Financial Accounting and Control

Class Note-6

CASH FLOW STATEMENT

Cash Flow Statement

An organization's cash flows can be used to help users of financial statements evaluate the
organization's capacity to produce cash and cash equivalents as well as its requirements for using
those cash flows. Users' economic decisions necessitate assessing an enterprise's capacity to produce
cash and cash equivalents, as well as the predictability and timing of such generation. The financial
statement known as a cash flow statement reflects a company's total cash inflows from both external
investment sources and ongoing operations. It also comprises all cash outflows made within a specific
time period to cover investments and business expenses.

Investors and analysts can see a picture of all the business transactions through a company's financial
statements, where each transaction plays a part in the company's performance. These activities are to
be classified into three categories: (1) operating, (2) investing, and (3) financing activities so as to
show separately the cash flows generated (or used) by (in) these activities. Operating activities are
the principal revenue-producing activities of the enterprise and other activities that are not investing
or financing activities. The amount of cash flows arising from operating activities is a key indicator
of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain
the operating capability of the enterprise pay dividends, repay loans and make new investments
without recourse to external sources of financing.

Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents. Financing activities are activities that result in changes in the size and
composition of the owners’ capital (including preference share capital in the case of a company) and
borrowings of the enterprise.

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 The tatement of Cash Flows focuses
attention on:

Operations
Cash received and paid
for day-to-day activities
with customers, suppliers,
and employees.

Investing Financing
Cash paid and received Cash received and paid
from buying and selling for exchanges with
long-term assets. lenders and stockholders.

Because it tracks the money generated by the company in three primary ways, the cash flow statement
is thought to be the most logical of all the financial statements: Cash flow from operations (CFO),
which comprises transactions from all operational business activities, is the first section of the cash
flow statement. The second section, cash flow from investment (CFI), shows the profit and loss on
investments. The last component, cash flow from financing (CFF), gives a summary of the cash used
for both debt and equity. The sum of the cash generated by these three segments is called “net cash
flow.” (i.e., CFO + CFI + CFF). As stated earlier, cash flow statement shows inflows and outflows of
cash and cash equivalents from various activities of an enterprise during a particular period. Cash’
comprises cash in hand and demand deposits with banks, and ‘Cash equivalents’ means short-term
highly liquid investments that are readily convertible into known amounts of cash, and which are
subject to an insignificant risk of changes in value. An investment normally qualifies as cash
equivalents only when it has a short maturity, of say, three months or less from the date of acquisition.
Effect of exchange rate changes on cash and cash equivalents usually adjusted separately as they can
not be part of the any three cash flow activities mentioned above.

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Objectives of Cash Flow Statement:

A Cash flow statement shows inflow and outflow of cash and cash equivalents from various activities
of a company during a specific period. The primary objective of cash flow statement is to provide
useful information about cash flows (inflows and outflows) of an enterprise during a particular period
under various heads, i.e., operating activities, investing activities and financing activities. This
information is useful in providing users of financial statements with a basis to assess the ability of the
enterprise to generate cash and cash equivalents and the needs of the enterprise to utilise those cash
flows. The economic decisions that are taken by users require an evaluation of the ability of an
enterprise to generate cash and cash equivalents and the timing and certainty of their generation.

tatement of Cash Flows

Advantages of Cash Flow Statement

Benefits are mentioned as follows: Highlights liquidity position, Helps in cash management, Maintain
optimal cash balance, Comparability, Indicates future.

Cash flow statement provides the following benefits:

1. A cash flow statement when used along with other financial statements provides information that
enables users to evaluate changes in net assets of an enterprise, its financial structure (including
its liquidity and solvency) and its ability to affect the amounts and timings of cash flows to adapt
to changing circumstances and opportunities.

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2. Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash
equivalents and enables users to develop models to assess and compare the present value of the
future cash flows of different enterprises.
3. It also enhances the comparability of the reporting of operating performance by different
enterprises because it eliminates the effects of using different accounting treatments for the same
transactions and events.
4. It also helps in balancing its cash inflow and cash outflow, keeping in response to changing
condition.
5. It is also helpful in checking the accuracy of past assessments of future cash flows and in
examining the relationship between profitability and net cash flow and impact of changing prices.
6. Users of an enterprise’s financial statements are interested in how the enterprise generates and
uses cash and cash equivalents. This is the case regardless of the nature of the enterprise’s
activities and irrespective of whether cash can be viewed as the product of the enterprise, as may
be the case with a financial enterprise. Enterprises need cash for essentially the same reasons,
however different their principal revenue-producing activities might be. They need cash to
conduct their operations, to pay their obligations, and to provide returns to their investors.
7. Historical cash flow information is often used as an indicator of the amount, timing and certainty
of future cash flows. It is also useful in checking the accuracy of past assessments of future cash
flows and in examining the relationship between profitability and net cash flow and the impact of
changing prices.

Cash from Operating Activities

Operating activities comprised of the primary activities of a company. These activities create the
principal revenue stream for the company. Cash flow from operating activities is the first subdivision
portrayed on a cash flow statement. Cash from operations is an indicator of the internal solvency of
the company. There are two different methods to identify cash from operating activities: the indirect
method and the direct method.

