CASH FLOW ANALYSIS

Cash flow analysis is another important technique of financial analysis. It involves preparation of Cash Flow Statement for identifying sources and applications of cash; Cash flow statement may be prepared on the basis of actual or estimated data. In the latter case, it is termed as ‘Projected Cash Flow Statement’, which is synonymous with the term ‘Cash Budget’. In the following pages we shall explain in detail in preparation of cash flow statement, utility and limitations of cash flow analysis etc. 

MEANING OF CASH FLOW STATEMENT 

A cash flow statement is a financial statement that provides aggregate data regarding all cash inflows a company receives from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period.

For example, 

If the cash balance of a business is shown by its Balance Sheet on 31st December, 1998 at Rs. 20,000 while the cash balance as per its Balance Sheet on 31st December, 1999 is Rs. 30,000, there has been an inflow of cash of Rs. 10,000 in the year 1999 as compared to the year 1998.

The cash flow statement explains the reasons for such inflows or outflows of cash, as the case may be. It also helps management in making plans for the immediate future. A Projected Cash Flow Statement or a Cash Budget will help the management in ascertaining how much cash will be available to meet obligations to trade creditors, to pay bank loans and to pay dividend to the shareholders. A proper planning of the cash resources will enable the management to have cash available whenever needed and put it to some profitable or productive use in case there is surplus cash available. The term “Cash” here stands for cash and bank balances. In a narrower sense, funds are also used to denote cash. In such a case, the term “Funds” will exclude from its purview all other current assets and current liabilities and the terms “Funds Flow Statement” and “Cash Flow Statement” will have synonymous meanings. However, for the purpose of this study we are calling this part of study Cash Flow Analysis and not Funds Flow analysis.

UTILITY OF CASH FLOW ANALYSIS 

A Cash Flow Statement is useful for short-term planning. A business enterprise needs sufficient cash to meet its various obligations in the near future such as payment for purchase of fixed assets, payment of debts maturing in the near future, expenses of the business, etc. A historical analysis of the different sources and applications of cash will enable the management to make reliable cash flow projections for the immediate future. It may then plan out for investment of surplus or meeting the deficit, if any. Thus, a cash flow analysis is an important financial tool for the management. Its chief advantages are as follows:

1.  Helps in Efficient Cash Management 

Cash flow analysis helps in evaluating financial policies and cash position. Cash is the basis for all operations and hence a projected cash flow statement will enable ill management to plan and co-ordinate the financial operations properly. The management can know how much cash is needed, from which source it will be derived, how much can be generated internally and how much could be obtained from outside.

2.  Helps in Internal Financial Management 

Cash flow analysis provides information about funds which will be available from operations. This will help the management in determining policies regarding internal financial management, e.g., possibility of repayment of long term debt, dividend policies, planning replacement of plant and machinery, etc.

3.  Discloses the Movements of Cash 

Cash flow statement discloses the complete story of cash movement. The increase in or decrease of, cash and the reason therefore can be known. It discloses the reasons for low cash balance in spite of heavy operating profits or for heavy cash balance in spite of low profits. However, comparison of original forecast with the actual results highlights the trends of movement of cash which may otherwise go undetected.

 4. Discloses Success or Failure of Cash Planning 

The extent of success or failure of cash planning can be known by comparing the projected cash flow statement with the actual cash flow statement and necessary remedial measures can be taken.

LIMITATIONS OF CASH FLOW ANALYSIS 

Cash flow analysis is a useful tool of financial analysis. However, it has its own limitations. These limitations are as under:

• Cash flow statement cannot be equated with the Income Statement. An Income Statement takes into account both cash as well as non-cash items and, therefore, net cash flow does not necessarily mean net income of the
• The cash balance as disclosed by the cash flow statement may not represent the real liquid position of the business since it can be easily influenced by postponing purchases and other payments.
• Cash flow statement cannot replace the Income Statement or the Funds Flow Statement. Each of them has a separate function to perform.

In spite of these limitations, it can be said that cash flow statement is a useful supplementary instrument. It discloses the volume as well as the speed at which the cash flows in the different segments of the business. This helps the management in knowing the amount of capital tied up in a particular segment of the business. The technique of cash flow analysis, when used in conjunction with ratio analysis, serves as a barometer in measuring the profitability and financial position of the business.

Classification of Business Activities :-

Accounting Standard-3 (Revised) requires that the changes resulting in inflows and outflows of cash and cash equivalents will be classified into following three activities:

1. Cash flow from operating Activities
2. Cash flow from Investing Activities
3. Cash flow from Financing Activities

(a)Cash Flow from Operating Activities Operating activities are the principal revenue producing activities of the  enterprise and other activities that are not investing or financing activities.

(b)Cash Flow from Investing Activities: As per AS-3, investing activities are the acquisition and disposal of the long-term assets and other investments, not included in cash equivalents.       

© Cash Flow from Financing Activities Financing activities are the activities which result in change in the size and composition of the owner’s capital (including preference share capital and borrowings (including debentures) of the enterprise from other sources.
Meaning of Cash equivalent in  Cash flows

A cash flow statement shows inflows and outflows of cash and cash equivalents from various activities of an enterprise during a particular period. As per AS-3, ‘Cash equivalents’ means short term highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value.

Thus, cash equivalents refer to such investments that are held for the purpose of meeting short term cash commitments rather than for investments or other purposes. An investment normally qualifies as cash equivalent only when it has a short maturity, of say, three months or less from the date of acquisition.

Investments in shares are excluded from cash equivalents unless they are in substantial cash equivalents, e.g., preference shares of a company acquired shortly before their specific redemption date provided there is only insignificant risk of. failure of the company to repay the amount at maturity. Similarly, short term marketable securities which can be readily converted into cash are treated as cash equivalents.

Preparation of Cash Flow Statement As Per The Recommendation of ICAI in Accounting Standard(AS-3):
As per Accounting standard, Cash flow Statement divided into three groups/heading Viz,

• Operating Activities
• Investing Activities
• Financing Activities

Difference Between Cash Flow and Fund Flow Statement