Cash flow is an important indicator of a company's financial health. Even companies reporting profits may not survive in the long run without a positive cash flow. Of course, profits are incredibly important but cash flow is even more crucial.
It is possible for companies to report profit, but, at the same time, run out of cash. This is most common for companies that are growing at a faster phase. A cash-flow statement can tell us if this is happening. For any business, cash can come from both internal and external sources, and the cash-flow statement helps investors to separate and observe the differences and magnitude of the inflows and outflows.
A cash-flow statement is also known as “where got and where gone” statement. It is a statement that helps investors to know the sources from where the company got the cash and where that cash is being used during a period of a year. As the cash-flow statement is part and parcel of the annual statement of accounts, it is essential to understand it for informed decision-making.
Basically, cash flow statement shows how much the opening balance of cash, bank and cash equivalents is and how the cash is generated from various activities of the company and ends with the closing balance of cash, bank and cash equivalents. The statement of cash flows consists of three sections: cash flows from operating activities; cash flows from investing activities; cash flows from financing activities. Let us see each component in detail.
Cash flow from operating activities
This part of the cash-flow statement reports a company's cash flows from its core business operations, which it uses to reinvest in and grow its business. Items such as cash sales, collection from customers, payment to suppliers, selling, distribution and general expenses all come under operating activities of a company. Measuring the changes in cash flows from operations requires computation of the changes in account balances in the balance sheet between two accounting periods.
For instance, depreciation expense does not actually involve any cash outflow. So, depreciation expense for the period is added back to net income. In the same manner, changes in accounts receivable and stocks may either be added to the net income or subtracted from it, depending on whether the accounts increased or decreased. An increase in accounts receivable would be deducted from net income because while sales were recorded, cash was not yet received.