| LO3 – Interpret a statement of cash flows. |
Readers of financial statements need to know how cash has been used by the enterprise. The SCF provides external decision makers such as creditors and investors with this information. The statement of cash flows provides information about an enterprise’s financial management policies and practices. It also may aid in predicting future cash flows, which is an important piece of information for investors and creditors.
The quality of earnings as reported on the income statement can also be assessed with the information provided by the SCF. The measurement of net income depends on a number of accruals and allocations that may not provide clear information about the cash-generating power of a company. Users will be more confident in a company with a high correlation between cash provided by operations and net income measured under the accrual basis. Recall, for instance, that although Example Corporation has net income of $80,000 during 2018, its net cash inflow from operations is only $46,000 – chiefly due to the large increase in inventory levels. Although net cash flow from operations is still positive, this discrepancy between net income and cash flow from operations may indicate looming cash flow problems, particularly if the trend continues over time.
Example Corporation’s SCF also reveals that significant net additions to plant and equipment occurred during the year ($1,016,000), financed somewhat by cash flow from operating activities but primarily by financing activities that included the assumption of loans and issue of shares that amounted to $857,000, net of dividend payments.
It appears that a significant plant expansion may be underway, which may affect future financial performance positively. However, the magnitude of this expansion coupled with the payment of the dividends to shareholders has more than offset cash inflows from operating and financing activities, resulting in a net overall decrease in cash of $123,000. Though the current cash expenditure on plant and equipment may be a prudent business decision, it has resulted in (hopefully temporary) adverse effects on overall cash flow.
The SCF is not a substitute for an income statement prepared on the accrual basis. Both statements should be used to evaluate a company’s financial performance. Together, the SCF and income statement provide a better basis for determining the enterprise’s ability to generate funds from operations and thereby meet current obligations when they fall due (liquidity), pay dividends, meet recurring operating costs, survive adverse economic conditions, or expand operations with internally-generated cash.
The SCF highlights the amount of cash available to a corporation, which is important. Excess cash on hand is unproductive. Conversely, inadequate cash decreases liquidity. Cash is the most liquid asset, and its efficient use is one of the most important tasks of management. Cash flow information, interpreted in conjunction with other financial statement analyses, is useful in assessing the effectiveness of the enterprise’s cash management policies.
Readers who wish to evaluate the financial position and results of operations of an enterprise also require information on cash flows produced by investing and financing activities. The SCF is the only statement that explicitly provides this information. By examining the relationship among the various sources and uses of cash during the year, readers can also focus on the effectiveness of management’s investing and financing decisions and how these may affect future financial performance.
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