Cash flow statements concentrate on the sources and uses of cash and are a useful
indicator of a company’s liquidity and solvency. In other words it is about a page long
and it summarizes the inflows and outflows of cash under specific sections. Most
importantly though, a cash flow statement distinguishes between profit and cash.
Well, it has been argued that the figure for profit in the profit and loss account is
misleading because it is calculated after numerous non-cash deductions or additions
such as depreciation, profit on disposal of assets and accruals, whereas a cash flow
statement simply says, let’s just discuss what the company paid or received in terms
of cash only.
To illustrate this further, suppose a company made a profit of 1 million pounds, does
this necessarily mean that it has that amount of money in its bank account? As such,
the survival of a business depends not so much on profits as on its ability to pay its
debts when they fall due.
Obviously a company’s net cash flow within a specific period may be measured by
deducting the opening cash balance from the closing cash balance. However, would
not one prefer to know the details of the transactions? Or what their effects are?
Without disclosing much information, it is recommended that a cash flow statement
summarizes the inflows and outflows of cash under the following categories:
1. Net Cash Flow from Operating Activities
2. Returns on Investments and Servicing of Finance
4. Capital Expenditure and Financial Investment
5. Acquisitions and Disposals
6. Equity Dividends Paid
7. Cash Flow before Management of Liquid Resources and Financing
8. Management of Liquid Resources
Okay, but what do these headlines mean, and where do we get the information to
find the net cash flow for each of these categories?
operating activities refer to the company’s trading activities and day-to-day
operations, such as selling, distribution, administration expenses, etc. The cash flow
statement attempts to summarize the net cash flow of these transactions, and this
may be done in two distinct ways:
1. The Direct Method
2. The Indirect Method
The direct method of calculating the net cash flow from operating activities is done in the following way:
Cash received from customers
Less: Cash paid to suppliers
Cash paid to and on behalf of employees
Equals: Cash flow from operating activities
The indirect method calculates the net cash flow from operating a