Purpose of Cash Flow Statements

Cash flow statements are useful in determining liquidity and identifying the amount of capital that is free to capture existing market opportunities. As one of the core financial statements publicly traded organizations release to the public, it is also useful as a benchmark for investors when considering the capacity for different organizations within an industry to adapt and capture new opportunities.

In short, we can summarize what cash flows are used for as:

1. Measure liquidity and the capacity to change cash flows in future circumstances
2. Provide additional information for evaluating changes in assets, liabilities, and equity
3. Compare between different firms' operating performance
4. Predict the amount, timing, and probability of future cash flows

Limitations 

However, there can be a number of issues with utilizing the statement of cash flows as an investor speculating about different organizations. The simplest drawback to a cash flow statement is the fact that cash flows can (but not always) omit certain types of non-cash transactions. As the name implies, the statement of cash flows is focused exclusively on tangible changes in cash and cash equivalents.

Regulation

However, to offset some of this, governments have enacted various requirements on the statement of cash flows to limit any information that may be misleading. The primary pieces of legislation are the Generally Accepted Accounting Principles (GAAP) cash flow requirements (1973) and, later on (1992), the International Accounting Standards 7 (IAS 7). A few key points include:

• Under IAS 7, cash flow statement must include changes in both cash and cash equivalents. US GAAP permits using cash alone or cash and cash equivalents.
• Bank borrowings (overdraft) in certain countries can be included in cash equivalents under the IAS 7.
• Interest paid can be included in operating activities or financing activities under the IAS 7. US GAAP requires that interest paid be included in operating activities.
• When the direct method is used, US GAAP (FAS 95) ensures organizations present a supplemental schedule using the indirect method. The IASC strongly recommends the direct method but allows either method. The IASC considers the indirect method less clear to users of financial statements.
• Non-cash investing and financing activities are disclosed in footnotes under IAS 7. Under GAAP, non-cash activities may be disclosed in a footnote or within the cash flow statement itself.

Like all financial statements, the statement of cash flow is only designed to highlight one aspect of operational output. As a result, it is not an indication of an organization's health from an holistic point of view, but instead a snapshot of operational success from one specific perspective. 

IAS 7

This chart illustrates the various important enactments of the International Accounting Standards, including the IAS 7.

This chart illustrates the various important enactments of the International Accounting Standards, including the IAS 7.