In the indirect method, the profit/loss before tax (PBT) (or net profit/loss) forms the base to calculate
net cash flow. Non-cash and non-operating charges put in the Profit & Loss account are added back,
whereas non-cash and non-operating incomes are deducted to calculate operating profit. Adjustments
are further needed in current assets and current liabilities to obtain net cash from operating activities.
The indirect method provides a way to convert net income into cash flow from operations by making
the necessary adjustments for non-cash items and changes in working capital accounts. This method

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is widely used because it links directly to the income statement and provides insights into how
changes in working capital impact cash flow.

ome of the important points while calculation Cash flow from operation (CFO) are as follows:

• Adjustments for Non-Cash Items:

1. Depreciation and Amortization: Add back depreciation and amortization expenses because
they reduce net income but do not involve actual cash outflow.
2. Provision for Doubtful Debts: Add back any bad debt expense as it is a non-cash charge. If
there is a provision for doubtful debt it should be added if there is an increase in provision.
This is because when we increase provision for doubtful debt, we charge it to the income
statement, and it is basically a non-cash expenses charge.
3. Losses and Gains on ale of Assets: ubtract gains and add back losses from the sale of assets
because these are not related to operating activities. However, the total proceeds arising from
the sale of assets, whether it is a gain or loss situation will be added to the CFI.
4. Impairment Charges: When calculating Cash Flow from Operations (CFO) using the indirect
method, impairment charges need to be adjusted because they affect net income but do not
involve actual cash outflow. Impairment charges are non-cash expenses related to a decrease
in the recoverable value of an asset. ince impairment charges are non-cash expenses, you
need to add them back to net income. This adjustment reflects that while the net income or
PBT has been reduced by the impairment, no actual cash outflow occurred. This adjustment
ensures that the cash flow from operations more accurately represents the company's cash-
generating ability, excluding the impact of non-cash accounting adjustments.
• Changes in Working Capital:

1. Accounts Receivable: Subtract any increase in accounts receivable or add any decrease. An
increase indicates sales made on credit that have not been collected in cash.
2. Inventory: Subtract increases in inventory or add decreases. An increase in inventory implies
cash was used to purchase it, which is not included in net income.
3. Accounts Payable: Add increases or subtract decreases. An increase means the company has
received goods or services without yet paying cash.
4. Accrued Expenses: Add increases or subtract decreases. These represent expenses
recognized but not yet paid in cash.
5. Prepaid Expenses: Subtract increases or add decreases. An increase in prepaid expenses
means cash has been paid in advance for expenses not yet incurred.

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 6. Outstanding expenses: Add increases or subtract decreases. An increase in outstanding
expenses means cash has not been paid for expenses although expenses have been incurred.
So, there is still cash in the business.

• Other Adjustments:

• Deferred Taxes: Deferred tax liabilities (DTL) arise when there's a temporary difference
between the accounting income and the taxable income due to differences in the timing of
recognizing income and expenses for tax and accounting purposes. When calculating Cash
Flow from Operations (CFO) using the indirect method, adjustments related to changes in
deferred tax liabilities are necessary because these items affect net income but not cash flow
directly. If there's an increase in deferred tax liability, it generally means that more tax expense
has been recognized for accounting purposes than for tax purposes, resulting in lower tax
payments in the current period. In the indirect method, an increase in DTL is added back to
net income. This is because the income statement tax expense is higher, but the actual cash
tax paid is less. Hence, it reflects an increase in cash flow. A decrease in deferred tax liability
indicates that the company is recognizing less tax expense for accounting purposes compared
to tax purposes, implying higher cash tax payments.

Deferred tax assets (DTA) arise when a company pays more tax to the tax authorities than is
recorded on the income statement, often due to timing differences in recognizing income and
expenses. Changes in DTAs need to be adjusted to accurately reflect cash flows. An increase
in DTA suggests that the company has recognized higher tax expenses on the income
statement than it has actually paid in cash. This is a non-cash asset increase, implying that tax
benefits are expected in the future. In the indirect method, an increase in DTA is subtracted
from net income. This is because the income statement tax expense is higher than the actual
cash paid, leading to a decrease in cash flow. A decrease in DTA indicates that the company
is now utilizing its deferred tax asset, meaning it is paying less in cash taxes than what is
recognized on the income statement.

Thus, add (subtract) changes in deferred tax liabilities (assets). Increases in deferred tax
liabilities or decreases in deferred tax assets are added because they reflect future tax benefits
or obligations.

• Interest and Dividend Income: If these are classified as investing activities, adjust them out
of operating activities. Interest and dividend income adjustments in the calculation of Cash

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 Flow from Operations (CFO) using the indirect method are essential to correctly represent the
cash flows from core business activities. If interest income is included in net income (or PBT),
it should be subtracted from net income when calculating CFO. This is because it is not
considered part of the company’s core operating activities. Similar to interest income,
dividend income should be subtracted from net income (or PBT) when calculating CFO. This
exclusion ensures that only cash flows directly related to operating activities are included in
the CFO. Moreover, it should be added back to the CFI activity.

