36: Cash Flow Analysis

B A (JMC) (3-YDC), SEMESTER SYSTEM

SEC III: PUBLIC RELATIONS AND EVENT MANAGEMENT

Unit-2: EVENT MANAGEMENT

LESSON – 36: Cash Flow Analysis

 

Objectives:

1.      Know what is a balance sheet as a financial statement.

2.      Explain the importance of balance sheet.

3.      List types of balance sheet.

4.      Learn the features of balance sheet.

5.      Understand the preparation of a balance sheet.

Introduction:

Cash flow analysis refers to the evaluation of inflows and outflows of cash in an organisation obtained from financing, operating and investing activities. In other words, it determines the ways in which cash is earned by the company. Cash flows are narrowly interconnected with the concepts of value, interest rate, and liquidity. The term 'cash flow' is mostly used to describe payments that are expected to happen in the future, are thus uncertain, and therefore need to be forecast with cash flows. It helps companies understand how well they manage their cash, and can help them identify potential cash shortages or surpluses, adjust financial strategies, make informed decisions about investing, identify inefficiencies in operations, take steps to reduce costs and improve profitability.

Symbolically Cash Flow = CF (t, N, CCY, A) where CF is cash flow, determined by its Time (t) Nominal amount (N) Currency (CCY), and Account (A). In a cash flow statement, "tN" represents a future point in time where a cash flow will occur, while "t0" represents the present time. It means "tN" is a future cash flow that needs to be discounted back to its present value using the ‘time value of money’ concept to compare it with current cash flows at "t0".  This process is known as discounting by adjusting the nominal amount of the cash flow based on the prevailing interest rates at the time.

In the previous lesson, we dealt with Cash Flow Statement. Now, we learn in detail about the history of cash flow statement, types of cash flow statement, its importance, steps to prepare it, formulas, cash flow analysis, purpose of analysis, benefits thereof and what it is for Not-for-Profit Organisations.

History:

The history of the cash flow statement can be traced back to the 19th century, when some large US and British companies began to include a document similar to a cash flow statement with their financial statements. The first known cash flow statement was produced in 1862 by the Assam Company, the first tea plantation company in the world, which showed changes in cash and cash equivalents.

The other key events in the history of the cash flow statement are - In 1863 the Manager of Dowlais Iron Company in UK created a comparison balance sheet to explain why the company had no cash to invest, despite making a profit. This statement is considered the genesis of the modern cash flow statement. In 1973, the Financial Accounting Standards Board (FASB) in the United States defined rules that required companies to report the sources and uses of funds. In 1987, FASB Statement No. 95 mandated that companies provide cash flow statements. In 1981, the Institute of Chartered Accountants of India (ICAI) issued Accounting Standard-3 (AS-3), which revised the Fund Flow Statement to include the preparation and presentation of cash flow statements.

Cash Flow Statement

Cash flow statement is one of the 3 primary financial statements. The major difference between a balance sheet and a cash flow statement is that a balance sheet shows a company's financial status at a specific date in time, while a cash flow statement also called as income and expenses statement shows the movement of cash over a period of time. Balance sheet provides a snapshot of a company's financial status and helps determine its ability to pay obligations. On the other hand, cash flow statement provides insights into a company's liquidity, operational efficiency and ability to generate cash. It categorizes cash activities into operating, investing and financing activities.

It provides an analysis of a company’s cash flow by showing how much cash is entering and leaving the business over a period of time. It helps understand a company’s financial health and operational efficiency. A cash flow statement is organised into three sections based on activities. They are (1) Operating activities, means the cash flow from a company’s core business activities such as sales and expenses. (2) Investing activities i.e. cash flow from the acquisition and disposal of non-current assets and other investments and (3) Financing activities that means cash flow from debt and equity.

Cash flow statement helps companies with (1) Liquidity management to ensure that a company has enough cash to pay its bills and other financial obligations (2) Financial planning to make informed decisions about investments, expansions and other financial activities (3) Debt management in assessing the company’s ability to repay its loans and make informed decisions about borrowing and repayment and (4) Investment decisions by assessing the potential return on investment and the risks involved. 

