Cash flow statements provide valuable insights into a company’s financial health by tracking cash inflows and outflows. However, like any financial tool, they have limitations that must be understood for accurate interpretation. This article delves into the constraints of cash flow statements and their implications in financial analysis.
A cash flow statement is one of the three main financial statements that are prepared by every business, the other two being the balance sheet and income statement. The statement which is used by businesses to measure their cash flows over a given period of time is the cash flow statement. According to Indian Accounting Standard (Ind AS) 7: Statement of Cash Flows, a cash flow statement is a statement that reflects the inflow and outflow of cash & cash equivalents during a given period of time. The net increase or decrease of cash is shown under three categories, namely operating activities, investing activities and financing activities.
Liquidity does not depend on “cash” only. Hence, along with cash, the cash flow statement also takes into account inflows and outflows of cash equivalents. Cash equivalents are those assets that can be readily converted into cash such as bank deposits, highly liquid short-term investments, etc.
A cash flow statement holds great significance for any business. It shows the cash position at a given point in time, i.e., whether there is a surplus or a shortage and whether the business is capable of meeting its liabilities on due dates.
When a business knows its cash position in and out, it helps its managers to plan and coordinate the business operations properly. As it gives information about cash available from operations, it enables the management to properly plan for the repayment of loans, replacement of assets, etc. In addition, it also enables the users (both internal & external stakeholders) to understand the cash position of the business.
Moreover, if the cash flow statement is compared with the cash budget for the same period, it will allow the management to control cash inflows and outflows. Actuals will be compared with the budgeted figures to find out the reasons for deviation.
Even though a cash flow statement is a useful tool for financial analysis, it has its own limitations. Some of these are discussed below:
1. Does not show a complete picture: A cash flow statement, on its own, cannot give an exhaustive analysis of the financial position of a business.
2. Needs other tools for analysis: For better interpretation, a cash flow statement would need to be seen in confirmation with other financial statements (like balance sheet & income statement) and analytical tools like ratio analysis. In isolation, its usage is limited.
3. Shows cash position only: Since it depicts only the cash position, one cannot arrive at the actual profit and loss of the business by just looking at this statement alone. Moreover, as working capital is a wider concept of funds, a funds fund statement might give a clearer picture than a cash flow statement.
4. Difficult to define the term “cash”: It becomes quite difficult to precisely define the term “cash”.
5. Cannot be equated with income statement: You cannot equate the cash flow statement with the income statement of a business entity. Since an income statement takes into consideration both cash as well as non-cash transactions, the net cash flow arising from the cash flow statement need not necessarily depict the net income of the business. Income statements are prepared based on the accrual basis of accounting whereas cash flow statements are based on the cash basis of accounting.
For example, while calculating cash generated from business operations, depreciation on fixed assets is excluded. But to match expenses and revenues while determining the business results, a depreciation charge is made in the profit and loss account for the use of fixed assets. Similarly, provision for bad debts, taxation, etc. is not taken into consideration while making a cash flow statement. Thus, there is no way one can equate it with the income statement.
6. May not represent the real liquid position: You cannot assess the real liquid position of a business by looking at the net cash balance as disclosed by the cash flow statement. This is so because many times, this balance may be easily influenced by postponing purchases and other payments. At the year-end dates, entities may postpose major payments to deliberately show a better picture of cash than what actually is. Thus, the cash balance disclosed by the cash flow statement may not represent their real liquid position.
This is called window dressing. The cash balance can be manipulated by deferring purchases and other payments and speeding up collections from debtors just before the balance sheet date. As compared to the “cash” position, the possibility of such manipulation is lesser in the case of the “working capital position” of a business. Thus, the funds flow statement might give a more realistic picture.
7. Pay higher dividends: A comparatively greater amount of cash generated from business operations in comparison to net profit earned may influence the management to pay a higher rate of dividend, which may have a negative impact on the financial health of the company.
8. Future estimates not possible: A cash flow statement is prepared on the basis of historical information. It shows the current inflows and outflows of cash but not the projected ones.
9. Inter-industry comparison may be difficult: Cash flow statements do not compare the economic efficiency of one company to another. A company with a large capital investment will often have a larger cash inflow. As a result, comparing cash flow numbers across industries may be misleading.
In spite of the above limitations, a cash flow statement remains a useful and important tool for financial analysis. It helps to show the volume as well as the speed at which cash & cash equivalents flow in different segments of a business entity. This information enables the management to know the amount of cash/capital tied up with a particular segment of the business. Moreover, the usefulness of cash flow analysis increases manifold when it is used in conjunction with ratio analysis. The two, when used together, help in measuring the profitability and financial position of the business.