Cash flow statement and the accounting equation. A =C + L
Adam Kamulika
17 May 2021
Perhaps as an accountant, banker, or financial analyst, anyone who works in the business world has probably come across the term "Cash flow." A cash flow statement is one of the most common financial statements in the financial report of any company, parallel to the income statement and the balance sheet. The cash flow statement provides a total summary of money going in and out of business. The report shows how well the business can manage its cash situation by generating cash through revenue, settling its debt obligation, and covering its expenses. Any company's reported profit at the end of its financial accounting year is not all cash. Therefore, the cash flow statement demonstrates what percentage of the profit generated by the business is cash.
The Cash flow statement classifies the cash movement, in the business, into three general categories—money in and out of business from operating activities, investing activities and financing activities. Operating activities shows the business's cash movement from daily business performance. These include sales and purchases, maintenance and repair, rent and other administrative expenses like accounting fees, office supplies and insurance. Investing activities include purchases and sales of long-term business assets. Financing activities cover the movement of business capital structure, including share capital and long-term debts.
It takes more than one or two examples to grasp the cash flow's conceptual framework. As an accountant, I strive to compose an excellent cash flow statement on every financial report I prepare, and I do not take this challenge lightly. The bigger the company, the more complicated the cash flow becomes. However, in all regards, the composition of the cash flow statement can be explained by the ancient accounting equation "A = C + L".
Assets = Capital + Liabilities. (The Balance Sheet equation)
The equation elaborates that a business obtains asset from either fund provided by the business owners as capital or outside resources the company brings as debt.
The equation further expands to "FA + CA = C + NCL + CL".
Fixed Asset + Current Assets = Capital + Noncurrent liabilities + Current Liabilities.
The business can possess long term assets which are fixed assets, and short-term assets identified as current assets. An excellent example of "fixed assets" is delivering trucks, office computers, servers, and furniture. A perfect illustration of "current assets" is business inventory, trade debtors, prepaid expenses, trade securities, and bank and cash balance. The business can either acquire long-term or short-term loan facilities to finance assets, hereafter non-current liabilities and current liabilities. An excellent example of a company's liabilities is a bank loan, trade creditors, bank overdraft, tax payable and customer deposits.
Any equation can expand in more than one form.
Let's do this.
FA + (CA - CL) = C + NCL.
Further elaboration.
CA-CL = working capital and...
FA + (CA - CL) = capital employed = C + NCL
Capital employed is a fancy name for resources utilised by the business to generate profit in the long run (C + NCL). The assets reflect the company's resources expected to produce earnings ((FA + (CA - CL). From this equation, we can deliver the conceptual framework of the cash flow statement.
We already know that the cash flow statement has operating activities, investing activities and financing activities. From the extended accounting equation, we can place these domains.
From the diagram, we can see the three components assigned to respective parts of the accounting equation.
Cash flow from operating activities is associated with the change of the net current assets (CA - CL). The key takeaway here is that any movement in inventory, trade debtors, other debtors, prepaid expenses, customer deposits, trade debtors and other debtors is considered cash flow from operating activities.
Cash flow from investing activities is associated with the fixed asset movement; This involves the buying and selling of fixed assets. For example, a company sells its worn-out company’s cars to employees; we consider it cash inflow. On the contrary, when a company decides to buy new cars and trucks for office use, we term that cash outflow.
Finance activities deal with change in a company's capital and debt structure. Issue of shares to the public and acquiring a bank loan is cash inflow, loan and interest payment is a cash outflow.
In summary, any transaction that brings money into the business is cash inflow, and any activity that releases cash is a cash outflow. The term "movement" considers the difference between the opening and closing balance of an account. For example, John Quinn is a debtor; the closing balance of his account was $ 4,000 in January, and February is $ 2,500. The difference between the two balance is a cash inflow from operating activities. A decrease in closing balance indicates receipt from John for previous credit sales.
For more insight on cash flow and its use as a business performance measurement, visit my previous article published on the movement. This article provides an understanding of the preparation of the cash flow statement; how to treat a specific transaction and account for it in the activities. Additional studies are required to obtain more knowledge.
Tip: For a cash flow statement to be accurate, a company’s balance sheet must balance.
Adam Kamulika
ACPA: tech-savvy with a passion for technology, especially tools and software that enhance productivity in the work environment.
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