Importance of Cash Flow Statement

The adage is “Revenue is vanity, Profit is sanity, but Cash is king.” It means that while a high revenue figure might seem impressive, it is not a true indicator of a healthy business unless it is making a profit. However, the most important factor is having readily available cash on hand, as it represents the real financial stability and power of a company. Cash flow statements can help businesses navigate the need for positive cash-related activity. There are strong reasons why a flow statement of cash is important. Here are eight reasons why a cash flow statement might be useful for a business:

1.      Insight into spending activities: Cash flow statements give a holistic picture of the different payments companies make that are not typically reflected in a profit and loss statement. For instance, if a company took out a loan and is paying it back, those payments would not be included in a profit and loss statement. Comparatively, this information would be included in a cash flow statement, providing insight into the actual cash the business has spent. To know where the business is spending money, a cash flow report can give a precise portrait of outflow.

2.      Short-term planning: Cash flow statements are especially useful to companies when it comes to short-term planning. All companies must stay solvent to avoid bankruptcy and meet obligations, such as paying wages, operating costs and more. Because cash flow statements provide a detailed report on how much cash a business has on hand at a given time, they can help financial managers project the cash flow in the near future and keep track of spending to meet specific, short-term goals.

3.      Better picture of cash planning results: Businesses typically create cash plans to follow and ensure that their ventures are successful. Despite this, there are times when businesses are not able to execute their cash plans perfectly or meet the objectives identified during the planning period. A cash flow statement can help companies analyze whether their cash planning was actually effective by allowing readers to compare projected cash flow numbers to actual cash flow results. Companies can use this information to make more accurate projections in the future.

4.      Ability to increase cash inflow: When businesses have data regarding their current inflow and outflow, they can focus on creating cash from activities other than earning profits. While profit inevitably helps to create cash, there are other ways to do so, and sometimes these methods can be more lucrative overall. For instance, if a company's employees find that they are spending a lot of money on inventory, they can try to create excess cash by optimizing operations, such as using inventory efficiently to collect receivables faster.

5.      Improved knowledge of cash balance: It is vital for business owners and stakeholders to know the optimal amount of cash they need to operate successfully. This is one of the most important things a cash flow statement can accomplish. With such a statement, companies can analyze whether they have an excess or deficit of funds. If a company has an excess of cash, they can invest that money, and if they are in a deficit situation, they can turn to external lenders or investors to reach their optimal cash balance.

6.      Working capital analysis: Working capital is defined as the funds that are currently available to businesses, like the amount of cash, deposits or other reserves kept on hand to manage operational and day-to-day expenses. Cash flow statements can help business executives, investors and other stakeholders analyze the working capital movement within a given company. This analysis makes it easier for a business to improve its operations in order to preserve cash and improve inflow numbers.

7.      Long-term planning: Similar to short-term planning, cash flow statements can help financial managers plan for the long term. A company's growth is dependent on accurate financial planning, and a cash flow statement can help managers identify specific, implementable changes. These changes could very well situate the business within a solid financial position over time. In essence, a cash flow statement helps financial managers understand what activities a company needs to prioritize.

8.      Crisis management: Because a cash flow statement gives business stakeholders insight into whether they have a shortage or excess of cash on hand, the report can help with crisis management. If a manager can project a potential cash shortage in a company's future, they may be able to come up with ways to help the company overcome such a challenge ahead of time. This can make an enormous difference in a company's ability to reach its goals.

Types of statements:

There are two methods to calculate a company's cash-flow. These methods differ in how they calculate cash flows from operating activities, with the direct method listing actual cash inflows and outflows, while the indirect method reconciles net income to cash flow by adjusting for non-cash items like depreciation. Key points about the two types of cash flow statements are -

a)      The direct method of calculating cash flow from operating activities is a straightforward process that involves taking all the cash collections from operations and subtracting all the cash disbursements from operations. This approach lists all the transactions that resulted in cash paid or received during the reporting period.

b)      The indirect method of calculating cash flow from operating activities requires to start with net income from the income statement and make adjustments to “undo” the impact of the accruals made during the reporting period. Some of the most common and consistent adjustments include depreciation and amortization.

The direct and indirect methods will result in the same number, but the process of calculating cash flow from operations differs. While the direct method is easier to understand, it is more time-consuming because it requires accounting for every transaction that took place during the reporting period. Most companies prefer the indirect method because it is faster and closely linked to the balance sheet.

Steps to prepare a Cash Flow Statement

We already know that a typical cash flow statement comprises three sections that is cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In order to make out a cash flow statement there are certain steps followed. Let us look at them.

1.      Determine the starting balance: The first step in preparing a cash flow statement is determining the starting balance of cash and cash equivalents at the beginning of the reporting period. This value can be found on the income statement of the same accounting period. The starting cash balance is necessary when leveraging the indirect method of calculating cash flow from operating activities. However, the direct method doesn’t require this information.

