The Statement of Cash Flow Is Not Redundant and Necessary for Investment Decision Making

Topics: Cash flow, Asset, Balance sheet Pages: 7 (2428 words) Published: April 18, 2013
The manager of Dowlais Iron Company, made a new financial statement called "comparison balance sheet", in 1863 to explain the reason for the inability to invest was due to the holding of too much inventory, despite the profit made. This was the beginning of the cash flow statement, which was later made compulsory by the Financial Accounting Standard Boards (FASB) under Generally Accepted Accounting Principles (GAAP). This step was followed by International Accounting Standard Boards (IASB) when they issue IAS 7 Cash Flow Statement. The Cash Flow Statement only reported transactions that took place by the use of cash or cash equivalents, and discarded anything that was recorded on accrual basis in Balance Sheet (Statement of Financial Position) and the Profit and Loss Statement (Statement of Comprehensive Income).

The construction of the Cash Flow Statement is divided into three; cash flow from operating, investing and financing activities. With two approaches in constructing Cash Flow Statement; direct and indirect approach, the difference is basically on the construction of the first part, operating activities. Cash flow from operating activities are cash flow from principal revenue-producing activities of the company and other activities that are not investing or financing activities. In using the direct method approach, it would have to start from scratch; what are the cash receipts and cash payments made during the period, while the indirect method approach would start with the profit before tax figure and later, adjustments are made, i.e. depreciation, increase or decrease in inventories, receivables, payables, etc.

The other two activities (financing and investing) remain the same regardless of methods used. Financing activities are activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise. For example, the issuance of the company's shares, payment of dividends, borrowings, etc. With regard to the investing activities, it consists of any activities of investment for capital assets, financial markets, and even operating subsidiaries.

Although the existence of the Cash Flow Statement is considered quite new in the accounting world (which starts around 1490s by Luca Pacioli, that was called "bookkeeping"), it is agreed that there are a lot of benefits with the presence of the Cash Flow Statement. This position paper will touch on a couple of them just to be firm on the topic, that is "The Statement of Cash Flow is not Redundant and Necessary for Investment Decision Making".

Cash Flow Statement as a Tool for Investment Decision
There are ways and ratios that we could use to measure the solvency and liquidity of a company, using the information from the Balance Sheet (Statement of Financial Position) and the Profit and Loss Statement (Statement of Comprehensive Income). However, with the presence of Cash Flow Statement, it is made easier and more logic. The first ratio would be the Operating Cash Flow Ratio which could be derive from the following formula: Cash Flow from Operations ÷ Current Liabilities

This ratio would give the indication as to whether or not the company is able to repay their current debt with the use of the cash from operating activities. This ratio is slightly similar to the Current Ratio, but the use of Cash Flow from Operations to replace Current Assets is simply more logical to measure the liquidity, because the Current Asset includes Inventories and Receivables which are not of the high liquidity compared to cash. The investors can make a reasonable and justifiable decision based on this ratio, simply because it gives a better view of liquidity than the Balance Sheet (Statement of Financial Position).

The second ratio that could help investors decision making is the Price/Cash Flow Ratio. Even though this ratio is not widely use as the Price Earnings Ratio, this ratio is often considered as the better...
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