Availability of adequate cash flow is more important than business profitability sometimes. This shows the “liquidity” position of a company over a period. Calculation of net cash flow is brought by adjusting all cash inflows and out flows. Profitability shows the performance of business over a period, but cash flow statement shows the actual position of cash flows. Main difference between profitability and cash flows is cash and non-cash items. In profit, non-cash items like depreciation are taken into account but cash flows consider the real cash items. This is measure of increase and decrease in cash flow. In order to convert profit into cash flow, certain financial elements need to be treated differently. We are concern with the liquid cash available or consumed over the period of account. So depreciation is added back in the original figure of “profit”.
Other items which will be added or subtracted are receivables, inventories, payables and loan.
In term of cash flows, increase in Receivables means more cash tie up so low liquidity, decrease in receivables means opposite. It is the case with inventories, payable as liability (expected cash outflow) when increased means more cash is available to manage business routine and payable payment has been delayed. This impact on positive dimension upon cash flows, so increase in payable means positive cash, decrease means negative cash(payment is made to creditors).
In case of bank loan, increase in loan means addition in cash while decrease shows repayment of loan (cash decreased). So increase in Receivables and inventories means Addition (+) in original figure of profit, decrease means Deduction (-). Increase in payable will be added in original profit figure and decrease will be deducted. While increase in loan will be addition in original or non-cash profit figure.
After making these adjustments, balance at the end will be a Cash flow profit.
Mainly, there are three types of Cash flows, Operation, investing and financing cash flows. Sum of all these cash flows will be Net cash flow of the business.
Operating cash flows, shows the liquid position of company`s operation. This is all incoming and outgoing cash from sale of inventories, generating cash from receivable, paying payables and loan receipt and payment. The negative cash flows at this point shows the poor operational survival of the business.al measure are taken into account to keep net operation`s cash flow as positive cash flow.
Investing cash flow, as the name shows, is cash generation from sale of non-routine and long-term assets, which account for disposal gains and losses. Financing cash flow is the liquidity generation by financing activities i-e debt and equity components.
The real difference between statement of financial position and performance when compared with the statement of cash flows is: cash flow is prepared on the basis if “cash accounting” which acknowledge any transaction when cash activity associated is done. At the other end, other two statements are based on “accrual accounting” which acknowledges transaction when sale or an expense is incurred rather than cash is eventually received or paid.