2.      Calculate cash flow from operating activities: With starting balance, one needs to calculate cash flow from operating activities. This step is crucial because it reveals how much cash a company generated from its operations. Cash flow from operations are calculated using either the direct or indirect method.

3.      Calculate cash flow from investing activities: After calculating cash flows from operating activities, it is necessary to calculate cash flows from investing activities. This section of the cash flow statement details cash flows related to the buying and selling of long-term assets like property, facilities and equipment. Keep in mind that this section only includes investing activities involving free cash, not debt.

4.      Calculate cash flow from financing activity: The third section of the cash flow statement examines cash inflows and outflows related to financing activities. This includes cash flows from both debt and equity financing i.e. cash flows associated with raising cash and paying back debts to investors and creditors.

5.      Determine the ending balance: Once cash flows generated from the three main types of business activities are accounted for, one can determine the ending balance of cash and cash equivalents at the close of the reporting period. The change in net cash for the period is equal to the sum of cash flows from operating, investing, and financing activities. This value shows the total amount of cash a company gained or lost during the reporting period. A positive net cash flow indicates a company had more cash flowing into it than out of it, while a negative net cash flow indicates it spent more than it earned.

Cash Flow Formulae:

There are several formulas for calculating cash flow and the four important formulae are:

a)      Free cash flow: It is net income + depreciation/amortization (non-cash expenses) - change in working capital - capital expenditure.

b)      Net cash flow: It is cash receipts – cash payments i.e. the difference between total cash inflows and total cash outflows.

c)      Operating cash flow: It is net income + non-cash expenses - change in working capital i.e. operating income + depreciation – taxes + change in working capital.

d)      Cash flow forecast: It is beginning cash + projected inflows - projected outflow = ending cash.

e)      Cash flow from financing activities: Cash inflows from issuing equity or debt - cash paid as dividends + repurchase of debt and equity

Cash flow is therefore calculated by comparing cash coming in with cash going out over a period of time.

Purpose of analysing cash flow:

As enumerated in the formulas, cash flow analysis will examine (1) Cash inflows i.e. money coming into the business from sales, investments, loans, etc. (2) Cash outflows that means money leaving the business for operational costs, debt payments, capital expenditures, etc. (3) Operating cash flow indicates cash generated from core business activities. (4) Investing cash flow is cash used for buying or selling assets and (5) Financing cash flow means cash raised from or paid back to investors and creditors.

The purpose of cash flow analysis is to assess a company's ability to generate cash, meet financial obligations and understand the sources and uses of cash within the business, providing insight into its financial health and allowing for informed decisions regarding investments, operations, and future growth potential by identifying potential cash shortages or excesses. Key points about cash flow analysis are that (a) It reveals how much cash a company has readily available to cover expenses and pay debts. (b) It identifies where the cash inflows are coming from, like sales, loans or investments. (c) By analyzing cash flow, investors can gauge a company's ability to weather economic downturns. (d) Cash flow analysis helps businesses make informed decisions about capital expenditures, expansion plans, and debt management.

Benefits of Cash flow analysis:

1.      Short term planning: A cash flow statement is an important tool that can be used for planning in the short term, and to control cash. Every business must have sufficient liquid assets that will allow them to meet the different financial obligations as and when they become due. Cash flow statements enable the finance department to project the cash flow for the upcoming period, basing it on past cash inflows and outflows.

2.      Provides the details of expense heads: Certain payments made by the company do not show up in the profit and loss statement, but they reflect in cash flow statements. The cash flow statement shows in detail where exactly the business spends its money. We can understand this better with an example. Let us suppose a company has taken a loan and is paying the principal amount off; this will not turn up in the Profit & Loss statement, but it will be reflected in the cash flow statement. Again, a situation where the company is profitable but lacks the liquidity to pay off its dues. This kind of issues can be easily detected with the cash flow analysis.

3.      Creates additional cash: The primary aim of any business is to be profitable, and it is the profit that helps in creating cash. However, there are other ways in which cash can be created in a business, and these can be identified by analyzing cash flows. If one depends solely on profit and loss statements, creating additional cash can be very difficult. For example, more efficient use of inventory, collecting receivables quicker from customers, and so on, can help bring in excess cash and this information is available in the cash flow statement.

4.      Revealing the cash planning results: Cash flow statements help companies evaluate the success of their cash planning by comparing the actual results with the projections laid out in the cash budget or statement. These insights will help businesses take better decisions for the future. The difference between the projected and actual expenditure can be recognized and factored into the projection for the next financial period.

