Any company, no matter how big or small, moves on cash, not profits. You can't pay bills with profits, only cash. You can't pay employees with profits, only cash. And when anyone asks you, "Did you make any profits?" all they probably want to know is whether you've got any cash; (Harvard Business Review, 1987)
The importance of cash and cash flow statements cannot be overemphasized, simply put it is essential for the operation of any business. Cash flow statement reveals the movements of cash over a period and the effect of these movements on the cash position of the business (Managing resources, 2008, pg. 105). Tracking the cash movements over several periods may reveal financing and investing patterns and my help predict future management action. (Managing resources, 2008, pg. 126) This means knowing the sources and uses of cash for a company can help a reader of a financial statement to make predictions about the possible future direction of a company.
Cash flow statement shows how the movement of cash is linked to the ending cash balance and the beginning balance shown on a company's balance sheet. (Financial Reporting and Analysis: CFA Program Curriculum, 2009, pg. 242)
The objective of the statement of cash flow is to show the sources of cash and all the uses of cash during an accounting period (Financial Statement Analysis: Schweser Study Notes, 2007, pg. 43)
The cash flow statement is normally broken down into three parts and can be calculated using either direct or indirect method. The direct method calculation begins at the top of the of the income statement and identify cash inflows and outflows while the indirect begins at the bottom of the income statement with net income and makes the necessary adjustments.
The three parts of a cash flow statement are:
Operating activities; this involves cash collection from sales, cash inputs into the manufacturing or retail process, cash operating expenses, interest paid or received, dividends received and tax paid.
Investing activities; this involves purchases of property, plant, equipment, investment in joint ventures and affiliates, payments for businesses acquired, proceeds from sales of assets, purchases or sales of marketable securities.
Financing activities: involves cash dividends paid, short and long term borrowings, stock sales and repurchases.
These three statements together serve as a link between a firm's income statement and the changes in its cash balances.
Some of the important pieces of information a cash flow statement tells us are:
Is the business generating enough cash to sustain its operations, to service its debts and to pay off existing debts as they mature
Can the business meet unexpected obligations or is it likely to need additional financing.
Is the firm in a position to take advantage of business opportunities that may arise?
Does the company have liquidity or solvency problems?
Is there a discrepancy between cash flow and income? (This may suggest that earnings trends may not be reliable).
Cash flow serves as a reconciliation of the beginning and ending cash on the balance sheet.
One of the reasons why there is controversy surrounding cash flow statements is that they are based on income statements and don't include accounts receivable, payable and inventory, therefore it gives a true indication of a company's cash position only during periods of steady sales.
In a study of 290 companies done by Cornelius J Casey and Norman J Bartczak, published by Harvard Business Review (1984), the pair found that operating cash flow for a five year period could not help to distinguish between healthy companies and those that would fail. The conclusion of this study was that operating cash flow has a serious draw back as a measure of potential financial distress because it disregards the size of business as well as any used of its borrowing capacity. They also found that the accuracy of cash flow was only 50% for the first and second year of the study and got worse from then on. This tells me that the argument over cash flow is not over therefore it should not be the only measure of a company's strength. All the same I believe that cash flow is an important measure of a company's strength provided it is use in conjunction with other financial ratios such as the acid test ratio.
In Canada, cash flow as part of all published financial statements has become something of a religion, every published financial statement one comes across has a cash flow statement attached to it. It is recommended by the accounting bodies in the country in all their publications, this has made cash flow something of a standard measure of a company's ability to survive. At Bank of Montreal, where I work, all businesses applying for a loan or a line of credit must provide us with their cash flow statements along with the financial statement before we can extend credit to them. Even for individuals the banks have a way of constructing a cash flow statement for them, this helps us to evaluate whether or not an individual has the capacity to service a loan or mortgage should we extend such credit to them.
Conclusion;
Personally I agree that cash is the life-blood of any business and without it survival is very unlikely, but cash flow is not the only or the most important measure of company's survival. A company's debt level, its ability to use the equity market or borrowing capacity and its reserves (near liquid assets) are as important as the cash flow statement.
