Chapter Notes

Introduction to the Cash Flow Statement

So far, you've learned about two main financial statements: the Position Statement (or Balance Sheet), which is a snapshot of a company's financial health on a specific day, and the Income Statement, which shows its profit or loss over a period. Now, we'll explore the third key financial statement: the Cash Flow Statement.

This statement is all about tracking the movement of cash. It shows the inflows (cash coming in) and outflows (cash going out) for a company over a specific period. Think of it like a detailed bank statement for a business, but organized into specific categories. Its importance has grown significantly because it gives a clear picture of how a company is generating and using its cash, which is crucial for making sound economic decisions.

In India, the Companies Act, 2013, requires companies to prepare a Cash Flow Statement according to Accounting Standard-3 (AS-3). This ensures that the information is reliable and presented in a standardized way. The statement classifies all cash movements into three main types of activities: operating, investing, and financing.

Objectives of Cash Flow Statement

The main goal of a Cash Flow Statement is to provide clear and useful information about a company's cash inflows and outflows during a particular period. By categorizing these flows, it helps users of financial statements to:

• Assess the company's ability to generate cash and cash equivalents.
• Understand the company's need to use that cash.
• Evaluate the timing and certainty of future cash generation.

This information is vital for making informed decisions, as it shows how well a company can manage its cash to run its operations, invest for the future, and meet its financial obligations.

Benefits of Cash Flow Statement

When used alongside the Income Statement and Balance Sheet, the Cash Flow Statement offers several key benefits:

• Evaluates Financial Structure: It helps users understand changes in a company's net assets, its financial structure (including its liquidity and solvency), and its ability to adapt to new opportunities by managing its cash flows.
• Assesses Cash Generation: It is a powerful tool for assessing a company's ability to generate cash and helps in developing models to predict and compare the future cash flows of different companies.
• Enhances Comparability: It makes it easier to compare the operating performance of different companies because it focuses on actual cash movements, removing the effects of different accounting treatments for the same types of transactions.
• Aids in Financial Planning: It helps a company balance its cash inflows and outflows, which is essential for managing changing conditions. It's also useful for checking the accuracy of past financial forecasts.

Cash and Cash Equivalents

The Cash Flow Statement tracks the movement of 'Cash' and 'Cash Equivalents'.

• Cash is straightforward. It includes cash on hand and demand deposits with banks (like money in a current account).
• Cash Equivalents are short-term, highly liquid investments that can be quickly converted into a known amount of cash with very little risk of changing in value.

Cash Flows

The term 'Cash Flows' simply refers to the movement of cash into and out of the business.

• A cash inflow is a receipt of cash from a non-cash item. For instance, receiving money from selling an old machine is a cash inflow.
• A cash outflow is a payment of cash. For example, paying cash to buy new machinery is a cash outflow.

Other common examples of cash flows include collecting cash from customers (trade receivables), paying suppliers (trade payables), paying employee salaries, and receiving dividends.

Classification of Activities for the Preparation of Cash Flow Statement

According to AS-3, to make the Cash Flow Statement clear and useful, all cash flows must be classified into one of three categories. This separation helps users understand the impact of each type of activity on the company's financial position. The three categories are:

1. Operating Activities
2. Investing Activities
3. Financing Activities

Cash from Operating Activities

Operating activities are the principal revenue-producing activities of a company. These are the day-to-day activities that form the core business of the enterprise. They are not investing or financing activities.

Cash flow from operations is a key indicator of a company's internal financial strength. It shows whether the business can generate enough cash from its main operations to maintain its capabilities, pay dividends, repay loans, and make new investments without needing external funding.

Examples of Cash Flows from Operating Activities:

• Cash Inflows:
  • Cash received from the sale of goods or services.
  • Cash received from royalties, fees, and commissions.
• Cash Outflows:
  • Cash paid to suppliers for goods and services.
  • Cash paid to and for employees (salaries, wages).
  • Cash payments of income taxes (unless they can be linked to investing or financing activities).

For a financial enterprise, like a bank or investment firm, activities like making loans or buying/selling securities for trading purposes are considered operating activities because that is their main business.

Cash from Investing Activities

Investing activities involve the purchase and sale of long-term assets and other investments that are not considered cash equivalents. These transactions relate to the resources a company acquires to generate future income and cash flows.

Examples of Cash Flows from Investing Activities:

• Cash Outflows:
  • Cash payments to buy fixed assets like machinery, buildings, or intangible assets like patents.
  • Cash payments to buy shares or debt instruments of other companies (for investment, not trading).
  • Cash loans made to third parties.
• Cash Inflows:
  • Cash received from selling fixed assets.
  • Cash received from the repayment of loans made to others.
  • Cash received from selling shares or debt instruments of other companies.
  • Interest received from loans and advances.
  • Dividends received from investments in other companies.

