Advantages and Limitations of the Cash Flow Statement
Chapter Forty-Five
Syllabus topic 1, "Meaning, objectives, significance, advantages and limitations of Cash Flow Statements"
Pages 123 to 124 of 162
The advantages
| Advantage | Why | |
|---|---|---|
| 1 | It explains the gap between profit and cash | The single question no other statement answers |
| 2 | It shows whether the business finances itself | Net cash from operations against the investing outflows and the dividends |
| 3 | It is not affected by accounting policy | Depreciation methods and stock formulas move profit and cannot move cash, so companies are comparable |
| 4 | It shows the sources and uses of cash in a classified form | Three headings, so a reader sees at once where money came from and went |
| 5 | It helps plan | Next year's cash budget starts from this year's cash flows |
| 6 | It measures the ability to pay | Dividends, interest, instalments, taxes; all are met out of cash and not out of profit |
| 7 | It is objective | An entry can be traced to a bank statement; a provision cannot |
| 8 | It reveals window dressing indirectly | A company that delayed paying creditors to flatter its current ratio shows the payment in the following year's operating cash flow |
The limitations
| Limitation | Why it bites | |
|---|---|---|
| 1 | It is not a substitute for the revenue statement | A large positive cash flow can accompany a heavy loss, and a profitable growing company can show negative cash flow |
| 2 | It ignores non-cash transactions | AS 3 excludes them expressly. A machine bought by issuing shares is a real investment and appears nowhere in the statement |
| 3 | It is historical | It reports a period that has ended |
| 4 | It can be manipulated by timing | Delaying payment to suppliers until 2 April improves this year's operating cash flow, exactly as it improves the current ratio |
| 5 | It does not show liquidity fully | A company can have cash and still be illiquid if that cash is committed, and the statement shows the balance and not the commitment |
| 6 | It depends on the definition of cash equivalents | An investment classified as a cash equivalent produces no cash flow when bought or sold; classified otherwise it produces two |
| 7 | It is prepared once a year | Cash positions move daily, and an annual statement can conceal a year in which the company was repeatedly overdrawn |
Limitation two deserves a worked line. A company acquires plant worth Rs 10,00,000 by issuing shares. Nothing appears in the cash flow statement, and the balance sheet grows by Rs 10,00,000 on both sides. A reader who used only the cash flow statement would not know the company had invested at all, which is why AS 3 requires such transactions to be disclosed elsewhere in the financial statements.
Cash flow against fund flow
A question sometimes asks for the distinction, because both were long taught.
| Basis | Cash flow statement | Fund flow statement |
|---|---|---|
| Traces | Cash and cash equivalents | Working capital |
| A movement between two current items | Changes the statement if it is between cash and a non-cash current item | Does not appear, since working capital is unchanged |
| Required by law | Yes, by AS 3 and section 2(40) | No; it is not a prescribed statement |
| Classification | Operating, investing, financing | Sources and applications of funds |
| Useful for | Short-term solvency and the ability to pay | Medium-term financing and the change in working capital |
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