Guide to Understanding the Statement of Cash Flows and Improving Company Cash Management Strategies

The statement of cash flows is one of the most important financial statements. It is the lifeblood of a company, showing the movement of cash both into and out of the business over a specific period. Understanding the Statement of Cash Flows allows you to analyze a company’s ability to generate cash, how it uses that cash, and how effectively it manages its working capital cycle. In this article, we will provide a guide to Understanding the Statement of Cash Flows, discussing its key components, methods of preparation, and how to analyze it, as well as providing tips and strategies for improving cash management in the company, emphasizing the role of technology in enhancing the efficiency of cash flows.

What is the Statement of Cash Flows?

Understanding the Statement of Cash Flows is important to analyze an entity’s financial position. It is a financial statement that shows the movement of cash inflows (cash receipts) and outflows (cash payments) during a specific period, usually a fiscal year or a quarter. The statement of cash flows classifies this cash movement into three main activities: operating activities, investing activities, and financing activities.

Importance of the Statement of Cash Flows:

The importance of the statement of cash flows lies in its being:

• Completes the Income Statement and Statement of Financial Position: Understanding the Statement of Cash Flows is necessary because it complements the Income Statement and the Statement of Financial Position, as it provides information that other financial statements do not, such as how the company obtains and uses cash.
• Helps in Assessing the Company’s Liquidity: Understanding the Statement of Cash Flows helps assess the company’s liquidity, as the statement shows the company’s ability to generate enough cash to cover its short-term obligations.
• Helps in Assessing the Company’s Ability to Finance its Growth: Understanding the Statement of Cash Flows contributes to assessing the company’s ability to finance its growth, as the statement shows the extent to which the company can finance its investments and expansion activities through its operating activities.
• Provides Indicators of Earnings Quality: Understanding the Statement of Cash Flows provides indicators of earnings quality, as significant differences between net profit and net cash flow from operating activities may indicate problems with earnings quality.
• Helps in Forecasting Future Cash Flows: Understanding the Statement of Cash Flows helps in forecasting future cash flows, as the information in the statement can be used to estimate the company’s future cash flows.
• Facilitates the Decision-Making Process: Understanding the Statement of Cash Flows facilitates the decision-making process, as the statement provides essential information for making investment, financing, and management decisions by various stakeholders.
• A Tool for Financial Control: Understanding the Statement of Cash Flows is a tool for Financial control, as the statement helps monitor the movement of cash within the company and ensure that it is used efficiently and effectively.

Components of the Statement of Cash Flows:

The statement of cash flows consists of three main sections:

1. Cash Flows from Operating Activities:
   • Definition: Cash flows resulting from the entity’s principal revenue-producing activities and other activities that are not investing or financing activities.
   • Examples of cash inflows:
     • Cash receipts from the sale of goods and the rendering of services.
     • Collections from royalties, fees, commissions, and other revenue.
     • Interest received (may also be classified under investing activities).
     • Dividends received (may also be classified under investing activities).
   • Examples of cash outflows:
     • Cash payments to suppliers for goods and services.
     • Cash payments to employees (salaries and wages).
     • Income tax payments.
     • Interest paid (may also be classified under financing activities).
     • Other operating expenses paid in cash.
2. Cash Flows from Investing Activities:
   • Definition: Cash flows resulting from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
   • Examples of cash inflows:
     • Proceeds from the sale of property, plant, and equipment.
     • Proceeds from the sale of equity or debt instruments of other entities.
     • Proceeds from the sale of investment property.
     • Collection of the principal of loans made to others.
     • Examples of cash outflows:
       • Payments to acquire property, plant, and equipment.
       • Payments to acquire equity or debt instruments of other entities.
       • Payments to acquire investment property.
       • Loans made to others.
3. Cash Flows from Financing Activities:
   • Definition: Cash flows that result in changes in the size and composition of the contributed equity and borrowings of the entity.
   • Examples of cash inflows:
     • Proceeds from issuing shares.
     • Proceeds from issuing bonds or obtaining borrowings.
     • Capital-related Cash government grants
   • Examples of cash outflows:
     • Dividend payments.
     • Repayment of borrowings.
     • Repurchase of treasury shares.