5.      Long term planning: Cash flow analysis and prepared cash flow statements help businesses plan long-term cash requirements. Business growth depends on the savvy long-term financial planning the company does. The cash flow statement uncovers the crucial changes a company must make in its financial planning and allows the management to prioritize important activities. For example, the cash flow projection can help management to determine the ability of the business to repay long-term debts as it depends on cash availability.

6.      Knowing the optimal cash balance: Cash flow statements also help businesses to determine the optimal cash balance level, which helps management to see if there is an excess or shortage of cash and if funds are lying idle. These factors help businesses to take smart decisions around cash planning. If the statement shows a cash surplus, and there are funds lying idle; this money can be invested. On the other hand, if there is a deficit, money can be borrowed in time to overcome the deficit.

7.      Helps in working capital analysis: Working capital refers to the liquid assets like cash that the business has in hand to run its daily operations. It is important for investors to be aware of the movement of the working capital of a business. Cash flow can be increased by collecting receivables faster, settling payables later, and so on.

Cash flow for NPOs

Organisations are generally two kinds. One kind is For-Profit and the other is Not-for-Profit. For profit organizations focus is on cash flow derived from sales and revenue generation, while Not-for-profit organizations primarily rely on donations and grants, leading to a greater emphasis on managing irregular income streams and restricted funds when analyzing their cash flow. Essentially, profit organizations prioritize maximizing profits through sales, while non-profits prioritize using funds effectively to fulfil their mission, often with limitations on how donated money can be spent.

Non-profit organizations may need to prepare separate cash flow statements for different purposes.

1.                  Internal reporting: Non-profit organizations may prepare a cash flow statement for internal purposes, as it helps to monitor their financial performance and manage their cash flow. This statement typically includes more detailed information about the organization's cash inflows and outflows than a cash flow statement prepared for external financial reporting. It may also include future cash flow projections to help with budget planning.

2.                  Donor and grant reporting: Many non-profits that receive money from donors or grant funding may be required to prepare a cash flow statement. This statement often provides detailed information illustrating how the organization used the donated money, such as the donor contribution or grant award amount, how the organization spent the funds, and any matching or in-kind contributions.

3.                  External financial reporting: Non-profit organizations may need to prepare financial statements, including a cash flow statement, for external financial reporting purposes. Non-profits may also include a statement of cash flows in their annual report to provide stakeholders with a summary of the organization's financial performance.

The cash flow components for profit organisations are thus cash received from sales, payments to suppliers, employee salaries, operating expenses, investments and returns. For non-profit, they are donations from individuals and corporations, grant funding, fundraising event proceeds, program expenses and administrative costs.

Summary:

A cash flow statement is a financial statement that shows the amount of cash a company receives and spends over a period of time. It is a useful tool for analyzing a company's liquidity, financial health, and ability to generate cash. It summarizes a company's cash inflows and outflows, and the change in its cash position. It breaks down these activities into three areas namely operating, investing, and financing. It can also help determine a company's short-term viability and its ability to pay bills. It can be used to assess a company's financial health and how well it manages its cash. Accounting personnel, potential lenders, creditors, investors, and employees may use a cash flow statement to understand a company's financial situation. Cash flow analysis can involve looking at the margin of difference between cash inflows and outflows. A low margin of difference may indicate that a company is investing in its financial health, while a high margin of difference may indicate that it is not. Positive cash flow means that more money is flowing into a company than out of it. This can allow a company to reinvest in itself, pay off debt and grow.

Frequently Asked Questions (FAQs):

1.        Explain briefly about cash flow statement.

2.        What do you understand by cash flow analysis?

3.        What is the purpose of analysing cash flow?

4.        Explain the two types of cash flow statement.

5.        What are the benefits of cash flow analysis?

Model answers to FAQs:

1.      The Cash flow statement is one of the 3 primary financial statements. The major difference between a balance sheet and a cash flow statement is that a balance sheet shows a company's financial status at a specific date in time, while a cash flow statement also called as income and expenditure statement shows the movement of cash over a period of time. Balance sheet provides a snapshot of a company's financial status and helps determine its ability to pay obligations. On the other hand, cash flow statement shows the flow of cash in and out of a company over a period of time. It provides insights into a company's liquidity, operational efficiency and ability to generate cash.

2.      Cash flow analysis refers to the evaluation of inflows and outflows of cash in an organisation obtained from financing, operating and investing activities. In other words, it determines the ways in which cash is earned by the company. The term 'cash flow' is mostly used to describe payments that are expected to happen in the future, are thus uncertain, and therefore need to be forecast with cash flows. A cash flow (CF) is determined by its time t, nominal amount N, currency CCY, and account A; symbolically CF = CF (t, N, CCY, A).

