Statement of cash flows (excluding partnerships)

Welcome to the Statement of Cash Flows!

Hi there! Welcome to one of the most important chapters in your Financial Accounting (FA) journey. If you have ever wondered, "My company made a huge profit, but why is the bank account empty?" then this chapter is for you. We are going to learn how to track where every penny of cash came from and where it went. Don't worry if this seems a bit technical at first—we will break it down piece by piece until it clicks!

1. Why Do We Need a Statement of Cash Flows?

In accounting, we usually use accrual accounting. This means we record income when we earn it (even if the customer hasn't paid yet) and expenses when we incur them. Because of this, Profit is not the same as Cash.

The "Lemonade Stand" Analogy:
Imagine you sell a glass of lemonade for \$2. Your neighbor buys it but promises to pay you next week. Under accrual accounting, you have \$2 in profit. But if you look in your pocket, you have \$0! The Statement of Cash Flows exists to show that "missing" cash. It is vital because, at the end of the day, a business cannot pay its employees or suppliers with "profit"—it needs cold, hard cash.

Controlling Cash Flow:
A business can be highly profitable yet still go insolvent if it runs out of cash to meet liabilities as they fall due (overtrading). Controlling cash flow ensures sufficient liquidity for daily survival.

2. Benefits and Drawbacks to Users

The statement of cash flows provides crucial insights for investors, lenders, and management:

Benefits:
• Objective measure: Cash flows are factual and free from accounting estimates and policies (like depreciation methods or allowance estimates).
• Liquidity assessment: Helps users assess the entity's ability to settle debts, pay dividends, and survive without borrowing.
• Comparability: Enhances comparability between entities because cash transactions are not distorted by differing accounting treatments.

Drawbacks:
• Historical focus: Like all primary financial statements, it reports past transactions rather than future prospects.
• Excludes non-cash transactions: Crucial investing or financing events, such as acquiring an asset via a finance lease or issuing bonus shares, do not appear in cash flows.
• Timing manipulation: Management can manipulate year-end operating cash flows by delaying payments to suppliers or accelerating collections.

3. What is "Cash and Cash Equivalents"?

Under IAS 7 Statement of Cash Flows, we classify:
1. Cash: Cash on hand and demand deposits (bank balances).
2. Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash (normally maturing within 3 months) with insignificant risk of changes in value.
3. Bank Overdrafts: Where repayable on demand and forming an integral part of cash management, bank overdrafts are included as a negative component of cash and cash equivalents.

4. The Three Main Buckets (O-I-F)

All cash transactions are grouped into three categories:

1. Operating Activities (O): The principal revenue-producing activities of the entity, including cash receipts from customers and payments to suppliers and employees.
2. Investing Activities (I): The acquisition and disposal of long-term assets and other investments (such as purchasing or selling non-current assets).
3. Financing Activities (F): Activities that alter the equity capital and borrowing structure of the business (such as issuing shares, taking out loans, repaying loan principal, and paying dividends).

5. Operating Activities: Direct and Indirect Methods

Under IAS 7, operating cash flows before income taxes can be determined using either the Direct Method or the Indirect Method.

The Indirect Method

We start with a profit subtotal (such as operating profit or profit before tax) and eliminate non-cash and non-operating transactions:

Step 1: Non-Cash Items
Depreciation and amortisation do not involve cash outflows, so we add them back to profit.
\( \text{Adjusted Profit} = \text{Profit} + \text{Depreciation and Amortisation} \)

Step 2: Profit or Loss on Disposal
Any profit on disposal is removed (deducted), and any loss on disposal is added back, because the full cash proceeds belong in investing activities.

Step 3: Working Capital Adjustments
• Increase in Inventory: Cash was spent to buy stock \(\rightarrow\) Subtract.
• Increase in Receivables: Sales made have not yet been collected \(\rightarrow\) Subtract.
• Increase in Payables: Bills have been deferred, saving cash \(\rightarrow\) Add.
(Decreases in each work in the opposite direction.)

The Direct Method

The direct method shows the actual gross receipts and payments from operations:
• Cash received from customers: \( \text{Opening Receivables} + \text{Revenue} - \text{Closing Receivables} - \text{Irrecoverable debts written off} \)
• Cash paid to suppliers: \( \text{Opening Payables} + \text{Purchases} - \text{Closing Payables} \)
• Cash paid to and on behalf of employees and other operating expenses

Subtotal: Cash from Operating Activities Before Income Taxes

Both methods arrive at the identical syllabus-required subtotal:
Cash from operating activities before income taxes (or cash generated from operations).
From this subtotal, deduct income taxes paid (and interest paid if classified here) to arrive at Net cash from operating activities.

6. Investing and Financing Activities

Investing Activities

• Cash Out: Purchase of property, plant, and equipment, intangible assets, or external investments.
• Cash In: Proceeds from disposal of non-current assets (Cash proceeds \( = \text{Carrying value} + \text{Profit} \) or \( - \text{Loss} \)), plus interest and dividends received.

Financing Activities

• Cash In: Proceeds from issuing ordinary shares (including share premium) or issuing loans/debentures.
• Cash Out: Redemption or repayment of borrowings, and dividends paid to equity holders.

7. Preparing the Statement: Step-by-Step Flow

1. Calculate cash from operating activities before income taxes (via direct or indirect method).
2. Deduct income taxes paid to give Net cash from operating activities.
3. Add Net cash from / (used in) investing activities.
4. Add Net cash from / (used in) financing activities.
5. The sum of these three totals gives the Net increase / (decrease) in cash and cash equivalents.
6. Add the Cash and cash equivalents at the beginning of the year to arrive at the Cash and cash equivalents at the end of the year.

Top Exam Tip: Practice preparing general ledger accounts for Property, Plant and Equipment, Retained Earnings, and Tax liabilities to find missing cash figures such as additions, dividends paid, and taxes paid!