Cash from Financing Activities

Financing activities are activities that change the size and composition of the company's owner's capital and its borrowings. These flows are related to how the company raises funds to finance its operations and investments.

Examples of Cash Flows from Financing Activities:

• Cash Inflows:
  • Cash received from issuing shares (equity or preference).
  • Cash received from issuing debentures, bonds, or taking out loans.
• Cash Outflows:
  • Cash repayments of borrowed amounts (loan principal).
  • Interest paid on debentures or loans.
  • Dividends paid to shareholders.

Treatment of Some Peculiar Items

Certain items require special attention when classifying them in the Cash Flow Statement.

Extraordinary items

These are non-recurring events, like losses from a fire or flood. Cash flows related to extraordinary items should be classified under operating, investing, or financing activities based on their nature and disclosed separately. This helps users understand their impact on the company's cash position.

Interest and Dividend

The classification of interest and dividends depends on the type of company:

• For a financial enterprise (like a bank):
  • Interest paid, interest received, and dividends received are Operating Activities.
  • Dividend paid is a Financing Activity.
• For a non-financial enterprise (like a manufacturing company):
  • Interest received and dividends received are Investing Activities.
  • Interest paid and dividends paid are Financing Activities.

Taxes on Income and Gains

Cash flows from taxes should generally be classified as Operating Activities. However, if a tax payment can be specifically identified with an investing or financing activity, it should be classified accordingly.

• Tax on operating profit is an operating cash flow.
• Tax paid on the gain from selling a fixed asset is an investing cash flow.
• Dividend distribution tax is a financing cash flow, just like the dividend payment itself.

Non-cash Transactions

Investing and financing transactions that do not involve cash or cash equivalents are excluded from the Cash Flow Statement.

Ascertaining Cash Flow from Operating Activities

Calculating cash flow from operating activities is a critical step. AS-3 allows for two methods to do this:

• Direct Method: This method discloses the major classes of gross cash receipts (e.g., cash from customers) and gross cash payments (e.g., cash paid to suppliers). It provides information that can be useful in estimating future cash flows.
• Indirect Method: This method starts with the net profit or loss from the Income Statement and adjusts it for non-cash transactions and items related to investing or financing activities. The indirect method is more commonly used by companies in practice.

Indirect Method

The indirect method begins with net profit because the Income Statement already captures the results of a company's operating activities. However, it's prepared on an accrual basis, not a cash basis, and includes non-cash and non-operating items. Therefore, adjustments are needed to convert the net profit figure into a cash flow figure.

The process involves adjusting the Net Profit before Tax and Extraordinary Items for three types of items:

1. Non-cash items: These are expenses that reduce net profit but don't involve an outflow of cash. They must be added back to the net profit.

   • Examples: Depreciation, amortization of goodwill or patents.

2. Non-operating items: These are incomes or expenses related to investing or financing activities that have been included in the Income Statement. Their cash effects belong in other sections of the Cash Flow Statement, so they must be reversed here.

   • Investing/Financing Expenses to be Added Back: Interest paid on loans (financing), loss on sale of fixed assets (investing).
   • Investing/Financing Incomes to be Deducted: Interest received (investing), dividend received (investing), profit on sale of fixed assets (investing).

3. Changes in Working Capital (Current Assets and Current Liabilities): These adjustments convert the accrual-based profit to a cash basis.

   • Add to operating profit:
     • Decrease in current assets (e.g., collecting cash from trade receivables).
     • Increase in current liabilities (e.g., receiving goods on credit from trade payables).
   • Deduct from operating profit:
     • Increase in current assets (e.g., buying more inventory for cash).
     • Decrease in current liabilities (e.g., paying off trade payables).

After these adjustments, the final step is to deduct the income tax paid to arrive at the Net Cash from Operating Activities.

Ascertainment of Cash Flow from Investing and Financing Activities

Calculating cash flows for these sections is more direct. You simply list the major items of gross cash receipts (inflows) and gross cash payments (outflows) for each category.

• For Cash Flow from Investing Activities, you would show items like "Proceeds from sale of machinery" as an inflow and "Purchase of machinery" as an outflow.
• For Cash Flow from Financing Activities, you would show "Proceeds from issue of shares" as an inflow and "Repayment of long-term loan" and "Dividends paid" as outflows.

The net result for each section is then calculated as either "Net cash from" (if inflows are greater) or "Net cash used in" (if outflows are greater).

Preparation of Cash Flow Statement

Once the net cash flow from each of the three activities (Operating, Investing, and Financing) has been calculated, the final statement is assembled.

1. The net cash flows from the three activities are added together to find the Net Increase (or Decrease) in Cash and Cash Equivalents for the period.
2. The amount of Cash and Cash Equivalents at the Beginning of the period is added to this net change.
3. The result is the Cash and Cash Equivalents at the End of the period.