3.      The purpose of a cash flow analysis is to assess a company's ability to generate cash, meet financial obligations, and understand the sources and uses of cash within the business, providing insight into its financial health and allowing for informed decisions regarding investments, operations, and future growth potential by identifying potential cash shortages or excesses. Key points about cash flow analysis are that (1) It reveals how much cash a company has readily available to cover expenses and pay debts. (2) It identifies where the cash inflows are coming from, like sales, loans, or investments. (3) By analyzing cash flow, investors can gauge a company's ability to weather economic downturns. (4) Cash flow analysis helps businesses make informed decisions about capital expenditures, expansion plans, and debt management.

4.      The two types of cash flow statements are direct method and indirect method (a) The direct method of calculating cash flow from operating activities is a straightforward process that involves taking all the cash collections from operations and subtracting all the cash disbursements from operations. This approach lists all the transactions that resulted in cash paid or received during the reporting period. (b) The indirect method of calculating cash flow from operating activities requires you to start with net income from the income statement and make adjustments to “undo” the impact of the accruals made during the reporting period. Some of the most common and consistent adjustments include depreciation and amortization.

5.      There are several benefits in analysing cash flow in an organisation be it FPO or NPO. They are (a) short term planning to control cash (b) showing in detail where exactly the business spends its money (c) for creating additional cash (d) revealing the cash planning results (e) long term planning for cash (f) to know and understand the optimal cash balance and (g) help in analysing working capital analysis. It is important to be aware of the movement of the working capital of a business. Cash flow can be increased by collecting receivables faster, settling payables later, and so on.

Multiple Choice Question (MCQs):

1. Cash flow (CF) is determined by and symbolically expressed as ______________.

a)      CF (N, t, CCY, A)

b)      CF (t, N, CCY, A)

c)      CF (A, N, CCY, t)

d)      CF (N, A, t, CCY)

2. The first known cash flow statement was produced in 1862 by _______________.

a)      Assam Tea Company

b)      Indian Branch Railway Company

c)      Jamalpur Locomotives

d)      Indian Audit & Accounts Department

3. The ____ &_____methods are the two ways to calculate a company's cash-flow.

a)      Simple & Elaborate

b)      Arithmetic & Composite

c)      Open & Close

d)      Direct & Indirect.

 

4.  _________ is the amount of cash generated from core business activities during a period.

a)      Investing cash flow

b)      Financing cash flow

c)      Free cash flow

d)      Operating cash flow

5. Not-for-profit organizations primarily rely on _______________.

a)      Asset and Liabilities

b)      Profit and Loss

c)      Donations and Grants

d)      Income and Expenditure

 

Keys to MCQs: 1(b) 2(a) 3 (d) 4(d) 5(c)

Glossary:

Cash: It is the money a business has available and is considered a current asset on the balance sheet. It is the money that can be used immediately or is readily available for withdrawal

Fund: A fund is a collection of different people's money, collected & managed by high market professionals. Money accumulated and invested in various stocks, bonds, and other securities to provide better returns.

Currency: It is the monetary unit used to record a company’s transactions and present its financial statements. It is also known as the reporting or presentation currency.

Analysis: It is the process of examining financial data to assess a company’s financial health and performance.

Debt: It is a liability that represents a financial obligation to pay back money at a later date. Debt can be incurred by individuals and businesses and can take many forms like loans, credit cards, bonds, accrued expenses like unpaid salaries etc.

Equity: The value of a business’s owners’ interest after substracting all liabilities from total assets. It is also known as stockholders’ equity for corporations and owner’s equity for sole proprietorships and partnerships.

Depreciation: A process of spreading the cost of a physical asset over its useful like and is a non-cash expense that reduces the asset’s value

Amortization: A technique used to periodically reduce the book value of a loan or intangible assets across a set period. When applied to an asset, amortisation is slightly similar to depreciation.

Liquidity: Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. Cash is the most liquid of assets, while tangible items are less liquid.

Formula: Generally, a fixed pattern that is used to achieve consistent results. It might be made up of words, numbers, or ideas that work together to define a procedure to be followed for the desired outcome.

Key words: Cash flow, Assets, Fund, Analysis,

Y. Babji, 

Editor, Public Relations Voice, 

Academic Counsellor, Public Relations (since 1989) 

at AP Open University/Dr BR Ambedkar Open University