taxes. That might affect a company’s net income but do not result in actual inflows or outflows of cash.

FAQs:

What is the difference between operating cash flow and free cash flow?

Operating cash flow measures how much actual cash a company brings in through its operations. On the other hand, free cash flow measures how much actual cash is over. After all investment plans have been execute by management. This means that net income and operating cash flows might be different because of one-time or non-cash items. Such as depreciation & amortization, changes in working capital (changes to assets/liabilities), etc. Free cash flow on the other hand does not include these items since they result in non-cash adjustments.

Conclusion:

In short, a company’s operating cash flow is the amount of actual cash. It brings in during an accounting period says Aron Govil. In contrast, free cash flow provides us with a clearer picture of how much actual cash is. After management has made all investment decisions for the future.

See here for more information on examining changes in working capital and how it affects liquidity and solvency ratios.