2.1 What is cash flow?

Cash flow statement is about where the money came or will come from, where it went and will go. In short, cash flow statements show the predictability, timing and amount of cash-inflows and cash-outflows. Furthermore, it is also used in business planning and budgeting. Accounting personnel are interested in knowing organization’s ability to cover payroll and other immediate expenses while creditors or potential lenders would like to see the company’s able to repay or not. In addition, potential investors have to judge company’s finance and contractors or potential employees that happy to know the company is able to afford compensation.

2.1.1 Classification of Cash Flow

In cash flow statements, it has three distinct activities that are operations, investing and financing.

Cash flow from operating activities indicates the cash provided or used by a company’s normal operations. This cash flow figures show the ability of the company to be consistent in generating positive cash flow from operations activities. Operations activities are the core business of the company. It is the cash that the company produces internally.

Investing activities are disposing and acquiring of property, plant and equipment, investment, collecting the loans and lending money. Cash flows in investing include all the cash provided or used by the sale and purchase of income-producing assets. Cash flow from investing usually generates cash outflows. For example, activities like capital expenditures for plant, property and equipment, the purchase of investment securities and business acquisitions. On the other hand, inflows generated from the investment securities, businesses and sale of assets. Capital expenditure is what investor would like to look at. Investors think that it is necessary to ensure proper maintenance of assets of the company and support company’s operation efficiency and competitiveness.

Financing activities generate cash from issuing debt, repurchasing shares, repaying the amounts borrowed, paying dividend and get cash from stockholders. In financing activities, the cash flow is calculated with flow of cash between a firm and its creditors and owners. Negative numbers may illustrate the company paid dividends and repurchase stock but it also may show the company is servicing debt. Debt and equity transactions are in financing activities. The issuance of stock is much less frequent. Cash dividends paid is the most important for investors.

2.1.2 Different methods in Cash Flow

Different methods are used in different cash flow statements’ format. One of the methods is indirect method while the other is direct method. The indirect method adjusts net income for items that do not affect cash. This method is more widely used by companies because it is easier and less costly to prepare. Moreover, it differentiated between net income and net cash flow from operating activities. But operating cash receipts and payments are shown in direct method which makes direct methods to be consistent with the cash flow statement’s objective.

2.1.3 Cash Flow versus Income

It is vital to able to see and differentiate between having positive cash flow transactions and being profitable. Companies does not bringing in cash is not mean that they not making profit.

For example, a manufacturing company sells off half of its factory equipment because low product demand. Cash will be received from the buyer for the used equipment. Manufacturing company is actually losing money on the sale. Equipment is manufacture products to earn an operating profit would be preferable. Best choice is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Cash flow can be positive while profitability is negative.

2.2 Financial Stability

Financial stability is defined in terms of its ability to facilitate and enhance economic processes, manage risks, absorb shocks. Financial system enables the financial intermediation process which facilitate and the flow of funds between savers and borrowers which ensure that financial resources can efficiently towards promoting economic growth and development. Positive cash flow ensures good flow of funds. Good cash flow will show good liquidity ratio and acid test ratio.

Financial stability is important to evaluate the risks within a financial product such as in matching re-investment requirements, evaluating default risk, cash requirements and others. Financial statements are accrued based accounting which takes into account non-cash items. It hopes to reflect the financial health of company. But accrual accounting may sometimes not clear actual amount of cash generated. Operating cash flow ratio shows the ability of company to service its interest and loans payments. Even a slight change in the cash flow statement can jeopardize its loan payments, therefore company will bare more risk than a company with stronger cash flow levels.

Acid test ratio takes a closer look at the paying debt ability. It is a stringent test to determine whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. This is a test of immediate solvency. The higher the ratio, the more financially secure a company is in a short term. Quick ratio greater than 1.0 is sufficient to meet their short-term liabilities. This acid test ratio will be combined with explanation of how solvency affects the financial stability. Solvency ratios measure the stability of a company and its ability to repay debt. If is negative acid test ratio, then company should find ways to make it become positive. An acid test of 1.1 is considered satisfactory. This way to calculate acid test ratio is:

Acid test ratio= Quick Asset (current asset- stock) ÷