• Non-Operating Items: Adjust for any other non-operating items that were included in net
income but do not involve cash flows from operations (e.g., Sale of brand rights). These
incomes (e.g., Sale of brand rights) if realised fully in cash will go to the CFI activity as an
addition. Another example is Share-based payments. Share-based payments, such as stock
options or restricted stock units (RSUs) granted to employees as part of their compensation,
are a common form of non-cash expense. Share-based compensation is an expense that
represents the fair value of shares or options granted to employees. These payments are
recorded on the income statement as an expense, reducing net income. However, since these
are non-cash transactions, adjustments are necessary when calculating Cash Flow from
Operations (CFO) using the indirect method. Since share-based payment expenses are non-
cash, they should be added back to net income in the indirect method of calculating CFO. This
adjustment ensures that CFO reflects only cash-based operating activities. It will also not
come under CFF as there is no actual cash transactions involved due to the issue of shares.
• Fair Value Gains or Losses: Fair value gains or losses arise when the carrying value of
certain financial instruments or assets (like marketable securities or derivatives) is adjusted to
reflect their current market value. This gain is usually unrealized and non-cash, meaning no
cash is received until the asset is sold. These gains or losses are typically recorded on the
income statement and can impact net income. However, since they are non-cash items, they
require adjustment when calculating Cash Flow from Operations (CFO) using the indirect
method. Since fair value gains increase net income but do not represent actual cash received,
they should be subtracted from net income when calculating CFO. This adjustment ensures
that only cash-related operating activities are reflected in CFO.

A fair value loss occurs when the market value of an asset decreases. Like gains, these losses
are often unrealized and non-cash. Fair value losses decrease net income but do not involve
actual cash outflows. Therefore, these losses should be added back to net income when
calculating CFO to reflect the non-cash nature of the adjustment. However, unlike gain or loss
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 on sale of assets which should have two effects, i.e., CFO (part of gain or loss) and CFI (total
proceeds), the fair value gain or loss will have only effect under CFO. The fair value gain or
loss will have no effect under CFI as it is a completely non-cash item.

➢ Other Examples:

1. Suppose a company has the following financial data: Net Income: $200,000. Depreciation:
$30,000. Impairment Charge: $15,000. Increase in Accounts Receivable: $8,000. Decrease in
Inventory: $5,000. Increase in Deferred Tax Liability: $7,000. To calculate CFO using the indirect
method:
CFO = 200,000+30,000+15,000−8,000+5,000+7,000=$249,000

2. 3. Suppose a company reports the following figures: Profit before tax: $250,000. Depreciation:
$20,000. Impairment Charge: $10,000. Increase in Accounts Receivable: $5,000. Decrease in
Inventory: $8,000. Interest Income: $6,000. Dividend Income: $4,000. To calculate CFO using
the indirect method:
CFO = 250,000+20,000+10,000−5,000+8,000−6,000−4,000=$273,000

3. Suppose a company reports the following figures: Net Income: $150,000, Depreciation: $20,000,
Impairment Charge: $10,000. Changes in Working Capital: $5,000 (net increase in working
capital). To calculate CFO using the indirect method:
CFO = 150,000+20,000+10,000−5,000=$175,000

4. Suppose a company reports the following figures: Net Income: $100,000. Depreciation: $10,000.
Amortization: +$5,000. Provision for Doubtful Debts: $3,000. Loss on Sale of Asset: $2,000.
Gain on Sale of Asset: $1,500. Increase in Accounts Receivable: $4,000. Decrease in Inventory:
$6,000. Increase in Accounts Payable: $3,500. Decrease in Accrued Expenses: $2,000. Increase
in Deferred Tax Liability: $1,500. To calculate CFO using the indirect method:
CFO=100,000+10,000+5,000+3,000+2,000−1,500−4,000+6,000+3,500−2,000+1,500
=$123,500

5. Suppose a company has the following data: Net Income: $300,000. Depreciation: $25,000.
Impairment Charge: $10,000. Increase in Accounts Receivable: $7,000. Decrease in Inventory:
$5,000. Fair Value Gain on Investments: $8,000. Fair Value Loss on Commodity Derivatives:
$3,000. To calculate CFO using the indirect method:

CFO=300,000+25,000+10,000−7,000+5,000−8,000+3,000=$328,000

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6. Company has the following data for the year: Net Income: $100,000. Depreciation Expense:
$10,000. Increase in Accounts Receivable: $5,000. Decrease in Inventory: $3,000. Increase in
Accounts Payable: $4,000. To calculate CFO using the indirect method:

CFO=100,000+10,000−5,000+3,000+4,000=$112,000

7. Company ABC has the following data: Net Income: $150,000. Depreciation Expense: $20,000.
Fair Value Gain on Investments: $8,000. Increase in Accounts Receivable: $10,000. Decrease in
Accounts Payable: $2,000. To calculate CFO using the indirect method:
CFO=150,000+20,000−8,000−10,000−2,000=$150,000