Methods of Preparing the Statement of Cash Flows:

The statement of cash flows can be prepared using one of two methods:

1. Direct Method:
   • This method discloses major classes of gross cash receipts and gross cash payments for operating activities.
   • This information is obtained either from the entity’s accounting records or by adjusting items in the Income Statement (such as sales and cost of sales) for non-cash items and changes in operating asset and liability balances.
   • This method is more clear and transparent, but it may be more difficult to apply, as it requires detailed information about cash inflows and outflows.
2. Indirect Method:
   • This method adjusts net profit or loss from the Income Statement for the effects of non-cash transactions and changes in operating asset and liability balances during the period.
   • This method starts with net profit or loss and then makes adjustments to arrive at net cash flow from operating activities.
   • This method is easier to apply, but it may be less clear than the direct method.

IAS 7 encourages the use of the direct method, but also permits the use of the indirect method.

Example of Preparing a Statement of Cash Flows:

Company “Al-Namaa” Statement of Cash Flows for the Year Ended December 31, 2023 (Indirect Method)

Notes:

• This is a simplified example and is intended to illustrate the main idea of preparing a statement of cash flows.
• The items in the statement of cash flows may vary from one company to another depending on the nature of its activities.
• Refer to IAS 7 for more detailed guidance on preparing the statement of cash flows.

How to Read the Statement of Cash Flows:

• Read the title of the statement: The title should clearly state the company name, the name of the statement (“Statement of Cash Flows”), and the period covered by the statement.
• Examine cash flows from operating activities:
  • Note the net cash flow from operating activities. Is it positive or negative? A positive net cash flow indicates that the company is generating cash from its core business activities.
  • Compare net cash flow from operating activities with net profit. If net cash flow from operating activities is significantly lower than net profit, it may indicate problems with earnings quality.
  • Look for non-cash items that have been adjusted to arrive at net cash flow from operating activities. These items can provide insight into earnings quality and working capital management efficiency.
• Examine cash flows from investing activities:
  • Note whether the company is investing in new assets. A negative net cash flow from investing activities usually indicates that the company is investing in new fixed assets, which may indicate plans for expansion.
  • Look for any proceeds from the sale of assets. These proceeds may indicate that the company is restructuring its operations or divesting some activities.
• Examine cash flows from financing activities:
  • Note whether the company relies on borrowing to finance its operations. A positive net cash flow from financing activities indicates that the company relies on borrowing or issuing new shares to finance its operations.
  • Look for any dividend payments made to shareholders. Dividends indicate that the company is generating sufficient profits to reward its shareholders.
  • Note any repurchases of treasury shares. Share repurchases may indicate that the company believes its shares are undervalued.
• Examine the net change in cash and cash equivalents: This item represents the change in the balance of cash and cash equivalents during the period. This amount should be reconciled with the change in the cash and cash equivalents balance in the Statement of Financial Position.
• Read the notes to the Financial Statements: The notes contain important additional information about the statement of cash flows, such as the Accounting Policies used in preparing the statement and details of cash flows from operating, investing, and financing activities.

Analyzing the Statement of Cash Flows:

The statement of cash flows can be analyzed through:

• Trend Analysis: Comparing items in the statement of cash flows across different time periods to identify trends in changes in cash flows from operating, investing, and financing activities.
• Vertical Analysis: Expressing each item in the statement of cash flows as a percentage of total cash inflows or outflows.
• Ratio Analysis: Calculating and using financial ratios derived from the statement of cash flows to assess the entity’s liquidity and ability to generate cash.

Key financial ratios derived from the statement of cash flows:

• Operating Cash Flow to Net Profit Ratio: Indicates earnings quality, as a high ratio indicates that earnings are supported by actual cash flows.
• Free Cash Flow Ratio: Represents the cash available to the company after paying for all its capital expenditures and can be used to finance growth, dividends, or debt repayment.
• Cash Flow Coverage Ratio: Measures the company’s ability to meet its obligations with its operating cash flows.

