Cash Flow Statement
1. Definition
The Cash Flow Statement summarizes the amount of cash and cash equivalents entering and leaving a company over a specific period.
Unlike the Income Statement which follows accrual accounting, the Cash Flow Statement follows "Cash Basis Accounting." It tracks actual liquidity and solvency.
2. Basic Principle
The change in the cash balance is determined by the total cash inflows minus total cash outflows during the period.
$$ \text{Ending Cash} = \text{Beginning Cash} + \text{Cash In} - \text{Cash Out} $$
3. Key Components
Cash flows are categorized into three main activities:
A. Operating Cash Flow
- Cash generated from core business activities, such as selling goods or services.
- Interpretation: Should ideally be Positive (+). This indicates the company can generate cash from its main operations.
B. Investing Cash Flow
- Cash flows related to the acquisition or disposal of long-term assets (e.g., property, equipment).
- Interpretation: Often Negative (-) for growing companies, as they actively invest in capital expenditures (CAPEX) for future expansion.
C. Financing Cash Flow
- Cash flows related to transactions with debt holders and shareholders (e.g., borrowing money, issuing stock, paying dividends).
- Interpretation: Paying down debt or distributing dividends results in a negative value, while borrowing funds results in a positive value.
4. Why It Matters
- Solvency Check: Revenue does not pay the bills; cash does. This statement ensures the company has enough liquid assets to cover payroll and immediate debts, preventing insolvency.
- Quality of Earnings: It allows investors to compare Operating Cash Flow to Net Income. If Net Income is high but Operating Cash Flow is low, the quality of earnings may be poor (e.g., high accounts receivable).
5. Limitations
- Timing Manipulation: Management can delay paying suppliers or accelerate collections near the reporting date to temporarily improve cash flow figures.
- Excludes Non-Cash Transactions: Significant investing or financing activities that do not involve cash (like exchanging stock for assets) are not directly reflected in the main body of the statement.