The Rationale for Preparing Cash Flow Statement
Cash Flow Statement
A cash flow statement is a report that measures and illustrates the company’s ability to generate revenues and meet its financial needs of the company.
This tool helps to understand the level of uncertainty in the company’s financial position that can affect the ability to meet business requirements in the future.
The key to a cash flow statement is to understand whether or not the company can generate sufficient cash to pay the working capital requirements.
To understand more about the cash flow statements, we will discuss how the Cash Basis in business is useful for understanding the company’s cash management and identifying and understanding financial implications.
What is a cash basis in business?
Cash basis in business is when there are no debts to be repaid or any liabilities to be incurred. At the beginning of the business, when there are no receivables or any expenses to be paid, the books of accounts will be in a state of balance. Cash basis is an accounting basis.
To determine cash flow, we need to take an accounting approach. In this method, we use the cash receipts and payout to understand the cash position of the business. A cash basis helps to understand if the cash requirement is enough to meet the working capital needs of the business.
IA7 on Cash Flow Statement
IAS 7 states that ‘information about the cash flows of an entity is useful in providing users of financial statements with a basis to assess the ability of the entity to generate cash and cash equivalents and the needs of the entity to utilise those cash flows.’ This highlights a crucial difference between the profit and loss account and the cash flow statement.
Purpose of Preparing Cash Flow Statement
The purpose of the cash flow statement is to show how the business has generated cash (for instance, by trading and raising finance) and how it has used those cash flows (for instance, to purchase fixed assets or pay dividends to shareholders).
Remember that the profit and loss account provides limited information about fixed assets (only to show how they are depreciating over time). Also, the profit and loss account does not provide information about how the company has increased sources of finance (such as ordinary shares and loans).
Numerous reasons have been advanced in favour of cash flow reporting. One of the greatest justifications is that because cash is such a critical aspect in evaluating a firm’s survival chances, cash flow information is required. Firms can collapse due to a cash constraint, not a lack of ‘accounting profitability.’
Historical cost accounting can often give an over-optimistic view of a firm’s performance, especially during rising prices.
Thus, cash flow reporting may cause a corporation to be more cautious, for example, regarding its dividend payout strategy. For instance, a business whose earnings are mostly reflected by rises in its stock and debts may choose to consider paying a high dividend. Large dividend payments to shareholders may require the company to increase its overdraft, which may not be the best course of action.
Another argument in favour of cash flow reporting is that the allocation of revenues and expenses to distinct time periods is avoided. Cash flow accounting does not involve the subjective assumptions which are associated with the profit and loss account and its reliance on accruals accounting conventions. In that sense, cash flow accounting is more objective.
Cash flow reports cannot be distorted by certain types of accounting manipulation (for instance, changing the depreciation policy or changing the basis on which provisions for doubtful debts are calculated). Moreover, cash flow statements are simpler and should be easier to understand, especially by readers of accounts who do not have a strong background in accounting.
Cash flow accounting, on the other hand, avoids time period allocation. On the other hand, the reader of a cash flow statement is left to interpret the information contained inside. Consider the example of a business that modifies its clients’ credit conditions in a given year, requiring them to pay their bills sooner than they previously did.
Conclusion
A profit and loss account would show no increase in sales revenue. But a cash flow statement would show an increase in cash received from customers, which is, of course, a benefit in terms of improved liquidity, but this could just be a ‘one-off’ benefit that could not be repeated in future years. So a cash flow statement could give the misleading impression that the business had benefited from a ‘permanent improvement in its financial performance.