Statement of Cash Flows and Effects of Liquidity Changes Order Instructions: Consider the need for the statement of cash flows and how changes in liquidity can affect an organisation.
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Statement of Cash Flows and Effects of Liquidity Changes Sample Answer
Introduction
Cash in most businesses is generated through sale of goods or services from the companies. These are referred to as cash inflows while the payment for labour, raw materials, transport or other expenses are basically the cash outflows and the difference between the two is the net cash flow. The statement of cash flow breaks down and analyzes the cash flows from different operations by categorizing them into three major processes, operating, investing and financing.
The cash flow statement indicates the cash balances and the flow of cash in and also out of business.
The need for cash flow can be illustrated in different aspects. The accountants in most companies would be interested in confirming if a company can afford to pay all its expenses like salaries, rent and other utilities. Potential investors would be interested in confirming from the cash flow if the company they are interested in can be able to generate enough profits to pay back the invested amounts while creditors would be interested in a company’s ability to pay back the advanced loan. The shareholders of a company would need the cash flow to determine the financial and investing activities that the company has engaged in the past financial year.
These activities may include the payment of dividends, purchase of shares or the purchase or sale of assets. The cash flow indicates the net cash flow for the business (Atrill & McLaney, 2013).
Cash flow is required to reveal the changes in the financial operations of a business and whether the changes were positive or negative. A positive cash-flow reflects a position where a company earns more money than it actually spends while a negative cash-flow the amount of cash received is less than the amounts spent in a company in a given financial period (Vance, 2003)
When budgeting, a company needs to confirm the company’s actual balances at the end of every financial period. This information is obtained from the cash flow statement (Garrison, Noreen, & Brewer, 2009)
Liquidity refers to the ability of a company to convert an asset quickly into cash and its mostly obtained by calculating a company’s liquidity ratios that are given by the current and quick ratio. The current ratio is obtained by dividing the current assets and the current liabilities. It measures the ability of a company to repay its current liabilities. The standard for current ratios for an average promising company is mostly 2: 1. The current assets should exceed the current liabilities by at least 2 to 1 while for quick ratios its 1:1 (Bodie, Kane & Marcus, 2008).
The cash flow supplements the other two financial statements. The income statement and the statement of financial position are prepared in accrual accounting system. Under accrual system, transactions are recognized when they occur and not when cash has been paid or received hence it’s possible for a company to register some profits in its books when actually it has no extra cash (Bowen, Burgstahler & Daley, 1987).
This condition is only recognizable when a cash flow statement has been prepared. The difference between the current assets and the current liabilities represent the working capital for a business. For a business to operate, it must have adequate working capital.
A company suffering from liquidity problems finds it difficult to honor most of its obligation hence the normal operations of the business is interrupted. For example, lack of operating cash can lead to the inadequate provision of transport facilities that are required to transport manufactured products to various retail shops across the country. Hence businesses would be affected as a result of a shortage of products in the market (Bodie, Kane & Marcus, 2008)
A company that has more liabilities than current assets would find it difficult to repay its creditors on time as the resources are not adequate. If the company does not seek external financing then it finally sinks into insolvency, a situation where a company cannot honor its financial obligations and commitments (Vance, 2003)
Liquidity status of a company may or may not attract visitors. When a company is liquid more customers are interested in the company and the demand for its shares increases hence the share prices increase. The value of a company’s share depends on the company’s ability to distribute dividends out of the company’s.
Cash flow analysis enables proper planning on stock levels, payment procedures for all outstanding debts and also working out the cash flows to sustainable levels.
To conclude, liquidity and profitability are quite different; profitability refers to the profits as reflected in the income and expenditure and also in the statement of financial position while liquidity is the availability of cash. A company that is making profits may not be automatically liquid. Cash flow is important to a company especially during hard economic times when financing is difficult to arrange, companies face hard times, cash flow reveals the business activities that are least profitable and which ones should be discarded.
References
Atrill, P. & McLaney, E., 2013, Accounting and finance for non-specialists. 8th Ed. Harlow, UK: Pearson Publishing. (Chapters 3 & 5)
Bowen, M., Burgstahler, D. & Daley, L.A., 1987, ‘The incremental information content of accrual versus cash flows’, The Accounting Review, 62 (4), pp. 1–26.
Bodie, Z., Kane, A., & Marcus, A. J., 2008, Investments (7th International Ed.) Boston: McGraw-Hill. 303
Garrison, R., Noreen, W. & Brewer, P., 2009, Managerial Accounting, New York, NY: McGraw-Hill Irwin. 65 -70
Vance, D., 2003, Financial analysis and decision making: tools and techniques to solve financial problems and make effective business decisions. New York, NY: McGraw-Hill.