8. Company DEF has the following data: Profit Before Tax: $200,000. Depreciation Expense:
$30,000. Impairment Loss on Equipment: $15,000. Amortization of Intangible Assets: $5,000.
Increase in Deferred Tax Asset: $6,000. Decrease in Deferred Tax Liability: $4,000. Increase in
Inventory: $7,000. Decrease in Prepaid Expenses: $2,000. Increase in Accrued Liabilities: $3,000.
To calculate CFO using the indirect method:
CFO=200,000+30,000+15,000+5,000−6,000−4,000−7,000+2,000+3,000=$238,000
9. Suppose a company has the following data: Net Income: $400,000. Depreciation: $30,000.
Impairment Charge: $15,000. Increase in Accounts Receivable: $10,000. Decrease in Inventory:
$7,000. Share-Based Payment Expense: $20,000. To calculate CFO using the indirect method:
CFO=400,000+30,000+15,000+20,000−10,000+7,000=$462,000
10. Company has the following financial data for the year: Net Income: $150,000. Depreciation
Expense: $25,000. Amortization Expense: $5,000. Gain on Sale of Equipment: $8,000. Increase
in Accounts Receivable: $12,000. Decrease in Inventory: $7,000. Increase in Accounts Payable:
$4,000. Decrease in Prepaid Expenses: $3,000. Increase in Accrued Expenses: $6,000. Interest
Expenses: $9,000. Deferred tax asset: $ 4,000. Fair Value Gain on Marketable Securities $10,000.
To calculate CFO using the indirect method:
CFO=150,000+25,000+5,000−8,000−12,000+7,000+4,000+3,000+6,000+9000-4000-10000
= 1,75,000

Cash Flow from Investing Activities:

The separate disclosure of cash flows arising from investing activities is important because the cash
flows represent the extent to which expenditures have been made for resources intended to generate
future income and cash flows. Examples of cash flows arising from investing activities are:

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• Cash payments to acquire fixed assets (including intangibles). These payments include those
relating to capitalised research and development costs and self-constructed fixed assets.
• Cash receipts from disposal of fixed assets (including intangibles); cash payments to acquire
shares, warrants or debt instruments of other enterprises and interests in joint ventures.
• Cash receipts from disposal of shares, warrants or debt instruments of other enterprises and
interests in joint ventures. Proceeds from buy back of shares/capital reduction by joint venture.
• Cash advances and loans made to third parties. Cash receipts from the repayment of advances and
loans made to third parties.
• Cash dividends received from joint ventures and associates. Dividends received from others.
• Cash receipts from futures contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing, or trading purposes, or the receipts are classified
as financing activities. o, these forward or option contracts should be only related to assets in
the investment category.
• The aggregate cash flows arising from acquisitions and from disposals of subsidiaries or other
business units should be presented separately and classified as investing activities (CFI).
• Assets acquired through financial lease or through notes payable will have no effect under CFI as
there is no cash transactions involved.
➢ Other Examples:

Bank deposits placed (- CFI). Bank deposits matured (+ CFI). Proceeds from sale of investments
(+ CFI). Interest received (+CFI). Payment to acquire investments (-CFI). Proceeds from sale of
property, plant & equipment and other intangible assets (+CFI). Payment to acquire property,
plant & equipment and other intangible assets (-CFI). Transaction cost on acquisition of
subsidiary (-CFI). Contingent consideration paid on business combination (-CFI). Loans given to
others (-CFI), Investment in non-current deposits with banks (-CFI). ale proceeds of intangible
assets, e.g., brand rights (+CFI). Amounts incurred on investment properties (-CFI). Proceeds
from disposal of investment properties (+CFI). Proceeds from disposal of investment properties
(+CFI). Finance income received (+CFI). Proceeds from sale of equity shares in subsidiary
(+CFI). Acquisition of property, plant and equipment, capital work-in-progress and other
intangible assets (-CFI). Inter-corporate deposits placed (-CFI). Inter-corporate deposits redeemed
(+CFI). Proceeds from sale / redemption of non-current investments (+CFI). Receipt of
government grants (Capital Grant) (+CFI). Proceeds on sale of investments Government securities
(+CFI). Payment of contingent consideration pertaining to acquisition of business (-CFI).
Redemption of deposits placed with corporation (+CFI). Loan received back (+CFI).

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Financing Activities:
It is the part of a company’s cash flow statement, which shows the flows of cash used to fund the
company that involve equity, debt and dividends. It provides an insight into a company’s financial
strength and its capital structure. These activities are related to long-term funds or capital as cash
proceeds from issue of equity shares, debentures, bank loans etc. The separate disclosure of cash
flows arising from financing activities is important because it is useful in predicting claims on future
cash flows by providers of funds (both capital and borrowings) to the enterprise. Examples of cash
flows arising from financing activities are: (a) cash proceeds from issuing shares or other similar
instruments; (b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-
term borrowings; and (c) cash repayments of amounts borrowed.

