To gauge the firm’s financial health, the most preferred document is the financial statement and audited report. The statement comprises an audited report, which states whether the statements, figures, and record keeping are qualified or unqualified. The balance sheet portrays the financial position of that particular date. The main components of the balance sheet are current assets, current liabilities, non-current assets, fixed assets, non-current liabilities, long-term liabilities, and equity (which primarily comprises of capital, retained earnings, and long-term reserves). The second statement is the profit and loss statement, also called an income statement, which depicts the revenue and loss position for a specific period. There are various heads under this statement, such as sales, cost of goods sold, depreciation, financial expense, and other items. It gauges the operational efficacy, net profitability, and the earnings per share. The third and perhaps the most important statement is the cash flow statement. This statement is divided into three major components:
Cash Flow from Operating Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities.
To manage the firm’s cash flow statement effectively, the finance managers adopt their own unique and preferred methodologies for better management. At first, the entire amount of net profit is picked up from the income statement, and non-cash items (such as depreciation and amortization) are plowed back into the opening figure of the cash flow statement. To simplify the cash flow statement (for management’s ease), finance managers view it from a different tangent. They categorize it mainly into two main domains: “Needs and Sources.” Sources are the managed funds the company generates through operations and working capital sources or acquiring funds from outside the firm. Needs are requirements that are funded through external sources.
To manage cash flow efficiently, the statement is bifurcated into two further slots, which are short-term (also known as operating sources and operational needs) and long-term (non-operating sources and non-operating needs).
Figures extracted into operating sources are then filtered through operating needs to arrive at a net position of cash flow from working capital activities. This figure entails how much cash the firm generated from its main operations. The figure also foretells the position of working capital requirements or not. If the figure is negative, it implies that the inflows are less than the firm’s outflows, and the company requires additional funds to meet its working capital requirements. Upon seeing the picture of the figure, the business is in an able position to make an educated decision about securing any additional financing requirement or not. Naturally, the company will not decide to affect its liquidity and gearing ratio. It will also help the business analysis and determine that there is no mismatch in the balance sheet. If such a happenstance does occur, the business can go into balance sheet restructuring and improve its financial position in the eyes of the shareholder and investors.
Non-Operating Sources and Non-Operating Needs tell if the company is facing any stress on its cash flow due to capital expenditure or unnecessary dividend payout.
Cash flow management, in essence, represents the true financial health of the picture as opposed to an income statement (where depreciation and amortization are expensed out). The non-cash items are added to the cash flow statement to get a precise net cash flow amount. Furthermore, all those liabilities and expenses that are provisioned but not paid out are added back (such as the current portion of long-term debt or financial lease). The primary business agenda is to make a profit and generate revenue. Even if the income statement reveals a healthy profit for the business, due to certain accounting methodologies and deferment entries), the management of cash flow will depict the true policies the business complies with.
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