What is a statement of cash flows and why is it important?
Financial statements should be prepared frequently so that the company’s financial position can be noted, and if corrections need to be made, it is much easier to make them (International Accounting Standards Board 2010, 2). There are various financial statements that are prepared periodically. They include the consolidated earnings statements, The balance sheet, and the statement of cash flows. The IAS 7 requires that the business organization presents the Statement of Cash Flows together with other primary statements.
The Statement of Cash Flows is used to show, trace and track the movements of cash and the cash equivalents in an entity over a given period. The focus is on the movements of cash held at hand in banks, short-term liquid instruments, and any investments in demand deposits. The cash equivalents listed in the Statement of Cash Flows should be easily and readily convertible without any significant fall in the current value. The expected maximum maturity date for cash equivalent is three months. The IAS 7, 7-8 require that overdrafts payable on demand and equity investments with the substance of a cash equivalent, such as preference shares acquired by an entity three months to the date of redemption, be included in the Statement of Cash Flows.
The IFRS Board defines the objective of IAS 7 as “the objective of this Standard is to require the provision of information about the historical changes in cash and cash equivalents of an entity using a statement of cash flow which classifies cash flows during the period from operating, investing and financing activities” (International Accounting Standards Board 2012, 1).
The purpose of the IAS 7 is to analyze and present any change to cash and cash equivalents in an entity during a given period. The statement outlines the changes in the most liquid assets, such as cash, demand deposits, and money market instruments, that can be liquidated in less than three months.
There are three sections in the cash flow statement per the IAS 7, 10 are the cash flows from operating, investing, and financing activities.
The cash flows from operating activities deal with flows of all cash from operations, such as the sale of goods and services, less the cost of those goods. If the difference is positive, the business will go up and vice versa (Cross 2012, 20). The operating activities form the base of revenue generation in many companies. The segment reflects cash (inflow) received from the customers for goods supplied or services rendered. The segment also has cash (outflow) paid to suppliers and employees.
Cash flows from investing activities entail the amount used to purchase capital goods for investment purposes. The section reflects the movements of cash as a result of either acquisition or disposal of investments that generate income for the entity. After some, the equipment will depreciate, thus generating a depreciation expense. If – investment occurs, the high inflows are registered, and the reverse is true.
Cash Flow from Financing Activities includes the inflow of cash generated from outside financing activities such as selling bonds and stock shares. In this case, a loan and dividend payments will be cash outflow. The financing activities entail actions that change the equity capital and the company’s borrowing structures.
Net Cash Flow from Operating Activities can be calculated in two ways. The approaches are direct and indirect methods.
The direct method is mainly used to calculate the Net Cash Flow from Operating Activities (Walton 2009, 56). The direct method shows each class of gross cash payments and receipts. The Net Cash Flow from Operating Activities can be calculated as shown below;
Cash received from sales (clients) XXXX.
Cash paid for supplier’s xxxx
Cash payments to employee xxxx
Cash payments for other operating expenses xxxx
Interest paid xxxx
Income tax payments xxxx
Net Cash Flow from Operating Activities XXXX/ (XXXX)
The indirect approach entails adjustments of the accrual basis net profit/ loss to reflect the noncash events. The Net Cash Flow from Operating Activities is calculated using the indirect approach, as shown below;
Earnings before interest and income taxes xxxx
Depreciation expenses (added back) XXXX
Amortization of goodwill (added back) XXXX
Increases in receivables xxxx
Decreases in stock xxxx
Increases in payables xxxx
Interest expense xxxx
Deduct accrued interests, not paid xxxx
Interest paid xxxx
Paid Income taxes xxxx
Net cash from operating activities xxxxx/ (xxxxx)
The IAS 7 has certain provisions in the classifications of the different elements of the cash flow statement. Cash movements from the interests and dividends may fall in any of the above classifications provided the classification is consistent for each period, IAS 7, 31 (International Accounting Standards Board 2012, 2). The cash movements from taxes’ income fall under the operating activities unless the items can be directly related to either financing or investing activities; IAS 7, 35((International Accounting Standards Board 2012, 2).
The IAS 7 25 requires effective translations of currency exchanges to harmonize any foreign currency-based transactions (Muthupandian 2008, 5). The date of the statement should act as the base rate for the currency translation in case of foreign currency-dominated transactions. However, for the subsidiaries, the translations should take place using the prevailing rate on the transaction date.
The purpose and use of the Statement of Cash Flows benefit Hope Ltd.
The Statement of Cash Flows is vital for different entities’ stakeholders. From the above analysis, it is evident that the cash flow statement is beneficial not only to the management but also to other stakeholders such as the lenders, government, competitors, employees, and customers, among others, in many ways ( Beatty, Ramesh, and Weber 2002, 74).
Hope Ltd should start preparing the Statement of Cash Flows. The Statement of Cash Flows would help the company to know its liquidity status and meet the informational needs of its stakeholders (Wustemann and Wüstemann 2010, 2). Hope Ltd’s investor’s knowledge of where to invest their money. The cash flow statement makes it easy to determine the most suitable place to invest, expecting high returns on the investment based on net cash flows and the ability to pay short-term investment outcomes. In cash flow considerations, most investors are attracted to businesses with a lot of free cash flow. Free cash flow signifies that a business can pay the debt to lenders, pay dividends to shareholders, buy stock and enhance business growth. Hope Ltd employees need to know their employers’ stability and financial health. They want to know cash availability to have security in their employment. They need information about their remuneration for the current period Basu 1997, 24; Aboody and Liu 2003, 43). Short-term lenders, such as providers of demand bank overdrafts, use the cash flow statement to determine whether the overdrafts and interests will be paid in due time. The suppliers and trade creditors need to know the business’s liquidity to determine when they will be paid for the short-term credit.
Financial statements are tools that provide useful information that will be used during the decision-making process by the managers of a business entity. Though the financial statements are based on historical data, the information gives the basis of the trend in the business, and the business entity can easily predict the outcome of a decision they make regarding a financial decision (Bellandi 2011, 12). The cash flow statement is a statement that shows how much cash flow is in the business and how much cash flow is out of the business over a given period in a year. Although the cash flow statement may not provide all information to all users, there are certain needs that it can meet for all users- the risk information.
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