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Cash Flow Can Be More Important than Profit

Cash flow is an indicator of a company's financial health. Without a positive cash flow a business may not survive, even if it is profitable.

The statement of cash flows provides information over a specified period of time. This information is useful because it reveals how well a company can generate cash from operations, financing, and investing activities. Without cash a company will be unable to maintain or expand its operating capacity, pay its employees and vendors, or pay dividends to stockholders.

The statement of cash flows consists of three sections;

  • Cash flows from operating activities
  • Cash flows from investing activities
  • Cash flows from financing activities

A cash flow statement usually begins with net income for the period and then adjustments are made to net income for any changes in operating, investing, and financing activities over a specified period of time, usually from one year to the next.

Cash Flows from Operating Activities

Measuring the changes in cash flows from operations requires a computation of the changes in account balances in the balance sheet between accounting periods. Typically, these accounts include cash, accounts receivables, depreciation, stock, accounts payable, other liabilities, and prepaid expenses. For example, depreciation expense does not actually involve any cash outlay; therefore depreciation expense for the period is added back to net income.

Changes in accounts receivable and stocks may either be added to net income or subtracted from net income depending on whether the accounts increased or decreased. For example, an increase in accounts receivable would be deducted from net income because sales were recorded, but cash was not yet received. The changes in all of the operating accounts between periods would be calculated and listed accordingly on the statement of cash flows to arrive at a net cash flow from operating activities.

Cash Flows from Investing Activities

This section of the cash flow statement recognizes any changes in equipment, assets, or investments. Selling a capital asset is considered a cash inflow, while purchasing equipment or short term assets such as marketable securities are considered cash outflows.

Cash Flows from Financing Activities

This section reflects any changes in debt, loans, or dividends. Issuing stock or increasing long-term borrowing is a cash inflow. Paying dividends or reducing debt is a cash outflow.

The net decrease or increase in cash can be determined by calculating the total cash inflows and outflows for each of the three sections of the cash flow statement and adding the totals accordingly. For example, if cash flow from operations is £123,500, cash flow from investing activities is (£42,000), and cash flow from financing activities is £5,800, the total increase in net cash is £87,300. Adding this figure to the cash balance at the beginning of the year will equal the cash balance on the balance sheet at the end of the year.

A cash flow statement can be used for many different purposes. Investors can use the statement to determine if the company has enough cash to expand operations and pay dividends. The company can use the information in the cash flow statement to measure the efficiency of operations. However it is used, the statement of cash flows is a significant tool in assessing the financial performance of any company.