➢ Other Examples:

Principal payment of lease liabilities (-CFF). Interest paid on lease liabilities (-CFF). Interest paid(-
CFF), Repayment of bonus debentures (-CFF). Proceeds from non-current borrowings (+CFF).
Repayment of non-current borrowings (-CFF). Dividends paid(-CFF). Interest paid(-CFF). Proceeds
from issue of shares to employees by E OP (+CFF). Proceeds from borrowings (+CFF). Repayments
of borrowings (-CFF). Proceeds from issue of compulsorily convertible preference shares (+CFF).
Repayment of lease liabilities (including interest) (-CFF). Dividends paid including payment of
unclaimed dividends (-CFF). Interest, commitment and finance charges paid (-CFF). Dividend paid
to non-controlling interests (-CFF). Borrowings repaid (-CFF). Interest paid other than on lease
liabilities (-CFF). Employee stock options paid (-CFF). Amount taken for short term purpose (+CFF).
Repayment of amount taken for short term purpose (-CFF). Transaction cost for the issue of debt or
equity instruments (-CFF). Payment towards purchase of non-controlling interest (-CFF). hares
issued on exercise of employee stock options (+CFF). Payment of dividend to non-controlling interest
of subsidiary (-CFF). Buyback of equity shares including transaction cost and tax on buyback (-CFF).
Proceeds from issue of equity shares (+CFF). Transaction cost on issue of shares (-CFF).

Firm Lifecycle and Cash Flow:

The lifecycle of a firm typically consists of several stages—startup, growth, maturity, and decline. At
each stage, the firm's cash flow patterns change significantly due to differences in revenue generation,
capital expenditures, and financing needs. Understanding these cash flow patterns across the firm’s
lifecycle can help stakeholders make informed decisions about investment, financing, and operations.

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Understanding these cash flow patterns helps stakeholders make strategic decisions that align with
the firm’s current lifecycle stage, ensuring sustainable growth and long-term success. Based on the
cash flow patterns, firm years are classified into different stages: introduction, growth, maturity,
shakeout and decline. CFO, CFI and CFF are considered to classify a firm in any stage of its life
cycle. This is called the life cycle effect. Dickinson (2011)1 develops a proxy for life cycle using cash
flow patterns that captures the nonlinear relation of firm life cycle with firm profitability, size, and
age.

Startup Stage: Negative CFO, heavy investment, reliant on external financing. Growth Stage:
Improving CFO, continued investment, some external financing. Maturity Stage: Strong CFO,
moderate investment, possible debt repayment or shareholder returns. Decline Stage: Weak or
negative CFO, reduced investment, asset sales, varied financing activities.

Impact of roduct Life Cycle on Cash Flows: Strategic Finance

Introductory hase: To support asset
purchases the company may issue stock or
debt. Expectation : cash from operations to
be negative cash from investing to be
negative . cash from financing to be
positive .
rowth hase: The company is striving to
expand its production and sales.
Expectation : small amounts of cash to be
generated from operations. cash from
investing to be negative . cash from
financing to be positive
Maturity hase: ales and production
level -off. Expectation : Cash from
operations to exceed investing needs cash
from investing to be neutral cash from
financing to be negative
ecline hase: ales and production
declines Expectation : cash from
operations to decline, cash from investing
to possibly become positive, cash from
financing to possibly become negative

I. Startup or Introductory Stage: At this early stage, firms are typically focused on
developing products or services, building infrastructure, and entering the market. Revenues

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Introduction, Growth, Mature, hake-out, and Decline, using the pattern of cash flow from operating
(OANCF), investing (IVNCF), and financing (FINCF) from the cash flow statement. A firm-year is in the (1)
Introduction stage if OANCF < 0, IVNCF < 0, and FINCF > 0; (2) Growth stage if OANCF > 0, IVNCF < 0,
and FINCF > 0; (3) Mature stage if OANCF > 0, IVNCF < 0, and FINCF < 0; (4) Decline stage if OANCF <
0, IVNCF > 0 regardless the sign of FINCF; and (5) hake-out stage for remaining firm-years. ( ource: V.
Dickinson Cash flow patterns as a proxy for firm life cycle, Accounting Review, 86 (2011), pp. 1969-1994)
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 are usually low or non-existent, while costs are high due to research and development (R&D),
marketing, and administrative expenses. Cash Flow Patterns:

o CFO: Typically negative, as the firm has low or no revenue while incurring significant
operating expenses.
o CFI: Negative due to high capital expenditures on product development, technology,
equipment, and facilities.
o CFF: Positive, as the firm relies heavily on external financing (e.g., venture capital, angel
investors, or loans) to fund its operations and investments.
• Key Focus: Securing funding, developing a viable product or service, and achieving initial
market traction.

II. Growth Stage: In the growth stage, the firm experiences increasing sales and market share.
It focuses on scaling operations, expanding market reach, and optimizing production.
Although costs are still high, revenues start to increase significantly. Cash Flow Patterns:

o CFO: Begins to turn positive as the firm generates higher sales, though reinvestment in
working capital (e.g., inventory, receivables) may still absorb significant cash.
o CFI: Remains negative, as the firm continues to invest heavily in capital expenditures
(e.g., new equipment, facilities, or technology) to support growth.
o CFF: May still be positive, as the firm may seek additional external financing to support
growth. Over time, dependence on external financing may decrease as operational cash
flows improve.
• Key Focus: Scaling up operations, increasing market penetration, and optimizing cash flow
management to support sustainable growth.

