The Concept of cash flow estimation?
Every business survives on liquid to cater for its daily operational activities. It is therefore important to monitor the flow of cash from the source to the area where it is used. A business could be making profit but its cash account is inconsistent and could result in insolvency. If a business realizes at the end of financial year that the cash account has a deficit, then it would be imperative for the company to review all cash transactions to evaluate where the deficit came from. The international accounting standards board (IASB) requires that all businesses comprehensively consolidate their financial statements.
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Cash flow refers to the inflow and outflow of cash in a business. It estimates how a company expenses on cash and where the company obtains cash from .Besides the current inflow and outflow of cash, a company can forecast the amount of cash in the account it anticipates to have in the future from expected revenue or expenses. Cash flow estimation is monitored from the following areas; cash flow from operating activities, cash flow from investments and cash flow from financing activities. The main goal of estimating the flow of cash is to caution the business against insolvency.
Steps involved in the concept of cash flow estimation
Cash flow estimation is an accounting concept recommended for both start-up business and existing businesses. Since a business is a going concern, the management is expected to project if it shall be able to raise enough liquid cash to cater for current liabilities in the future.
Cash flow can be made monthly, bi-monthly, quarterly or half-yearly. In our case we shall assume that the business is going-concern and has been in operation for several years.
Step 1
Using the summary of the trial balance from last financial period, outline all assets, liabilities and capital accounts. Project the transaction changes that are likely to occur in the next financial year for ever account. For example, by the end of last financial year, the debtors were valued at $1500.This means that during this year, we expect the debtors to pay in full or partly. This information is debited in the debtors account as an inflow of cash.
Step 2
Open three main accounts: cash flow from operation activities, cash flow from investment activities and cash flow from financing activities.
Cash flow from operation activities: This account involves all projected current assets and current liabilities projections .For example sales earnings, debtors, creditors, wages, rent. For instance, by the end of last financial year, total number of creditors amounted to $ 60.Therefore, we expect to pay this amount this financial year. This is an expected cash outflow that should be credited in this account.
Cash flow from investment activities: This account evaluates or investment activities that the business anticipates to undertake. They include acquisition new machinery or another business, disposal of depleted assets, acquisition of land, receipt of rent from building lease. For example, a business intends to invest in real estates and approximates the cost to be $300000 for completion. This is a projected cash outflow in the business which is debited.
Cash flow from financing activities: This account evaluates all cash receipts and expenditure that affect the capital account of a business. Examples include selling shares to the public, retention of profits and Drawings. For instance, a company may decide to expand its capital base by selling shares to the public. This will increase the cash account and capital account and thus a cash inflow.
Step 3
This is the final step. This step entails preparation of a cash flow statement. Add the net cash inflow or outflow from each of the previous accounts in step 2. The total amount should be equal to the final amount in the cash account.
Advantages of cash flow estimation
Cash flow estimation is used to assess the financial strength of a business. It enables the management to evaluate whether the cash at hand can be able to run the short term expenses of the business as they fall due.
Cash flow estimation helps the business to predict the future cash inflow and outflow of a business. In addition, using cash flow estimation is a tentative approach for the company to consider non-viable investment activities that may not yield enough cash.
Disadvantages of cash flow estimation
Cash flow estimation does not consider the profitability trend of a business. It concentrates only on cash account. Another advantage is that the approach only evaluates the flow of liquid cash and ignores other forms of cash flow.
Why are negative earnings a problem?
Every business operates on a going concern concept where it is assumed that it will continue functioning for a period of time. During early stages of operation, it is logical for business to have negative earnings due to initial fixed costs that exceed the revenue. However, this is expected to change in Future.A Company making negative earnings means that its costs exceed the revenues and it difficult to sustain its operations. A business with negative cash in hand account is risky since it would be difficult to cater for short term cash expenses in the daily operation of a business. The business may be rendered insolvent.
Principles of cash flow estimation
Separation principle
This principle enables in estimating the inflow and outflow of cash .This principle separates operation cash flow activities from investment and financial activities, this is important to the financial managers because they are able to evaluate the area that brings the cash deficit and makes necessary changes. One core feature in the principle is that it excludes interest rates on debt securities while calculating profits and tax payable.
Consistency principle
This principle requires that the cash flows and the discount rates must be harmonized to show consistency in relation to the prevailing rate of inflation and investors intentions.
Incremental principle
This principle requires that cash flow is estimated on an incremental basis. All changes of a business should be included in the financial statements. For instance, if a company acquires new machinery on cash, the records should be made in the relevant accounts.
Post- tax principle
Cash flow estimates are to be calculated on a post -tax basis. The principle requires that corporate tax should be exempted from cash flow estimates. Estimates should only be recorded after projected tax rate has been deducted.
Example of Cash flow estimation use in Health care
Health care sector is a very delicate area that is susceptible to many eventualities. Enough liquid cash reserve is necessary to handle the unforeseen expenses. A health financial officer would require cash flow estimation approach to access the operational expenses on drugs, food for the patients and projected increase in staff wages. To caution itself from eventualities, the health facility can consider engaging in investment activities to replenish the cash in hand. Cash flow estimation will provide the facility with the necessary financial information to cater for its operational activities as they fall due.
References
Hillier, D. (2010). Corporate finance. London: McGraw-Hill Higher Education.
Khimich, N. V. (2012). Cash Flow and Discount Rate news estimation: Which method to choose? .Berkeley, CA.
