Understanding the accounting concept of cash flow

The accounting concept of cash flow provides insight into businesses operations and cash positioning at the time the cash flow is recorded. Cash flow in its simplest form is the sum of cash that moves in and out of a business, specifically in terms of business operations, financing i.e. borrowing activities and investing activities. These three elements of cash flow are frequently recorded on the cash flow statement. (investopedia.com)

Cash flow statements, which became mandatory financial reporting statements in 1987 (ibid) illustrate cash details not included in other financial documentation. Since net income includes revenue owed but not received, this net income calculation can fall short in accurately reporting a companies complete financial position. (Brigham and Houston p.48) For example, net cashflow subtracts depreciation, amortization and cash receivables that haven't been received from net income (Ibid)

Why cash flow is important

Cashflow is important because it provides financial analysts, managers, shareholders and regulatory institutions such as the Securities and Exchange Commission (SEC) or the Federal Deposit Insurance Corporation (FDIC) with more detailed information regarding a businesses cash inflow and outflows. This information is useful in determining several factors regarding a business or company's use of cash. A few of the insights and facts revealed by a cash flow statement include the following:

• Demonstrates efficiency of cash utilization

• Allows for more comprehensive financial reporting and identification of cash usage

• Cash flow returns over time i.e. with several cash flow statements

• Operating, financing and investing activities

• Information used in calculating cash flow ratios and equations ex-net cash flow

• Assists in determining business valuation *Allows for more comprehensive financial reporting

How cash flow is measured 

Cashflow and information within cashflow statements is used in measuring several useful accounting and financial functions. Three such metrics include 1) net cash flow calculation 2) cash flow ratios and 3) cash flow based calculations such as present value of cash flows and internal rate of return. (wikipedia) Since the cashflow statement is divided into three sections included cash flow from operations, investing and financial activity, different ratios can be formed using each area of the cash flow statement. For example, the operating cash flow ratio is determined by dividing operating cash flow by current liabilities. (Brigham and Houston p.56) A few of the different cash flow ratio metrics are listed below.

• Operating cash flow ratio

• Price to cash flow ratio

• Free cash flow ratio

• Cash flow to debt ratio

• Working cash flow ratio

Additional cash flow measurements such as present value of future cash flow and internal rate of return use cash flow values to determine how much a series of cash flows are worth in terms of achievable interest rates as applied to each cash flow over time in the case of present value of cash flow (Brigham and Houston p.294) and matching costs to present value through adjustment of interest rate in the case of internal rate of return or IRR. (Ibid. p.509). These latter two calculations are quite important in bond and project valuation because they allow investors and managers to determine reasonable assessment of valuation and worth.

Both present value of future cash flows and internal rate of return can be calculated by using the functions of a financial calculator. For example, if a business has a 12 annual cash flows of $100, that are able to earn an interest rate of 10% upon receipt and where the first payment is received at the beginning of the first year the following function buttons can be used. N (Number of payments), I (Interest rate), PMT (Payments/Future cash flow), and FV (Future value). (Brigham and Houston p.295). 

To calculate the present value of future cash flows first determine the future value for poseterity by entering the values using these function buttons. For example, N=12, I=10, PMT=-100, PV=0 then CPT (compute) FV=$2138.428. Since payments are reversed the value is recorded as negative. Then, to compute the present value of the future cash flows, enter the same values except enter $0 FV and compute PV for a value of $681.369. (Ibid.p305) This is also called an annuity cash flow present value.

Summary 

Cash flow is a vital part of business operations and is often reported on the 'cash flow statement'. Cash flow is the movement of cash in and out of a company for various purposes over a given time and as recorded in the cash flow statement. Cash flow records can be used for a variety of financial and accounting purposes including valuation, assessing business management decisions, determining cash solvency via cash flow ratios, and illustrating how and where cash is used in a company. The cash flow within a company is a dynamic and important aspect of business operations, financing and investment for which the ideal balance of cash usage varies depending on type of business, economic conditions, business management and accounting reporting requirements.

Sources:

1. Eugene F. Brigham and Joel F. Houston. '0Fundamentals of Financial Management 9th edition'. Mason, Ohio. Southwestern, 2001. P.48-52.

2.http://www.answers.com/topic/cash-flow-statement 

3. http://www.investopedia.com/articles/04/033104.asp 

4. http://en.wikipedia.org/wiki/Cash_flow 

5.http://www.exinfm.com/board/cash_flow_ratios.htm 

6. http://www.candlestickforum.com/PPF/Parameters/11_1262_/candlestick.asp