III. Maturity Stage: In the maturity stage, the firm experiences steady sales and profitability.
Growth rates slow down as the market becomes saturated or the firm reaches its optimal size.
The company focuses on efficiency, cost control, and maintaining its competitive position.
Cash Flow Patterns:

o CFO: Strong and consistently positive, reflecting stable revenues and efficient cost
management. The firm generates substantial cash from its core operations.
o CFI: Negative but more controlled. Investments are focused on maintenance, upgrades, and
incremental improvements rather than aggressive expansion.

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 o CFF: May be negative, as the firm begins to repay debt, buy back shares, or pay dividends.
The reliance on external financing decreases, and the firm often returns cash to
shareholders.
• Key Focus: Maximizing efficiency, maintaining market position, optimizing capital
structure, and generating shareholder returns.

IV. Decline Stage: In the decline stage, the firm faces decreasing sales, market share, and
profitability. This may be due to market saturation, technological obsolescence, increased
competition, or changing consumer preferences. The firm might start to downsize or divest
non-core assets. Cash Flow Patterns:

o CFO: May become weak or negative as revenues decline and costs remain fixed or
increase due to inefficiencies.
o CFI: Often positive, as the firm reduces capital expenditures and may sell off assets to
generate cash.
o CFF: Can vary. The firm may increase borrowing to sustain operations, or alternatively, it
may reduce debt or return cash to shareholders as part of a liquidation strategy.
• Key Focus: Restructuring, cost-cutting, divestitures, and possibly repositioning or exit
strategies. Management may focus on cash conservation and maximizing residual value.

Cash Flow Statement Analysis

Cash flow analysis involves examining various ratios to assess a company's financial health, liquidity,
and operational efficiency. Cash flow statement ratio analysis is essential for assessing a company's
financial health, liquidity, and ability to meet its obligations. Analysts utilize various cash flow ratios
derived from the cash flow statement to evaluate operational performance, compare it with industry
benchmarks, and identify potential concerns regarding financial sustainability. Cash flow ratios are
financial metrics that provide insight into a company's ability to generate cash from its operations and
manage its liabilities effectively. These ratios are critical for understanding how well a company
converts net income into actual cash flow, which is a key component of financial stability.

Benchmarking against industry standards is crucial for effective cash flow ratio analysis. Companies
can compare their ratios to these benchmarks to assess performance relative to competitors. While
cash flow ratios provide valuable insights, they should be used with caution and in conjunction with
other financial metrics. They may not tell the entire story of a company's financial condition, as they
rely on various assumptions and accounting practices. It's essential to understand the context of the
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ratios and monitor trends over time for a comprehensive analysis of a company's performance and
financial health.

Here are some important ratios for cash flow analysis:

1. Operating Cash Flow Ratio

• Formula:

Operating Cash Flow Ratio=Cash Flow from Operations (CFO)/Current Liabilities

• Purpose: Measures the ability of a company to cover its short-term liabilities with cash
generated from operations. A higher ratio indicates better liquidity and financial health. It is
also known as the current liability coverage ratio, also called the cash current debt coverage
ratio, calculates how much money a business has available to pay off its debt. This ratio
measures a company's liquidity.

2. Free Cash Flow (FCF)

• Formula: FCF=Cash Flow from Operations (CFO)−Capital Expenditures (CapEx)

• Purpose: Represents the cash available for distribution to investors (debt holders and
shareholders) after accounting for capital expenditures. Positive FCF indicates that the
company can generate sufficient cash to fund its growth and return value to shareholders.

3. Free Cash Flow to Equity (FCFE)

• Formula: FCFE=CFO−Capital Expenditures + Net New Debt

• Purpose: FCFE is a key measure for equity investors as it indicates the cash available for
dividends, stock buybacks, or reinvestment in the business, giving insight into the financial
health and value of the company from an equity perspective. To calculate Free Cash Flow to
Equity (FCFE) from Cash Flow from Operations (CFO), you need to adjust the CFO by
accounting for capital expenditures, and net financing activities.

4. Cash Flow Coverage Ratio

• Formula:

Cash Flow Coverage Ratio=Cash Flow from Operations (CFO)/Total Debt

• Purpose: Assesses a company’s ability to cover its total debt obligations with cash flow from
operations. Higher ratios indicate better ability to meet debt payments. Also called a solvency
ratio, the cash flow coverage ratio measures how much money a business makes in a year to
pay off its outstanding debt. If the ratio is greater than one, the company isn't in danger of
default.

5. Cash Flow to Debt Ratio

15
 • Formula:
Cash Flow to Debt Ratio=Cash Flow from Operations (CFO)/Total Debt

• Purpose: Indicates the proportion of debt that can be serviced by the cash flow from
operations. A higher ratio suggests lower financial risk.

6. Cash Flow Margin

• Formula: Cash Flow Margin=Cash Flow from Operations (CFO)/Net Sales

• Purpose: Measures the percentage of sales that is converted into cash flow from operations.
It reflects operational efficiency and the ability to convert revenue into cash.

