In terms of financial activities, it is essential to realize not only the meaning of a statement of cash flows but also the types of its calculation. According to Lewellen and Lewellen (2016), in modern practice, two methods of calculating cash flows have become widespread – direct and indirect. The division of all cash receipts and expenses into three categories – primary, investment, and financial activities – is common to both methods.
In the direct way, the basis is the conversion of all the proceeds from sales into net cash profit by consistently accounting for income and expenses in monetary form. The indirect type is necessary in order to transform the firm’s net profit into a real monetary form. Changes in financial assets and their equivalents during the reporting period show the ways of covering net cash flows. As Bollerslev, Xu, and Zhou (2015) note, the indirect method is considered preferable from the point of view of companies’ financial management since it clearly reflects changes in the balance structure of enterprises’ activities. Therefore, this way of calculating may be the valuable source of receiving important data.
Also, it is significant to clarify the advantages that the study of cash flows provides. This procedure allows evaluating liquidity and the threat of bankruptcy, calculating the effectiveness of financing capital investments, and assessing the production and financial risks of a certain company and the investment qualities of its securities. According to Barth, Clinch, and Israeli (2016), investors are interested in cash flows as a basis for paying dividends, and lenders use them as a guarantee of debt repayment. Therefore, this system is beneficial for various stakeholders and may be introduced in different financial schemes.
References
Barth, M. E., Clinch, G., & Israeli, D. (2016). What do accruals tell us about future cash flows? Review of Accounting Studies, 21(3), 768-807. Web.
Bollerslev, T., Xu, L., & Zhou, H. (2015). Stock return and cash flow predictability: The role of volatility risk. Journal of Econometrics, 187(2), 458-471. Web.
Lewellen, J., & Lewellen, K. (2016). Investment and cash flow: New evidence. Journal of Financial and Quantitative Analysis, 51(4), 1135-1164. Web.