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CASH FLOW STATEMENT ANALYSIS

Chapter 1: INTRODUCTIONCash is an important component of working capital of business, which provides speed and power to business. Keeping in view the present wealth dominated scenario, it can be said that cash is the life blood of business, as it governs and operates all the activities of business. For all the activities of business, continuous and healthy flow of cash is the main pillar of business solvency, thus cash is both the beginning and end of working capital cycle. In all the business organizations monetary and non-monetary activities takes place and out of which monetary transactions result in inflow and outflow of cash, so it is very important for business to know that from what sources and in how much quantity cash has been used. The cash flow statement is prepared to attain the above-mentioned objective.

WHAT IS A CASH FLOW STATEMENT?For your business, the cash flow statement may be the most important financial statement you prepare. It traces the flow of funds (or working capital) into and out of your business during an accounting period. For a small business, a cash flow statement should probably be prepared as frequently as possible. This means either monthly or quarterly. An annual statement is a must for any business. The cash flow statements primary purpose is to provide information regarding a companys cash receipts and cash payments. The statement complements the income statement and balance sheet. It is important to note cash flow is not the same as net income. Cash flow is the movement of money into and out of your company, and it can be affected by several noncash transactions. The cash flow statement became a requirement for publicly traded companies in 1987. There are various rules governing how information is reported on cash flow statements, as determined by generally accepted accounting principles (GAAP). While your business may not be a public company, a cash flow statement is still important to measure and track the flow of cash into and out of your business.

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CASH FLOW STATEMENT ANALYSIS Cash flow, simply, is the movement of money in and out of your business, or the inflows and outflows. A reliable accounting system is in place in your business and information typically recorded by small businesses is accessible to you. The cash flow statement reports the cash provided and used by the operating, investing, and financing activities of a company during an accounting period. In 1987, the Financial Accounting Standards Board issued Statement No. 95, which requires that a statement of cash flows accompany the income statement, balance sheet and statement of retained earnings. AN OVERVIEW The cash flow statement explains the change during the period in cash and cash equivalents. Cash includes currency on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to cash. Cash receipts and payments are required to be classified as operating, investing and financing activities. The cash flow statement will summarize the cash flows so that net cash provided or used by each of the three types of activities is reported. Beginning and ending cash must be reconciled based on the net effect of these activities.

DEFINITIONS OF CASH FLOW According to I.C.W.A. (India), Cash Flow Statement is a statement setting out the flow of cash under different heads of sources and their utilization to determine the requirements of cash during the given period and to prepare for its adequate provisions.

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CASH FLOW STATEMENT ANALYSIS

CLASSIFICATION OF CASH FLOWS ACCORDING TO AS-3Cash flows or sources and applications of cash: According to accounting Standard 3 cash flows has been divided into three parts:

CASH FLOWS FROM OPERATING ACTIVITIES The operating section of the cash flow statement is most important because it deals with the cash generated or used by the entitys primary activities. These activities, and the related cash flows, are recurring. The cash flow statement reports past cash flows, but the same or similar activities and cash flows can be expected to occur in the future. If an organization cannot sustain itself over the long run with the cash generated from operations, it cannot survive. CASH FLOWS FROM OPERATING ACTIVITIES

OPERATING ACTIVITIES

Cash in Flow

Cash out Flow

Cash Sales Cash received from Debtors Fees, commission, royalty and other receipts.

Cash Purchase

Operating Activities

Payment to creditors Cash operating expenses Wages, Income tax etc.

Most companies present the operating section of the cash flow statement using an indirect approach under which they start with accrual-basis net income and adjust that figure to obtain the cash generated or used by operations. Although accrual-basis income is regarded as the best measure of operating success, it does not tell us the amount of cash flows from operating and must be adjusted for all items that affect

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CASH FLOW STATEMENT ANALYSIS income and cash differently. Thus, this section of the cash flow statement includes the following adjustments to net income to determine the cash generated or used by operations: Expenses that reduced net income this period but did not use cash must be added back. Cash payments made this period for expenses of other periods must be deducted. Revenues that did not result in cash inflows during the current period must be deducted. Cash collections for revenues earned in other periods must be added. Items reported in the income statement but not directly related to normal operations must be removed. Lets consider a few of the more common adjustments to net income needed to convert to a cash basis.

Depreciation and Amortization Under accrual accounting, income is reduced for the cost of an operating assets service potential used up during the period. As we have seen earlier, depreciation, or the amount of cost recognized during the period under the matching concept, is an allocation of the original cost of the asset. The depreciation expense recognized during a period is not a cash expense; it does not result in a decrease in the cash balance. Cash was reduced initially when the asset was first acquired. The expense is simply an accountants allocation of a cost incurred previously. Therefore, while income for the period is decreased by the amount of the depreciation expense, cash is not. The difference in timing between the cash outflow for the purchase of a fixed asset and the related income effects can be shown as follows:

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CASH FLOW STATEMENT ANALYSIS

If we are interested in the amount of cash generated by a companys operations, then we need to add back the amount of depreciation expense to the companys net income. In other words, if all other revenues and expenses were cash items, net income would understate cash generated by the amount of the depreciation expense. Because depreciation is added back to net income to get the cash generated from operations, financial analysts sometimes mistakenly refer to depreciation as a source of cash. But this is silly because firms cannot generate cash just by depreciating. If depreciation were a source of cash, a change to a more rapid depreciation method would cause the cash balance to go up. But, that will not happen. The addition of depreciation in the cash flow statement is simply a way of adding back an amount that was deducted from income but did not use cash. Depreciation is neither a source nor a use of cash. The amortization of intangible assets and the depletion of natural resources also result in noncash expenses. As with depreciation, these expenses are deducted to get net income, but do not use cash. Therefore, they are added back to net income to get the amount of cash generated from operations.

Changes in Deferred Income Taxes Companies must report income tax expense on an accrual basis by matching tax expense to reported income. If temporary differences exist between the income reported in the income statement and that reported on the tax return, a deferred tax liability or asset is affected. In addition, the tax expense reported in the income

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CASH FLOW STATEMENT ANALYSIS statement is different from cash tax payments. Therefore, the cash flow statement must report an adjustment to bring net income to the amount of cash generated from operations.

Amortization of Debt Discount and Premium Debt discount arises when debt is issued for less than its maturity value. Because the debt ultimately must be repaid at maturity value, the actual (effective) interest costs are higher than the current cash interest payments. A portion of the discount is charged to interest expense each period under accrual accounting. However, the amount of discount expensed each period represents a noncash charge against income. When will cash actually be paid? When the debt matures, its maturity value will be paid in cash. The difference in timing between the cash flows and expense recognition can be shown as follows:

Because the companys interest expense contains a noncash portion, the net income figure must be adjusted to arrive at the cash generated from operations. Thus, when interest expense has been increased by the amortization of bond discount, an amount must be added to net income in the cash flow statement to determine the amount of cash generated from operations. If interest expense has been decreased by the amortization of bond premium, an amount must be deducted from net income in the cash flow statement to arrive at cash generated