Cash Flow Statement

The One Thing

A Cash Flow Statement explains the movement in cash and cash equivalents during an accounting period by classifying cash flows into operating, investing, and financing activities. Under the indirect method, accounting profit is converted into operating cash flow by adjusting for non-cash items, non-operating items, working capital changes, and income tax paid.

Definitions and Results

• Cash Flow Statement: A financial statement that reports cash receipts, cash payments, and the resulting change in cash and cash equivalents during a specified accounting period.
• Cash: Cash in hand and demand deposits with banks that are available for immediate use.
• Cash Equivalents: Short-term, highly liquid investments that can be quickly converted into known amounts of cash and have insignificant risk of changes in value.
• Operating Activities: Activities related to the main revenue-generating operations of the business, such as cash received from customers and cash paid to suppliers and employees.
• Investing Activities: Activities involving the purchase and sale of long-term assets and investments not treated as cash equivalents.
• Financing Activities: Activities that result in changes in the size and composition of the owners’ capital and borrowings of the business.
• Indirect Method: A method of calculating cash flow from operating activities by starting with net profit or loss and making suitable adjustments.
• Non-Cash Items: Items recorded in profit or loss that do not involve an actual movement of cash, such as depreciation, amortisation, and goodwill written off.
• Working Capital Adjustments: Adjustments for changes in current assets and current liabilities to convert accrual-based profit into operating cash flow.
• Net Increase or Decrease in Cash: The total of net cash flow from operating, investing, and financing activities.
• Cash Flow classification: Cash flows are classified into operating, investing, and financing activities.
• Basic relationship:

$$\text{Closing Cash and Cash Equivalents}=\text{Opening Cash and Cash Equivalents}+\text{Net Increase or Decrease in Cash and Cash Equivalents}$$

• Net cash flow relationship:

$$\text{Net Cash Flow}=\text{Cash Flow from Operating Activities}+\text{Cash Flow from Investing Activities}+\text{Cash Flow from Financing Activities}$$

• Operating cash flows: Generally include cash received from customers, cash paid to suppliers, cash paid to employees, and cash paid for operating expenses.
• Investing cash flows: Include the purchase or sale of property, plant and equipment; the purchase or sale of long-term investments; and loans or advances given to other parties and their repayment.
• Financing cash flows: Include the issue of shares or debentures, raising or repayment of loans, redemption of preference shares, and payment of dividend or interest according to the prescribed CBSE treatment.
• Non-cash transactions: Issue of shares for consideration other than cash and conversion of debentures into shares are not included in the main Cash Flow Statement. They may be disclosed separately.
• Purpose: The Cash Flow Statement assists users in assessing liquidity, solvency, cash-generating ability, financial flexibility, and the quality of reported profits. It should be read with the Balance Sheet and Statement of Profit and Loss because it explains cash movements rather than complete profitability or financial position.

Worked Methods

1. Classifying cash flows

• Identify the nature of the transaction.
• Classify cash received or paid as operating, investing, or financing.
• Exclude transactions that do not involve cash or cash equivalents from the main statement.
• Reconcile the resulting net cash flow with the opening and closing cash balances.

Examples:

• Cash received from customers, cash paid to suppliers, cash paid to employees, and cash paid for operating expenses are operating activities.
• Purchase or sale of property, plant and equipment and purchase or sale of long-term investments are investing activities.
• Loans or advances given to other parties and their repayment are investing activities.
• Issue of shares or debentures, raising or repayment of loans, and redemption of preference shares are financing activities.
• Payment of dividend or interest is classified according to the prescribed CBSE treatment.
• Purchase of an asset is normally a cash outflow under investing activities, whereas sale of an asset is normally a cash inflow under investing activities.
• Issue of shares for consideration other than cash and conversion of debentures into shares are non-cash transactions and are excluded from the main Cash Flow Statement.

2. Calculating cash flow from operating activities using the indirect method

• Begin with net profit or loss before tax, or with the starting figure prescribed by the applicable format.
• Add non-cash expenses that reduced accounting profit but did not reduce cash:

- depreciation; - amortisation; - impairment; and - goodwill written off.

• Deduct non-operating incomes included in operating profit but related to other classifications:

- profit on sale of fixed assets; - profit on sale of investments; and - dividend income.

• Add losses on the sale of fixed assets or investments when those losses reduced accounting profit but do not represent operating cash payments.
• Adjust for changes in working capital:

- deduct an increase in current assets, excluding cash and cash equivalents; - add a decrease in current assets; - add an increase in current liabilities; and - deduct a decrease in current liabilities.

• Deduct income tax paid, unless the question or applicable accounting treatment requires another presentation.
• The resulting amount represents cash generated from operating activities.

This method reconciles accounting profit with operating cash flow by removing non-cash and non-operating effects and incorporating working capital changes.

3. Determining the overall change in cash

• Calculate net cash flow from operating activities.
• Calculate net cash flow from investing activities.
• Calculate net cash flow from financing activities.
• Add the three amounts:

$$\text{Net Cash Flow}=\text{Operating Cash Flow}+\text{Investing Cash Flow}+\text{Financing Cash Flow}$$

• Add net cash flow to opening cash and cash equivalents:

$$\text{Closing Cash and Cash Equivalents}=\text{Opening Cash and Cash Equivalents}+\text{Net Increase or Decrease in Cash and Cash Equivalents}$$

• Confirm that the statement covers the accounting period reported by the financial statements and that the opening and closing cash balances are reconciled.

Where It Goes Wrong

• Treating profit as equivalent to cash: profit may coexist with a cash shortage because of credit sales, working capital changes, or large investments.
• Forgetting to add back depreciation, amortisation, impairment, and goodwill written off, even though these expenses reduce accounting profit without reducing cash.
• Failing to deduct non-operating incomes such as profit on sale of fixed assets, profit on sale of investments, and dividend income when they are included in operating profit.
• Reversing working capital rules: an increase in current assets is generally deducted, while an increase in current liabilities is generally added.
• Omitting income tax paid after the working capital adjustments, unless another presentation is required by the question or applicable accounting treatment.
• Including non-cash transactions, such as issue of shares for consideration other than cash or conversion of debentures into shares, in the main Cash Flow Statement.

What Gets Asked

• Define a Cash Flow Statement, cash, cash equivalents, operating activities, investing activities, financing activities, the indirect method, non-cash items, working capital adjustments, or net increase or decrease in cash.
• Classify transactions as operating, investing, financing, or non-cash activities.
• Prepare cash flow from operating activities using the indirect method.
• Adjust net profit or loss for depreciation, amortisation, impairment, goodwill written off, profits or losses on asset and investment sales, dividend income, working capital changes, and income tax paid.
• Calculate net cash flow from operating, investing, and financing activities.
• Determine closing cash and cash equivalents from opening cash and the net increase or decrease in cash.
• Explain why profit and cash differ and how credit sales, working capital changes, and major investments affect cash.
• Explain how the Cash Flow Statement assists in assessing liquidity, solvency, cash-generating ability, financial flexibility, and the quality of reported profits.
• Distinguish the information provided by the Cash Flow Statement from that provided by the Balance Sheet and Statement of Profit and Loss.