The Cash Flow Statement (CFS) provides vital information about an entity. It shows the movement of money in and out of a company. It helps investors and shareholders understand how much money a company is making and spending. They examine the statement to get a good sense of whether a company’s business is financially healthy or headed for trouble. So, let’s understand about the importance of cash flow statement for the shareholders and investors.
What Is A Cash Flow Statement?
The cash flow statement refers to a financial statement that provides details about the amount of cash and cash equivalents of a business. It is a key report that highlights the changes in a company’s cash flow over a specified period of time. It helps to understand how much money an enterprise is making and spending, where the money is coming from and also how it is being spent.
Generally, all investors and shareholders of a company want to get cash out of their investment. Hence, information about a company’s receivables and payables is of key importance to the users of financial statements.
Like the other financial statements, the Cash Flow Statement is also usually drawn up annually, but it can be drawn up more often, if required.
Analysing the cash flow statement and finding out trends is called cash flow analysis. This even helps you in cash flow forecasting. To know more about it, click here.
The statement includes the cash flow from operating, investing and financing activities.
Cash Flow From Operation (CFO)
It measures how much cash a firm makes and spends as a result of core operations. The operating activities include accounts receivable & payable, inventory costs, and depreciation. Investors should have a close look at how much cash an entity generates from its operational activities; this is also advantageous for the shareholders as they can determine whether the company is in a good position and is producing cash.
Cash Flow From Investing (CFI)
This section shows changes in cash outflow that result from capital expenditures such as purchase of new property, equipment and business vehicles, including investments in instruments such as stocks and bonds.
Cash Flow From Financing (CFF)
This section includes activities such as dividend payments, loan payoffs, stock issuances, and the repurchase of bonds.
Thus, the net cash flow = cash flow from CFO + CFI + CFF
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Importance Of The Cash Flow Statement
When an investor/shareholder is conducting due diligence and projections for a particular company, it as the most important statement.
Enables investors to use the information about historic cash flows of a company for projections of future cash flows on which to base their investment decisions.
Shows the changes in the balance sheet, and helps in analysing the operating, investing and financing activities.
Provides insights about the liquidity and solvency of a firm, which is vital for the survival and growth of any organization.
Shows the financial position of an entity during a period of time.
Helps in providing information regarding the cash-generating abilities of the entity’s core activities.
Shareholders and investors tend to compare the Cash Flow Statements of different companies as it helps them to reveal the quality of their earnings.
This helps in making them the right decision.
Assuming the company has some long-term debt obligations, a Cash FlowStatement helps the investors and shareholders to determine the possibility of repayment. It can be used to easily predict the timing, amounts, and uncertainty of future cash flows.
Important Ratios For Analysis
Cash flow analysis uses certain ratios that focus on the firm’s cash flow and how solvent, liquid, and viable the firm is. Here are some of the most important ratios-
1. Operating Cash Flow Ratio:
This is one of the important cash flow ratios. Operating cash flow considers cash flows that an entity accrues from operations as related to its current debt. It measures how liquid a company is in the short run. It shows whether cash flows from operations can cover its liabilities or not.
The formula for calculating the operating cash flow ratio is as follows:
Operating Cash Flow Ratio = Cash Flows From Operations/Current Liabilities
Here, the cash flow from operation comes from the statement of cash and cash flow from current liabilities comes off the balance sheet.
If suppose, the operating cash flow ratio of an entity is less than 1.0, the entity is not generating enough money to pay off its short-term debt.
2. Cash Flow Margin Ratio
The cash flow margin ratio expresses the relationship between the cash generated from operations and sales. The firm needs cash to pay dividends, debt, suppliers, and invest in new capital assets. This ratio measures the ability of a company to translate sales into cash.
The formula for cash flow margin ratio is:
Cash flow from operating cash flows/Net sales = _____%
Here, the larger the percentage, the better.
3. Current Ratio
The current ratio tells if current assets are sufficient to meet the company's current debt. The formula to calculate this ratio is as follows:
Current Ratio = Current Assets/Current Liabilities
The ratio indicates how many times a company can meet its short-term debt and is a measure of the firm's liquidity.
4. Quick Ratio
The quick ratio, also known as or acid test, is a more specific test of liquidity than the current ratio. It takes inventory out of the equation and measures the company’s liquidity if it doesn't have inventory to sell to meet its short-term debt obligations.
The formula for the quick ratio is-
Quick Ratio = Current Assets - Inventory/Current Liabilities
If the quick ratio is less than 1.0, then the company has to sell inventory to meet the short-term debt. This is not considered to be a good position for the firm to be in.
Conclusion
Investors consider the cash flow statement as a valuable measure of profitability and the long-term future outlook of an entity. It can help to evaluate whether the company has enough cash to pay its expenses. In other words, a CFS reflects a company’s financial health.
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