Banks go for analysis of cash flow and funds flow statement of a company to determine the company’s ability to meet its short term and long term obligations. Cash flow statement indicates a company’s ability to meet its short-term obligations, whereas funds flow statement is helpful to bankers to check up and confirm that the short-term funds are not used for non-current assets. From funds flow statements banks can verify that the long-term uses of funds are covered only by long-term sources of funds. Cash flow statement and Funds flow statement are explained below with illustrations.
Cash Flow Statement: The Cash flow statement represents the increased or decreased position of cash and cash equivalents in a business. In a way, it is useful in assessing the company’s ability to meet its short-term obligations. Cash equivalent means highly liquid current assets which can be readily converted into cash without any loss in value or time. For example, inventories in a restaurant will be exhausted on the daily basis and at the most, some provisions may not last long for over a month. Such items which will be quickly converted into cash can be treated as the cash equivalent.
Let us illustrate cash flow statement with an example of a Rice Trader. A trader buys 100 kilos of ‘Rice’ at the rate of Rs.50/= per Kilo and sells it at Rs.55/- per Kilo and makes the profit of Rs.5/= per Kilo. Here we will be able to determine his total profit is Rs.500/- as he has sold 100 kilos of rice with a profit margin of Rs.5/- per kilo. In this case, the profit remains same, but the cash flow may vary depending upon the method of his business decision such as
a. To buy and sell for “Cash”,b. To buy on cash and sell on credit,c. To buy on credit and sell on Cash,d. To buy on credit and sell on credit.
In the above illustrations, we may observe that buying the rice on cash payment and selling them on credit results in negative cash inflow as the trader does not receive money immediately against rice sold. Buying rice on credit and selling them on cash will have the positive effect on cash flow as the trader receives cash on selling rice for which he is yet to make payment.
Let us go for one more situation Suppose the trader has sold only 50 kilos of rice in the first week, out of 100 kilos purchased by him. The cash inflow for the first week is only Rs.2750.00 (=55×50).In this case, the inflow of cash during the week is Rs.2750.00 which is less than the outflow amount of Rs.5000.00. When inflow of cash is less than the outflow of cash it would reduce the working capital which affects the trader’s ability to meet his short-term obligations.However if the trader was able to sell 100 kilos of rice during the same period, cash inflow would have been Rs.5500.00=(55×100). In this case,the inflow of cash during the week is Rs.5500.00 which is more than the outflow amount of Rs.5000.00. Due to the availability of additional cash of Rs.500.00 by way of profit the working capital is increased by Rs.500.00 and therefore the trader is more comfortable in meeting his short-term obligations.
Effect of inventory holding in cash flow: Let us take following example, how a cash flow affects the working capital of a business over a period.
(a). In the first year, the trader has purchased 1000 kilos of Rice @ Rs.50/Kg and sold 900 kilos @Rs.55.00.(Inventory holding at the close of the year is 1000-900=100 Kilos)
(b). In the second year, he purchased 1000 kilos of rice @ Rs.50.00 and sold 1050 kilos @Rs.55.00.( Inventory holding at the close of the year is (100+1000)-1050=50 Kilos)
(c). In the third year, he purchased 1050 kilos of rice @ Rs.50.00 and sold 1000 kilos @ Rs.55.00.(Inventory holding at the close of the year is 50+1050-1000=100 Kilos)
(d).For computation purpose, it is presumed that there is no change in the purchase price and selling price of rice for the entire period of three years.
Computation of Cash flow for above example:
Note: The cash flow statement is always prepared for the period to which financial statements are prepared. The movement of cash is generally classified under the following three heads.
- Cash flow from operating activities: The revenue generated from the principal activity of the company.
- Cash flow from investing activities: Capital expenditure on purchase of tangible and intangible assets. The money received from disposal of old machines, interest received on deposits or from lending activities are included in cash flow from investing activities.
- Cash flow from financing activities: Money received from issues of shares, bonds, and debentures, repayments of the loan are examples of cash flow from financial activities.
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