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It has been argued that "profit" does not always give a useful or meaningful picture of a companies operations. Readers of a companies financial statements might even be misled by a reported profit figure.
• Shareholders might believe if a company makes a profit after tax, of say, 100000$ then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong.
• Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This option may not be correct: the ability to pay wages depends on the availability of cash.
• Cash is the life board of the business. Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due. Such payments might include "profit and loss" items such as material purchases, wages, interest and taxation etc, but also capital payments for new fixed assets and repayment of loan capital when this falls due.
From these examples, it may be apparent that a companies performance and prospects depend not so much on the "profits" earned in a period, but more realistically on liquidity or cash flows.
The great advantage of a cash flow statement is that it is unambiguous and provides information which is additional to that provided in the rest of the accounts. It also describes the cash flows of an organization by activity and not by balance sheet classification.
Format of the Cash Flow Statement
There are two methods for preparing cash flow statements
1. Direct method.
2. Indirect method.
A cash flow statement should list its cash flows for the period classified under the following standard headings:
• Operating activities
• Returns on investments and servicing of finance
• Taxation
• Capital expenditure and financial investment
• Acquisitions and disposals
• Equity dividends paid
• Management of liquid resources
• Financing
The last two headings can be shown in a single section provided a subtotal is given for each heading.
Individual categories of inflows and outflows under the standard headings should be disclosed separately either in the cash statements or in a note to it unless they are allowed to be shown net. Cash inflows and outflows may be shown net if they relate to the management of liquid resources or financing and the inflows and outflows:
• Relate in substance to a single financing transaction
• Or are due to short maturities and high turnover occurring from rollover or reissue, for example relating to operating activities.
The requirement to show cash inflows and outflows separately does not apply to cash flows relating to operating activities. Each cash flow should be classified according to the substance of the transaction giving rise to it.
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