What is a Cash Flow Statement?
It is a financial statement that summarizes an organisation’s total inflow and outflow of cash and cash equivalents. A Cash Flow Statement helps reveal the solvency and liquidity of an enterprise. It assesses the capability of a business to generate sufficient cash to clear its debts and operating expenses. The Cash Flow Statement gets prepared at the end of a financial year.
Elements of the Cash Flow Statement
The three main elements of a Cash Flow Statement are as follows:
- Cash Flow from Operating Activities – Operating activities are related to bringing the products and services of a company to the marketplace. The Cash Flow from these activities helps to understand the organisation’s net income from selling their produce. The items under operating activities include revenues, interest returns, salary and wage payments, rent payments, etc. You can use either the Direct or Indirect method to calculate the Cash Flow from Operating Activities.
- Cash Flow from Investing Activities – This method calculates the overall Cash Flow from activities selling or purchasing assets and investments along with receipt of interest, rent or dividend.
- Cash Flow from Financing Activities – Cash Flow from Financing Activities looks at proceeds from shares, debentures or other borrowings while deducting interest and dividend payments, repayment of debt and settlement for stocks repurchased.
Methods for preparing Cash Flow Statement
A Cash Flow Statement gets prepared using one of the two methods – Direct and Indirect. Both of them help calculate the Cash Flow from Operating Activities. The direct method uses the total cash spent and received for calculating the net cash flow from operating activities. On the other hand, the indirect method starts with the Net income, adds non-cash expenses, deducts non-cash incomes, and includes the net cash adjustments between current assets and liabilities to get the net cash flow. There are several differences between the two methods, which are as follows:
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Direct Method |
Indirect Method |
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Definition |
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The Direct Method considers cash transactions, i.e. total cash expenditure and cash receipts, to calculate the net cash flow from operating activities. |
The indirect method takes the net income, non-cash expenses, non-cash incomes and net cash adjustments between current assets and liabilities to ascertain the net cash flow. |
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Non Cash Transactions |
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The direct method considers only cash transactions while calculating cash flow from operating expenses. |
The indirect method considers both cash as well as non-cash transactions while calculating cash flow from operating expenses. |
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Accuracy |
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The direct method is very accurate as it makes zero adjustments while calculating the cash flow. |
The indirect method is not that accurate as it has to make adjustments for current assets and liabilities to the Cash Flow. |
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Time |
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The direct method is more time-consuming as it requires you to list down all cash receipts and disbursements. |
The indirect method is less time-consuming since there is no need to list down cash transactions. |
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Ease of Understanding |
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The Direct Method is easier to comprehend as it separates the transactions into negative (outflows) and Positive (inflows). |
The Indirect Method is difficult to understand compared to the direct method. |
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Transparency |
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This method is more transparent as it gives the direct sources of cash payments and receipts. |
The indirect method is less transparent compared to the Direct Method. |
Conclusion
The answer to the question ‘How to prepare a Cash Flow Statement?’ depends on whether a company’s accounting department uses the Direct or Indirect Method. Both these methods are effective in ascertaining the net cash flow in the organisation.
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