Strategies to Improve Cash Management in the Company:

Companies can improve cash management by following these strategies:

• Improve Accounts Receivable Collection: Accounts receivable collection can be accelerated by offering discounts for early payment and improving the collection follow-up process.
• Manage Inventory Efficiently: Cash flows can be improved by managing inventory efficiently and avoiding unnecessary inventory buildup.
• Negotiate Better Payment Terms with Suppliers: Companies can negotiate with their suppliers to obtain longer payment periods, which postpones cash outflows.
• Control Expenses: Companies must control their expenses and rationalize spending, especially on non-essential items.
• Use Technology: Accounting Software and Enterprise Resource Planning (ERP) systems can help automate cash management processes and improve their efficiency.
• Forecast Cash Flows: Companies must prepare accurate forecasts of cash inflows and outflows, which helps identify any expected cash shortages or surpluses.
• Obtain Credit Facilities: Companies can obtain credit facilities from banks, such as letters of credit or letters of guarantee, to ensure liquidity is available when needed.
• Optimal Investment of Surplus Cash: Companies can invest any surplus cash they have in short-term financial instruments that generate an appropriate return.
• Diversify Funding Sources: Companies can diversify their funding sources by obtaining loans from multiple financial institutions or issuing bonds.
• Manage Foreign Exchange Risk: For companies that deal in foreign currencies, it is important to manage the risks of exchange rate fluctuations through appropriate hedging tools.

Role of Technology in Improving the Statement of Cash Flows:

Technology plays an important role in improving the accuracy and efficiency of preparing the statement of cash flows, as Accounting Software and Enterprise Resource Planning (ERP) systems offer many advantages, such as:

• Automating the Preparation of the Statement: Software reduces reliance on manual work, saving time and reducing the likelihood of errors.
• Integration with Other Systems: Accounting software integrates with other systems in the company, such as sales and purchasing management systems, which facilitates the collection of data needed to prepare the statement of cash flows.
• Financial Data Analysis: Software provides advanced analytical tools that help analyze the statement of cash flows, identify trends, and understand patterns.
• Preparing Customized Reports: Software enables the preparation of customized reports on cash flows that meet the needs of management and other stakeholders.
• Improving the Accuracy of Forecasts: Software helps improve the accuracy of forecasts of future cash flows by analyzing historical data.

Importance of Understanding the Statement of Cash Flows for Companies:

Understanding the Statement of Cash Flows is crucial for all companies, regardless of their size or activity, as this statement helps in:

• Assessing the Company’s Ability to Continue: The statement of cash flows indicates the company’s ability to generate enough cash to cover its expenses, repay its debts, and invest in growth.
• Identifying Sources and Uses of Cash: The statement of cash flows shows where the cash comes from and where it goes, which helps in understanding the main activities that generate cash and the activities that consume it.
• Assessing Earnings Quality: Net profit can be compared with net cash flow from operating activities to assess earnings quality. If net cash flow from operating activities is significantly lower than net profit, it may indicate that earnings are not supported by real cash flows.
• Planning for Growth and Expansion: The statement of cash flows helps determine whether the company has enough cash to finance growth and expansion plans.
• Obtaining Financing: The statement of cash flows is one of the most important Financial Statements that creditors and investors are interested in when evaluating loan applications.

The Difference Between the Income Statement and the Statement of Cash Flows:

Although both the Income Statement and the statement of cash flows provide information about the entity’s performance, they differ in the nature of the information they provide:

• Income Statement: Focuses on measuring the entity’s profitability over a specific period, according to the accrual basis of accounting.
• Statement of Cash Flows: Focuses on measuring the movement of cash inflows and outflows of the entity during a specific period, regardless of the timing of revenue and expense recognition.

Illustrative Example:

A company may sell goods on credit and recognize the revenue in the Income Statement at the time of sale according to the accrual basis. However, this sale will not appear in the statement of cash flows until the value of the goods is collected from the customer.

Conclusion:

The statement of cash flows is an essential tool for understanding the movement of cash within an entity and assessing its ability to generate cash and use it effectively. Companies must pay close attention to managing their cash flows to ensure their ability to meet their obligations, finance their operations, and achieve their goals. Understanding the Statement of Cash Flows and how to analyze it is essential for all stakeholders, including investors, creditors, and management. Mastering the skills of analyzing this statement enhances your ability to evaluate an entity’s performance and make informed financial and investment decisions.

Finally, technological developments facilitate the preparation of the statement of cash flows and improve the quality and accuracy of the financial information provided, enhancing the effectiveness of this statement as a tool for assessing the entity’s performance and managing its cash resources. Remember that Understanding the Statement of Cash Flows is an essential part of understanding the financial statements as a whole, and mastering its analysis will give you a competitive advantage in the world of business and investment.