What is the importance of Cash Flow Statement?

What is Balance Sheet?

It is a financial statement. Companies usually prepare it at the end of the financial year. We usually show it in our annual report. The balance sheet gives us information about three major things.

1. Assets – The values that companies have.
2. Liabilities – The debt amount that the company has.
3. Shareholder Equity – The amount of money that shareholders have invested in the company. This can also be referred to as equity, owner’s equity, company’s net worth, or book value.

Why is it referred as balance sheet?

Companies divide the balance sheet into two parts. One part represents assets, while the other represents ( liabilities + equity). Assets are equal to (liabilities + equity), meaning both sides are balanced. This is the reason it is referred to as a balance sheet.

Different Methods of creating a balance sheet

1. Horizontal Balance sheet
2. Vertical Balance sheet

Companies usually follows the vertical pattern to maintain balance sheet.

Assets

Companies refer to assets as current assets or long-term assets. Current assets are those that the company uses and converts into cash within one year, such as cash and cash equivalents, short-term investments, inventory, accounts receivable, etc. Long-term assets are those the company uses for more than one year, such as land, buildings, factories, equipment, long-term investments, etc. Companies add these two assets are represent the balance sheet.

Liabilities

Companies divide liabilities into current and non-current liabilities. Current liabilities are those that the company must settle within one year, such as short-term loans, accounts payable, etc. Non-current liabilities are those where the company has more than one year to repay the debt, such as long-term loans. The company adds these forms of liabilities together and shows the total in the balance sheet.

Equities

This includes equity share capital, other equity, and retained earnings. The company adds them together and shows the total equity.

What is an Income Statement?

The income statement is referred to as a financial statement that tells about the company’s profitability. It represents revenues, expenses, or profit/loss for a fixed period. Generally, this period can be based on a quarter, half a year, or a full year. We usually see the income statement in a company’s annual report, where the period is for a year. In the income statement, the company describes two factors: revenue and sales. This means the company shows how much product/service it has sold during the period. The other factor is expenses, i.e., how much the company has spent in that fixed duration. When we deduct total expenses from total revenue, we get to know the company’s profitability.

Income statement = Revenue – Expenses

If Total Revenue > Total Expense; i.e. Profit | Total Revenue < Total Expense; i.e. Loss

We refer to the income statement as the statement of profit/loss, statement of operations, statement of revenue and expenses, or statement of earnings.

Methods of Making Income Statements

There are 2 various forms of making income statements which are referred as

1. Single Step format
2. Multi-Step format

We describe a single-step format by deducting total expenses from total revenue, resulting in profit before tax (PBT). On the other hand, in the multi-step format, the company presents its total revenue, from which we deduct the cost of goods sold (COGS) to arrive at gross profit. COGS includes only those expenses that the company incurs directly in producing its products, such as raw materials and labor costs.

Next, total expenses are deducted from COGS, which results in operating profit. Operating profit includes expenses related to day-to-day operations, such as selling, general, and administrative expenses or depreciation expenses. We refer to operating profit as the earnings before interest and taxes (EBIT).

After that, we deduct interest cost from operating profit, resulting in profit before tax (PBT). Finally, we subtract income tax from PBT to arrive at the company’s net profit.

Basic Formulas

Profit Before Tax – Income Tax = Net Profit/Net Income

Total revenue – Cost of Goods Sold (COGS) = Gross Profit

Gross Profit -Total Operating Expenses = Operating Profit

Operating Profit – Interest Rate = Profit Before Tax (PBT)

Profit Before Tax – Income Tax = Net Profit/Net Income

What is Cash Flow Statement?

This statement is referred to as a financial statement that shows how much cash the company received and how much cash flowed out during a specific period. It reflects the actual change in cash over that period. Typically, this analysis is presented in the annual report, where the period is one year.

The question that strikes our mind is, when we are getting net worth from the income statement, what is the importance of the cash flow statement?

Importance of Cash Flow Statement?

The answer to the above question is that the income statement is based on accrual accounting. In accrual accounting, a company calculates revenue and expenses when a transaction occurs, regardless of whether money has been exchanged.

1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities

Here, we deduct cash outflow from cash inflow individually and receive net cash flow. Then, we add the net cash flow from all three forms and get total change in cash.

Basic Formula

Total Cash inflow – Total Cash Outflow = Net Cash Flow From Operating Activities

We can calculate cash flow activities by mainly two methods

1. Direct Method
2. Indirect Method

Activities joined from the main businesses are referred to as operating activities. Mainly there are cash flows of sales, purchases, and general expenses.

Cash flow from investing activities refers to the buying and selling of long-term assets, such as property, plant, and equipment, and investments like mutual funds, shares, and interest income. Then, the company reduces the total cash inflow by the total cash outflow to determine the net cash flow from investing activities.

Cash flow from financing activities includes cash flows that affect the company’s debt and equity capital, such as taking on debt, repaying debt, dividend payments, issuing new shares, or buying back shares, etc.