Cash Flow Statements

The third financial statement

Why we need Cash Flow Statements

• The Cash Flow Statement gives further information to users on – Liquidity and solvency– Changes in net assets– The businesses financial structure– Its ability to effect cash flow timings

WHY PREPARE A CASH FLOW STATEMENT?

• Balance sheets, the income statement and statement of changes in capital are based on accrual accounting and provide only piecemeal information about flows of funds and cash

• Cash flow statement identifies cash inflows and outflows from activities over the period

• Statement helps answer questions such as:– Why is the company in a liquidity crisis when it has

been profitable over the past few years? 

 

 

CONTENT OF STATEMENT

• The statement must:

– identify cash at beginning and end of period– separately disclose cash inflows and outflows– classify cash flows as arising from operating,

investing or financing activities – Indian standard specifies either the direct or

indirect method of reporting cash flows

Components of the Cash Flow Statement

• There are six parts to every Cash Flow Statement:

1. Cash flows from operations2. Cash flows from investing activities3. Cash flows from financing activities4. Total change in cash5. Beginning cash6. Ending cash

• Items 5 & 6 must equal the amounts reported on the balance sheet

CONCEPT OF CASH

• As transfers between ‘cash’ items do not appear in the statement it is essential to determine what makes up cash

• Cash is defined in as cash and cash equivalents• Cash = cash on hand and demand deposits• Cash equivalents:

– Highly liquid investments with short periods to maturity, which are readily convertible to cash andhave minimal risk of value changes

CLASSIFICATION OF ACTIVITIES

• Classify the activities into:– Operating activities– Investing activities– Financing activities

• Treatment of item in financial statements does NOT determine cash flow statement classification

Cash flows from operating activities

• Relate to principle revenue-producing activities not investing or financing activities– cash receipts from customers– cash payments to suppliers of services

and inventory

• Also include any activities which are not investing or financing

Examples of Operating Activities

Cash Inflows Cash OutflowsCash from sale of goods Cash paid to suppliers

Cash from royalties, fees etc Cash paid to employees

Refunds of tax unless from investing etc

Cash payment of an insurance company

Cash refunds of an insurance company

Cash payment of income taxes

Cash receipts relating to future, forward, swaps if for dealing

Cash payments relating to future, forward, swaps if for dealing

Cash flows from investing activities

• Relate to acquisition and disposalof long-term assets and other investments– cash paid to buy new plant– cash received from sale of investment

• Interest and dividends received on these investments are classified as operating activities

Examples of Investing Activities

Cash Inflows Cash OutflowsCash received from disposal of fixed assets

Cash payments to acquire fixed assets

Cash received from disposal of shares

Cash payments to acquire shares, warrants etc

Cash received from payments of advances

Cash advances or loans to third parties

Cash received from derivatives if held as trade goods

Cash payments for derivatives

Cash Flows from financing activities

• Relate to changing size or composition of the equity and borrowings of an entity– cash received from new issue of share capital– cash used to repay mortgage loan

• Cash dividends paid to shareholders are classified as financing activities

Examples of Financing Activities

Inflows OutflowsCash proceeds from issuing shares or other instruments

Cash paid repayments of amounts borrowed

Cash proceeds from issuing debentures, loans and other short or long term borrowings

Cash redemption of preference capital and repayment on share buy back

PREPARING THE CASH FLOW STATEMENT

• There are two methods:

1. The Direct Method – This analyses the cash book and other accounting records

or

2. The Indirect Method - Analyse the financial statements (The Indirect Method)

• Both methods should produce the same cash inflows and cash outflows

PREPARATION OF THE CASH- FLOW STATEMENT-STEPS ARE:

1. Ascertain net cash used in operating activities2. Ascertain net cash used in investing activities3. Ascertain net cash used in financing activities4. Ascertain net cash and cash equivalents

increase (decrease) for the period5. Reconcile cash and cash equivalents at the end of the

year with that at the beginning of the period

CASH RECEIPTS FROM CUSTOMERS

• Calculate as follows

Accrual-basis Sales + beginning balance of accounts receivable – ending balance of accounts receivable

= cash received from customers

ACCOUNTS RECEIVABLE

Open Bal (A/R) 43 000 CASH 471 000Sales 480 000 Close Bal (A/R) 52 000

______ ______523 000 523 000

 

ACCOUNT RECONSTRUCTION

CASH PAID TO SUPPLIERS AND EMPLOYEES

• Requires two calculations which are then combined to given total cash flow:

– Payments for inventory purchases

and– Payments to employees and other suppliers

(relates to expenses other than cost of goods sold)

PAYMENTS FOR INVENTORY PURCHASES

• Calculate as follows

1. Cost of Goods Sold + ending balance of inventory beginning balance of inventory

= Accrual purchases

2. Purchases + beginning balance of accounts and bills payable – ending balance of accounts and bills payable

= cash paid to suppliers for purchases

PAYMENTS FOR INVENTORY PURCHASES

ACCOUNTS PAYABLE

Cash Payments 328 000 Beginning Balance 32 000Ending Balance 38 000 Purchases 334 000

366 000 366 000

 

INVENTORY

Beginning balance 52 000 Cost of goods sold 336 000Purchases 334 000 Ending balance 50 000 386 000 386 000

PAYMENTS FOR OTHER EXPENSES

• Calculate as follows:Other expenses – non-cash items and non-operating items + beginning balance of accrued expenses + ending balance of prepaid expenses – ending balance of accrued expenses – beginning balance of prepaid expenses = cash paid

• Non-cash items include depreciation• Non-operating items are expenses associated with

financing and investing activities such as cost of investment sold

CASH FLOWS FROM INVESTING ACTIVITIES

• Interest paid and received and dividends received are all required to be shown separately

• Cash flow = expense/revenue +/- beginning and ending balance of any prepayment or accrual accounts relating to these items

CASH FLOWS FROM INVESTING ACTIVITIES

• Purchase and sale of non-current assets

– Only payments made in cash and receipts of cash on sale are included

– Watch for non-cash transactions such as trade-ins and purchase by instalment

– Reconstruction of ledger accounts may be required to determine cash flows where depreciable assets have been sold

CASH FLOWS FROM FINANCING ACTIVITY

• Ignore non-cash transactions such as share dividends and debt conversions to equity

• Only dividends paid in cash are reported. Dividends paid = beginning balance of provision for dividend + interim cash dividends paid

• May need to reconstruct retained profits to determine interim dividends paid

ADVANCED ISSUES

• Some adjustments may need to be made in the conversion process from accrual basis reports to the cash flow statement

• Trade accounts receivable (bad debts, allowance for doubtful debts, discount allowed)

• Trade accounts payable • Non-trade receivables and payables• Bills receivable and bills payable• Short-term investments• Dividends• Income Tax

ANALYSING THE CASH FLOW STATEMENT

• Statements of cash flows help users evaluate a company’s ability to:

1. generate positive cash flows2. meet its obligations to shareholders, creditors and governments 3. assess a company’s solvency and need for external financing4. explain variances between reported accrual profit and cash

flows from operating activities

Single statements are of limited use, a useful analysis requires statements covering five or more years.

LIMITATIONS OF THE STATEMENT

• The usefulness of cash flow statements is limited due to the fact that they are:

– based on historical cash flows– non-cash transactions are only disclosed in the

notes– give only some of the information necessary to

assess liquidity and solvency– may be manipulated by management– costs involved in its preparation