Calculating the cash flow statement is a lengthy process, one which involves several variables. Along with the company’s income, you have to include the expenses, credit, payments, receipts, etc. After jotting them down and their corresponding figures, the accountants are supposed to find out that one figure we discussed above, closing cash balance.
Along with cash-based items, they include the non-cash items or cash equivalents to complete the balance sheet’s assets and liabilities column. And this is because there are several elements included in the same, which makes calculating the entire statement complex.
Hence, there are four constituents of cash flow statement analysis and preparation
1. Direct Presentation or Direct Cash Flow System
The direct method is a straightforward representation of all payments and receipts done every day. These are the activities that include payment to suppliers, money earned from customers, salaries, etc.
Example:
In this, the accountants calculate the beginning and the ending of the statements concerned with various individual accounts. In the end, a net increase or decrease in volume is calculated.
Direct cash flow systems work very well for small companies, but we cannot say the same for the bigger ones. With small companies, it is easy to keep a record of all the receipts and cash payments. But as the company grows, the volume and amount of cash inflow-outflow increase, not to mention the number of sources. So, it makes the entire exercise complex.
With the direct method included in cash flow statement analysis, the aim is to determine “Net Cash Flow from Operating Activities.” And to find this, we need to know;
- Cash flow coming in from revenue
- Payment made for expenses
| Cash Received from Customers: Receipts = Sales + Beginner AR – Ending AR (AR- Account Receivables) Cash Paid to Suppliers: Payments = COGS + Ending inventory – Beginning Inventory + Beginning AP – Ending AP (COGS: Cost of Goods Sold; AP: Accounts Payable) Cash Paid to Employees: Payments = Wages Expenses + Beginning WP – Ending WP (WP: Wages Payable) Cash Paid for Expenses: Payments = Expenses + Ending prepaid expenses – Beginning prepaid expenses + Beginning accrued expenses – Ending accrued expenses Interest Received: Receipts = Interest income + Beginning IR – Ending IR (IR: Interest Receivable) Dividend Received Receipts = Dividends income + Beginning DR – Ending DR (DR: Divided Receivable) Interest Paid Payments = Interest expense + Beginning IP – Ending IP (IP: Interest Payable) Income Tax Paid Payments = Income tax expense + Beginning TP – Ending TP (TP: Tax Payable) |
Subtracting these two will give us the income before taxes. But when you deduce the cash required to pay taxes, the final amount is the net cash flow from operating activities.
2. Indirect Cash Flow
Under this method of cash flow statement analysis, three things matter;
- Comparative balance sheets of two years.
- Current year income statement
- General ledger
With the indirect method of cash flow analysis, we need to take the company’s net income off the statement. The reason is accrual accounting, which means that any revenue is recorded when it is earned and not when it is received. As a result, we need to adjust the earnings made by a company before interest and taxes or EBIT.
EBIT Formula:
Revenue – Cost of Goods Sold – Operating Expenses
OR
Net Income + Interest + Taxes
EBIT Example:
3. Accounts Receivable and Cash Flow
Although Accounts Receivable (AR) is a balance sheet component, it is included in the cash flow after the following considerations. The changes in AR from one year to another (accounting year) are included in the cash flow statement. Accrued AR means more cash for the company which is yet to be realized.
Follow the two-step method to calculate the Account Receivables:
Step 1: Beginning AR + Ending AR / 2 = Net AR
Step 2: Net Credit Sales / AR = AR Turnover
Within this, we must also understand the role of operating cash flow and its impact on Account Receivables. But first, what is Operating Cash Flow?
Operating Cash Flow or OCF represents the amount of cash generated in a company via its regular business operations. We can also say that the operating cash flow is the pulse of the company and a measure of the company’s ability to sustain operations.
A positive cash flow is good for the company as it determines financial success and a negative cash flow says otherwise.
Operating Cash Flow Formula:
Operating Cash Flow = Net Income +/- Non-Cash Expenses – Changes in Assets and Liabilities
Working method of operating cash flow is as follows:
With the current figures in hand, the accountants can also forecast the cash flow for a fixed period in the future. The purpose of predicting the cash flow is to know the future payments and receipts a company can expect while taking into account the current cash flow figures.
Forecasting the cash flow begins with selecting a time. For our example, let’s take 6-months as the timescale to estimate the value of transactions in this period. In the next step, list out the cash you will receive. This includes the sales forecast, with a focus on recurring invoices and other cash receivable like investment inflows, asset sales, and tax rebates.
On the other side, list all the expected expenses like overhead costs, including salaries, rents, lease payments, taxes, etc. With these two figures in hand, subtract the Cash spent from the cash received, and you will have the net cash flow.
4. Value of Inventory
The same as AR impacts the cash flow statement and the amount of cash in a company, the inventory, also impacts. More inventory than the previous year means that the company has spent more money than last year on inventory. The value of inventory and how you have paid for it impacts the cash flow. When purchasing inventory with cash, the money spent here is deducted from net earnings.
