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Limitations of the Cash Flow Statement

Nnenna Nick-Obiegbu Written by Nnenna Nick-Obiegbu · 1 min read >

Although there are some limitations of the CashFlow statement, without further investigation, negative cash flow shouldn’t automatically be treated as a red flag. Sometimes a company’s decision to grow its business at a certain period, which might be beneficial for the future, results in poor cash flow.

An investor can have a better understanding of the performance of the firm and determine whether it is likely to succeed or go bankrupt by examining variations in cash flow from one period to the next. 

The income statement and balance sheet are two additional financial statements that can be reconciled using the indirect cash flow approach.

The cash flow statement evaluates a company’s performance over time. It is, however, less susceptible to manipulation by the timing of non-cash transactions. As previously stated, the CFS can be calculated using the income statement and the balance sheet. The information on the CFS is derived from the net earnings from the income statement. However, they only influence the CFS’s operating activities section. As a result, net earnings have nothing to do with the CFS’s investment or financial activities sections.

There are two Cash flow approaches and the distinction is in how cash inflows and outflows are calculated.

Actual cash inflows and outflows are known amounts when using the direct method.  Here, The cash flow statement is straightforward, using only cash payments and receipts.

For the Indirect method, the actual cash inflows and outflows do not need to be known when using the indirect method. The indirect method starts with the income statement’s net income or loss and then modifies it with balance sheet account increases and decreases to compute implicit cash inflows and outflows.

I am sure you are wondering if any method is better than the other. 

Neither is necessarily superior or inferior. However, the indirect method also allows for the reconciliation of balance-sheet items to income-statement net income. When an accountant prepares the CFS using the indirect method, they can identify balance-sheet increases and decreases caused by non-cash transactions.

It is beneficial to understand the impact and relationship of accounts on the balance sheet to net income on the income statement, and it can provide a better understanding of the financial statements as a whole.

In conclusion, a cash flow statement is a useful indicator of a company’s health, profitability, and long-term prospects. A company’s liquidity or cash flow situation can be evaluated using the CFS. An organization can utilize a Cash flow statement to forecast future cash flow, which aids in budgeting issues.

Since more cash is normally better for corporate operations, the CFS for investors serves as a gauge of a company’s financial health. This is not, however, a strict rule. A company’s growth plan, which takes the form of expanding its operations, can occasionally result in a negative cash flow.

Finally, we can say that the best way an investor can have a thorough idea of the cash flow generated by a firm and its financial health by examining the firm’s Cash flow statement.

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