7. Cash Return on Assets (CROA)

• Formula: Cash Return on Assets=Cash Flow from Operations (CFO)/Average Total Assets)

• Purpose: Evaluates how effectively a company uses its assets to generate cash flow. Higher
ratios suggest efficient use of assets. Indicates the cash flow generated per dollar of assets. A
higher ratio suggests better cash flow generation relative to the asset base. Please note that,
The ratios Sales/Total Assets and CFO/Total Assets are both important in assessing a
company's operational efficiency and financial performance, but they focus on different
aspects of asset utilization and cash flow generation.

8. Cash Conversion Cycle (CCC)

• Formula:
Cash Conversion Cycle=Days Sales Outstanding (DSO)+Days Inventory Outstanding (DIO)
−Days Payable Outstanding (DPO)

• Purpose: Measures the time it takes for a company to convert its investments in inventory
and receivables into cash flows from sales. Shorter cycles are preferable as they indicate
efficient cash flow management.

9. Cash Flow Adequacy Ratio

• Formula: Cash Flow Adequacy Ratio=Cash Flow from Operations (CFO)/

Capital Expenditures + Debt Repayments

• Purpose: Assesses whether the cash flow from operations is sufficient to cover capital
expenditures and debt repayments. A ratio greater than 1 indicates that the company generates
enough cash to meet its capital and debt obligations.

10. Operating Cash Flow to Capital Expenditures Ratio

• Formula:
Operating Cash Flow to Capital Expenditures Ratio=Cash Flow from Operations (CFO)/Cap
ital Expenditures

16
 • Purpose: Measures how well a company’s operating cash flow covers its capital expenditures.
A higher ratio indicates that the company is generating sufficient cash to fund its capital
investments.

11. Cash Flow Per Share (Cash EPS)

• Formula:
Cash Flow Per Share=Cash Flow from Operations (CFO)/Weighted Average Shares Outstan
ding or shares outstanding.
• Purpose: Provides a per-share view of the company’s ability to generate cash from
operations, which can be useful for comparing performance on a per-share basis.

11. Price-to-Cash-Flow Ratio

• Formula: Price to cash flow ratio = share price/cash flow price per share

• Purpose: The price-to-cash-flow ratio relates the shares of a company to cash from
operations. It shows you how appealing a company's stock is as it relates to its ability to
generate cash.

12. Cash Interest Coverage Ratio

• Formula: Price to cash flow ratio = CFO/Interest expenses

• urpose: This ratio measures how much money a company generates to cover its expenses
for interest payments. A higher ratio means the company generates sufficient cash to pay its
debt and interest. If this figure is higher than one, it may indicate the company will have no
difficulty paying its current interest payment obligations.

17
 Practice Question

Note: The following practice question is extracted from the Indian

Accounting standard document pertinent to the Cash Flow
tatement. Only extracted pages have been presented here. You may
refer to the below mentioned link for the entire document.
Source: https://www.mca.gov.in/Ministry/notification/pdf/A _3.pdf

18
 Cash Flow Statements 31

Illustration I
Cash Flow Statement for an Enterprise other than a Financial
Enterprise

This illustration does not form part of the accounting standard. Its
purpose is to illustrate the application of the accounting standard.

1. The illustration shows only current period amounts.

2. Information from the statement of profit and loss and balance sheet is
provided to show how the statements of cash flows under the direct method
and the indirect method have been derived. Neither the statement of profit
and loss nor the balance sheet is presented in conformity with the disclosure
and presentation requirements of applicable laws and accounting standards.
The working notes given towards the end of this illustration are intended to
assist in understanding the manner in which the various figures appearing
in the cash flow statement have been derived. These working notes do
not form part of the cash flow statement and, accordingly, need not be

3. The following additional information is also relevant for the preparation

of the statement of cash flows (figures are in Rs.’000).

(a) An amount of 250 was raised from the issue of share capital and a
further 250 was raised from long term borrowings.

(b) Interest expense was 400 of which 170 was paid during the period.
100 relating to interest expense of the prior period was also paid
during the period.

(c) Dividends paid were 1,200.

(d) Tax deducted at source on dividends received (included in the tax

expense of 300 for the year) amounted to 40.

(e) During the period, the enterprise acquired fixed assets for 350.
The payment was made in cash.

(f) Plant with original cost of 80 and accumulated depreciation of 60

was sold for 20.
(g) Foreign exchange loss of 40 represents the reduction in the carrying
32 AS 3

amount of a short-term investment in foreign-currency designated

bonds arising out of a change in exchange rate between the date of
acquisition of the investment and the balance sheet date.

(h) Sundry debtors and sundry creditors include amounts relating to

credit sales and credit purchases only.

