Following are some of the well-known limitations of the cash flow statement.
1-Liquidity assessment
Although cash flow statement shows the cash status of the company, it cannot be used to assess liquidity or solvency position. Liquidity is a complex issue, dependent upon a number of factors that the cash flow statement cannot accurately describe. The cash flow statement only helps with amount of obligation to be paid. Hence, one is not able to truly assess liquidity of the business by looking at cash flow statement.
2-Profitability assessment
Profitability is when revenue generated by a business exceeds its expenses. A cash flow statement is not a good representation of profitability of a company as it does not include revenue nor expenses, which are important indicators of company’s operational health.
3-Future forecast.
The purpose of cash flow statements is to provide a current picture of the company’s flow of cash. Cash flow statements take data form historical costs and can neither use future costs nor can be used for future cash projections.
4-Net Income presentation:
Cash flow statements do not present net income as they do not consider non-cash items like deferred income tax, depreciation or amortization. The income statement, however, does use revenue and expenses data to calculate net income.
5-Tool for comparability:
Cash flow statements are not a good tool to compare companies in the same industry. It will not adequately measure the economic efficiency of a firm as compared to other inter-industry firms. Company with a bigger cash flow does not translate to better business activity. Lesser cash flow can be due to many reasons .For instance, lesser capital investment. The companies use various financial ratios for inter-industry comparison such as liquidity, profitability ratio or net profit margin.
6-Representation of financial health:
As explained earlier, cash flow statements can neither represent profitability, show net income, and nor be used for inter-industry comparison. All in all, it is not a good measure of a business’s financial health.
Also read, Elements of finanial statement.
General Limitations:
Aside from specific limitations of cash flow statements, there are general limitation that pertain to financial statements as a whole. The following limitations also relate to cash flow statements.
1-Understatement or Overstatement:
Financial Statements can be over or under stated without intent. For instance, calculation of depreciation and scrap value is an estimation based on certain parameters of use, resale value etc. and can never be truly realistic.
2-Susceptibility for fraud:
Financial statements are susceptible to fraud. There are many ways by which amounts in the financial statements can be manipulated and reinforced by improper audit processes.
3-Inaccurate representation of firm’s capabilities:
Financial statement does not represent the overall attractiveness of the firm. The cash flow may be good but company reputation, industry competitiveness and rivalry, and demand in the market are other important indicators of a good business.
What is a cash flow statement?
A cash flow statement is a financial statement that provides a summary of data regarding all cash inflows that a business receives by its operations and all the cash outflows that are used to pay for business operations and investments for a specific period. In simple term, all cash flow coming in or out of the company from any resource in a particular period will be included in the company’s cash flow statement for that period. Cash flow statements focus on cash accounting, rather than accrual accounting like income statements, and show the actual cash status / position of the company.
Although cash flow statements have their limitations, they have a clear purpose in the financial analysis. They were designed to communicate a business’s cash flow for a definite period of time and can be used for information on a company’s cash position, due obligations, governance of cash and aid in formulating dividend policy and future allocation of cash.
Conclusion on limitations of cash flow statement
Cash flow statement comes with greater limitations. These limitations include but not limited to liquidity assessment, profitability assessment, future forecast, net income presentation and comparability etc.
Cash flow statement does not reflect true liquidity of the business as there are several factors that describe business liquidity/solvency. Similarly, it’s difficult to trace profitability of operations using cash flow statement.