Source: Pxhere
On the contrary, a decrease in y-o-y inventory and we must add it to the net earnings/income. If the company bought the inventory on credit, it would go under accounts payable on the balance sheet.
How Do You Do Statements Of Cash Flow Using Direct & Indirect Methods?
The direct and indirect method of cash flow statement is the most popular and widely used in accounting. For preparing the statements under these methods, you must know the components and how they interact.
Below you will find the accounts and their items included in the Direct Method cash flow statement.
1. Direct Method
The precise components coming under this method are;
- Cash Flow from Operating Activities:-
- Receipt from customers
- Payment to suppliers
- Payments to employees
- Cash accumulated from operations
- Interest paid
- Income tax paid
At the end of this, we will get Net Cash from Operating Activities.
- Cash Flows via the Investing Activities
- Property, plant, and equipment purchase
- Receipts from the sale of equipment
This will give Net Cash from Investing Activities
- Cash Flows via Financing Activities
- Benefit from issuance of Employee stock ownership plan (ESOP)
- Proceeds from issuance of long-term debt
- Principal payments made
- Dividends payment
Here you will get Net Cash in Financing Activities.
The final amount with the Direct method for cash flow statement will be made by calculating all the above items, which will give us a Net Increase in Cash and Cash Equivalents. We can find the Cash and Cash Equivalent at the end of the period by adding Cash and Cash Equivalent at the beginning of the period to Net Increase in Cash and Cash Equivalent.
Let’s assume that the Net Increase in Cash and Cash Equivalent is ₹360,000 and the Cash Equivalent at the beginning of the period is ₹140,000.
Then the Cash and Cash Equivalent at the End of the Period will be ₹360,000 + ₹140,000, which equals to ₹500,000
2. Indirect Method
- Cash Flows from Operating Activities
- Net income
- Adjustments made for – Depreciation and Amortization, Provision of losses on accounts receivable, and gains of sale of the facility.
- Increase in trade receivables
- Decrease in inventories
- Decrease in trade payables
From here, we will get cash Generated from Operations.
- Cash Inflows from Investing Activities
- Property, plant, and equipment purchase
- Receipts from the sale of equipment
This will give Net Cash Utilized in Investing Activities.
- Cash Flows from Financing Activities
- Benefit from issuance of ESOPs
- Proceeds from issuance of long-term debt
- Dividends payment
The calculation of these items will get Net Cash Used in Financing Activities.
The final amount with the Indirect Method for the cash flow statement will be made by calculating all the above items, which will give us a Net Increase in Cash and Cash Equivalents. We can find the Cash and Cash Equivalent at the end of the period by adding Cash and Cash Equivalent at the beginning of the period to Net Increase in Cash and Cash Equivalent.
Let’s assume that the Net Increase in Cash and Cash Equivalent is ₹360,000 and the Cash Equivalent at the beginning of the period is ₹140,000.
Then the Cash and Cash Equivalent at the End of the Period will be ₹360,000 + ₹140,000, which equals to ₹500,000
How does the Cash Flow Statement work With The P&L Statement And The Balance Sheet?
- Cash Flow Statement: This is a summary of the amount of cash and cash equivalent going out and coming into a company.
- Balance Sheet: A statement of the company’s assets, liabilities, and equity recorded in one place.
- Income Statement: An account or financial statement showing the company’s income and expenses.
You will find that the balance sheet and income statement influence the calculation of the cash flow statement. We can say that a cash flow statement, income statement and the balance sheet are highly interrelated. For instance, the net income we get in the income statement becomes a part of the retained earnings in the balance, which ultimately, modifies the equity amount on the balance sheet.
Another example is when we add the outstanding loan amount in liabilities under the balance sheet, it reflects in the cash flows from financing activities in the cash flow statement.
This is because the income statement is the record of revenue and expenses created on an accrual basis. On the other hand, the balance sheet tells us about how transactions included in the balance sheet affect various accounts included in the cash flow statement.
The earnings we get from the income statement is the leading figure which helps deduce the cash flow statement. With the balance sheet, take two cash flow statements into account, for the current year and one for the previous year. The Net Cash Flow from one statement to another should represent the increase or decrease in the cash on the balance sheet for the same two consecutive periods.
Example Of A Cash Flow Statement
Again, we cannot pinpoint the exact items of a cash flow statement that works for your organization. Below are a few examples of cash flow statements prepared by different companies according to their requirements.
Conclusion
The cash flow statement is a valuable and crucial element of the company and helps us identify the company’s strength and profit. Along with this, it is relevant for the long-term business analysis of the company while helping us know the company’s scope and potential to grow.
As we have discussed earlier, investors, banks, and other financial institutions use cash flow statements to assess the company’s current financial standings. So, it is imperative that every organization, no matter its scale and volume, must create a cash flow statement at the end of every year.