Balance Sheet as at 31.12.1996

(Rs. ’000)
1996 1995
Assets
Cash on hand and balances with banks 200 25
Short-term investments 670 135
Sundry debtors 1,700 1,200
Interest receivable 100 –
Inventories 900 1,950
Long-term investments 2,500 2,500
Fixed assets at cost 2,180 1,910
Accumulated depreciation (1,450) (1,060)
Fixed assets (net) 730 850
Total assets 6,800 6,660

Liabilities
Sundry creditors 150 1,890
Interest payable 230 100
Income taxes payable 400 1,000
Long-term debt 1,110 1,040
Total liabilities 1,890 4,030

Shareholders’ Funds
Share capital 1,500 1,250
Reserves 3,410 1,380
Total shareholders’ funds 4,910 2,630
Total liabilities and shareholders’ funds 6,800 6,660
 Cash Flow Statements 33

Statement of Profit and Loss for the period ended 31.12.1996

(Rs. ’000)
Sales 30,650
Cost of sales (26,000)
Gross profit 4,650
Depreciation (450)
Administrative and selling expenses (910)
Interest expense (400)
Interest income 300
Dividend income 200
Foreign exchange loss (40)
Net profit before taxation and extraordinary item 3,350
Extraordinary item – Insurance proceeds from
earthquake disaster settlement 180
Net profit after extraordinary item 3,530
Income-tax (300)
Net profit 3,230

Direct Method Cash Flow Statement [Paragraph 18(a)]

(Rs. ’000)
1996
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
Cash flows from investing activities
Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 160
Net cash from investing activities 30
34 AS 3

Cash flows from financing activities

Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Repayment of long-term borrowings (180)
Interest paid (270)
Dividends paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning of period
(see Note 1) 160
Cash and cash equivalents at end of period
(see Note 1) 910

Indirect Method Cash Flow Statement [Paragraph 18(b)]

(Rs. ’000)
1996
Cash flows from operating activities
Net profit before taxation, and extraordinary item 3,350
Adjustments for :
Depreciation 450
Foreign exchange loss 40
Interest income (300)
Dividend income (200)
Interest expense 400
Operating profit before working capital changes 3,740
Increase in sundry debtors (500)
Decrease in inventories 1,050
Decrease in sundry creditors (1,740)
Cash generated from operations 2,550
Income taxes paid (860)
Cash flow before extraordinary item 1,690
Proceeds from earthquake disaster settlement 180
Net cash from operating activities 1,870
 Cash Flow Statements 35

Cash flows from investing activities

Purchase of fixed assets (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 160
Net cash from investing activities 30
Cash flows from financing activities
Proceeds from issuance of share capital 250
Proceeds from long-term borrowings 250
Repayment of long-term borrowings (180)
Interest paid (270)
Dividends paid (1,200)
Net cash used in financing activities (1,150)
Net increase in cash and cash equivalents 750
Cash and cash equivalents at beginning of period
(see Note 1) 160
Cash and cash equivalents at end of period (see Note 1) 910

Notes to the cash flow statement

(direct method and indirect method)

1. Cash and Cash Equivalents

Cash and cash equivalents consist of cash on hand and balances with banks,
and investments in money-market instruments. Cash and cash equivalents
included in the cash flow statement comprise the following balance sheet
amounts.

1996 1995

Cash on hand and balances with banks 200 25

Short-term investments 670 135
Cash and cash equivalents 870 160
Effect of exchange rate changes 40 –
Cash and cash equivalents as restated 910 160
36 AS 3

Cash and cash equivalents at the end of the period include deposits with
banks of 100 held by a branch which are not freely remissible to the company
because of currency exchange restrictions.

The company has undrawn borrowing facilities of 2,000 of which 700 may
be used only for future expansion.

2. Total tax paid during the year (including tax deducted at source on
dividends received) amounted to 900.

Alternative Presentation (indirect method)

As an alternative, in an indirect method cash flow statement, operating profit
before working capital changes is sometimes presented as follows:

Revenues excluding investment income 30,650

Operating expense excluding depreciation (26,910)
Operating profit before working capital changes 3,740

Working Notes
The working notes given below do not form part of the cash flow statement
and, accordingly, need not be published. The purpose of these
working notes is merely to assist in understanding the manner in
which various figures in the cash flow statement have been derived.
(Figures are in Rs. ’000.)

1. Cash receipts from customers

Sales 30,650
Add: Sundry debtors at the beginning of the year 1,200
31,850
Less : Sundry debtors at the end of the year 1,700
30,150
 Cash Flow Statements 37

2. Cash paid to suppliers and employees

Cost of sales 26,000
Administrative and selling expenses 910
26,910
Add: Sundry creditors at the beginning of the 1,890
year
Inventories at the end of the year 900 2,790
29,700
Less: Sundry creditors at the end of the year 150
Inventories at the beginning of the year 1,950 2,100
27,600

3. Income taxes paid (including tax deducted at source from

dividends received)
Income tax expense for the year (including tax deducted 300
at source from dividends received)
Add : Income tax liability at the beginning of the year 1,000
1,300
Less: Income tax liability at the end of the year 400
900

Out of 900, tax deducted at source on dividends received (amounting to 40)

is included in cash flows from investing activities and the balance of 860 is
included in cash flows from operating activities (see paragraph 34).

4. Repayment of long-term borrowings

Long-term debt at the beginning of the year 1,040
Add : Long-term borrowings made during the year 250
1,290
Less : Long-term borrowings at the end of the year 1,110
180

5. Interest paid
Interest expense for the year 400
Add: Interest payable at the beginning of the year 100
500
Less: Interest payable at the end of the year 230
270
 Practice Question

Note: The following practice question is extracted from the

NCERT textbook pertinent to the Cash Flow Statement.