How to form a cash flow statement (1)

Cash flow statement is one of the financial statements prepared by the company for each financial period. It is important  so we will review some of its terms , its target and how to analyze  and read it correctly . It is known that the income statement is based on accruals as it records every revenue  or expense during the period either paid or not . For example the rent of the management office of June is 10000 and the it will be paid in July , the company makes a monthly accrual entry in June for the rent .

A cash flow statement form 

It is the same in the case of revenues, the company records them even if they are not collected yet . In contrary the cash flow statement is based on cash (  payments, cash collection  ) . Any non-cash expense or revenue is excluded  and terms are adjusted . Cash flow statement is easy to prepare but we have to know how to analyze it and connect it to the other financial statements and fix any problem.

The importance and use of cash flow statement :

If the income statement of my company shows one million pounds as profits but at the end of the period I found 150000 cash . Here comes the importance of the cash flow statement which fixes the difference between profitability and liquidity numbers and if the reason is due to any management problem  or a normal one .

The difference between profitability and liquidity numbers:

The cash flow statement shows the outcome net cash of operational , investment and financial activities . Then it analyzes the terms of each activity to fix any fault or failure  in comparison with numbers of other financial statements . The difference between profitability and liquidity numbers  is not an indicator of good or bad administration , it is the financial analysis that answers this question . For example , if the company income statement records loss but  the cash rate is high this can be due to assets sale or a loan taken by the company at the end of the financial period .

Financial analysis of financial statements :

When the company faces any liquidity problem during the financial period or problems in paying its liabilities for suppliers, creditors or employees’ salaries , here comes the role of cash flow statement to deal with reasons of liquidity crisis which is known as company credit policy evaluation , sales and purchases  evaluation in general and the forward processes in particular.

Banks and financial and investment organizations pay a special concern to cash flow statements (on the level of operational , investing and financial business) specifically operational business , because they want to know the net cash flow of this business and reasons of its increase or decrease in order to determine the ability of the establishment to pay the loans and interests and also its ability on the basis of profits distribution.

How to form the cash flow statement?

The analysis is performed over different periods of time to obtain  reliable results. Now we are aware of the importance of cash flow statement and its role in determining the effectiveness of liquidity, operational profits and the company ability to pay for its liabilities regularly or not . 

It is time to know how to form a correct cash flow statement and the included terms .

First , the final number in the cash flow statement which is the net cash balance at the end of the period must be the same number existed in the financial statement ( the amount of cash in active assets ) .

Some important facts about cash flow statement :

Cash flow statement consists of 3 main activities that include a set of terms :

Activity 1 : operational activity net cash flow :

The accounts of the company operating processes such as warehouse , clients’ , suppliers’ accounts  ,other creditors’ and debtors’ balances and income tax payments .

Activity 2 : Investment activity net cash flow :

The accounts of selling and buying fixed assets and investments in sister companies and available investments .

 Activity 3 :financial activity net cash flow :

The accounts of company financing either locally through issuing stocks or external financing via loans and facilities.

Cash flow statements has 2 methods :

A direct and an indirect methods. Of course the resultant will be the same but the difference is in the way of reviewing terms of  operational , investment and financial business.

Operational  business is different in displaying the cash flow statement value as each term is reviewed to calculate the amount of receipts from clients and payments for suppliers then then the same is repeated with investment and financial business .  

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Examples of cash flow statements 

If you use the direct method you will have to conclude the statement with an adjustment of  net profits before adding taxes in the income statement  and the number of net cash flow  at the end of the period . However when you use the indirect method , which is more common , in preparing financial statements.

You will start with net profits before taxes , adjustment on the non-cash revenues and expenses are performed then the terms of operational  business are calculated through the change in each term for the current financial period . After that you will determine if the change is a result of a local or external cash flow .

At the end the number of the net cash flow of operational business will be the same in both methods , but if you use the direct method , you will not need to add a clarification in the financial statement  in contrary to the direct  method .

In the second episode we will discuss the two methods and calculate the net cash flow of each term of the three activities .