Cash Flow Statement Overview

Definitions

Cash Flow: Represents the movement of cash in and out of a business,

categorized into three main activities: operating, investing, and financing. Cash
includes cash in hand, cash at bank, and cash equivalents .
Cash Equivalents: Short-term, highly liquid investments that are readily
convertible to known amounts of cash, with minimal risk, typically maturing in
three months or less .

Key Components of Cash Flow Statement

1. Operating Activities:

Main revenue-generating activities of a business, including cash received

from sales and cash paid for operating expenses .
Examples include:
Cash received from sale of goods and services .
Payments for operating expenses like rent, salaries, and utilities .
Interest and dividends received are typically classified as operating
activities for non-financial enterprises .

2. Investing Activities:

Transactions involving the acquisition or disposal of long-term assets and

investments .
Examples include:
Purchase and sale of fixed assets (e.g., buildings, equipment) .
Investments in securities or shares .

3. Financing Activities:

Activities related to obtaining or repaying capital .

Examples include:
Issuing shares or debentures, and repaying loans .
Paying dividends and interest on borrowings .

Cash Flow Calculation

Cash flows are classified into the three categories mentioned above. The net cash
flow is calculated by summing the cash flows from operating, investing, and
financing activities .
The cash flow statement can be prepared using either the direct method (listing
cash receipts and payments) or the indirect method (adjusting net income for
changes in working capital) .

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Important Concepts

Liquidity and Solvency: Liquidity refers to the ability of a company to meet its
short-term obligations, while solvency refers to its ability to meet long-term debts .
Depreciation: While depreciation reduces the book value of an asset, it does not
represent a cash flow and should not be included in the cash flow statement .

Conclusion The cash flow statement is essential for understanding how a company
generates and uses cash, providing insights into its financial health and operational
efficiency. It categorizes cash movements into operating, investing, and financing
activities, allowing stakeholders to assess the company's liquidity and solvency
effectively.

Cash Flow Statement Overview

1. Indirect Method Basics

The indirect method of preparing a cash flow statement starts with net profit and
adjusts for non-cash items and changes in working capital. This method is primarily
used for cash flow from operating activities .

2. Key Steps in the Indirect Method

Reverse Non-Cash Items: Non-cash items such as depreciation, amortization, and

provisions for tax must be reversed. If they were debited (subtracted) in the profit
and loss statement, they should be added back in the cash flow statement .
Eliminate Outsiders: Remove items that belong to investing or financing activities
from the operating cash flow. For example, interest received and dividends
received should be subtracted as they are not part of operating cash flow .
Adjust for Changes in Working Capital: Analyze changes in current assets and
liabilities. An increase in current assets decreases cash flow, while an increase in
current liabilities increases cash flow .

3. Important Definitions

Net Profit Before Tax: This is the starting point for the indirect method. If not
available, net profit after tax or retained earnings can be used .
Extraordinary Items: These are unusual and infrequent events that must be
reversed if they have affected the profit and loss statement .

4. Cash Flow from Operating Activities

To calculate cash flow from operating activities, start with net profit, reverse non-
cash items, eliminate non-operating items, and adjust for changes in working
capital. The final figure represents the cash generated from operations .

5. Tax Considerations

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 In the cash flow statement, the tax provision (a non-cash item) is reversed, while
actual tax paid (cash outflow) is included .

6. Example Adjustments

If there are extraordinary items like insurance claims due to disasters, these
should be reversed in the cash flow statement. For instance, if a loss due to an
earthquake was recorded, both the loss and any insurance proceeds must be
adjusted accordingly .

7. Final Steps

After adjustments, the cash flow from operating activities is calculated. This figure
reflects the liquidity position of the company and how cash has moved over the
period .

8. Summary of Relationships

Assets and Cash: Assets are negatively related to cash; an increase in assets
results in a decrease in cash.
Liabilities and Cash: Liabilities are positively related to cash; an increase in
liabilities results in an increase in cash .

This structured approach to the cash flow statement using the indirect method provides
a clear understanding of how to transition from net profit to cash flow from operating
activities, ensuring all relevant adjustments are made.

Dividend Accounting

Dividend Declaration: Dividends are declared by the board of directors and are
paid in the current year. The accounting entry for dividends is straightforward,
typically involving a single ledger account for adjustments .

Provision for Tax: When creating a provision for tax, it is simply an estimated tax
liability for the current year. This provision is reversed when calculating cash flows,
specifically when starting from retained earnings or net profit after tax .

Impact of Current Assets and Liabilities:

A decrease in current assets (e.g., accounts receivable) positively impacts

cash flow, while an increase negatively impacts it. For example, a decrease of
$5,000 in current assets should be noted as a positive cash flow adjustment .
Conversely, an increase in current liabilities is a positive adjustment to cash
flow, while a decrease is negative .

Cash Flow Adjustments

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 Operating Activities: Cash flows from operating activities include adjustments for
changes in working capital. For instance, if current assets increase, this is a
negative impact on cash flow and should be subtracted .

Extraordinary Items: Items like insurance claims or disaster settlements are

treated as operating activities if they relate to the business's operations. Such
items should be added back to cash flow calculations .

Tax Payments: When tax is paid, the provision for tax account decreases. This
should be reflected in the cash flow statement, particularly in the operating
activities section .

Working Capital Changes

Understanding Working Capital: Working capital is defined as current assets

minus current liabilities. An increase in working capital (e.g., current assets rising
faster than current liabilities) negatively affects cash flow and should be subtracted
.

Cash Flow Statement Preparation: In preparing the cash flow statement using
the indirect method, adjustments for working capital changes are crucial. For
example, if trade receivables increase, this should be subtracted from cash flow .

Dividend Payable

Dividend Payable Accounting: When dividends are declared, they create a liability
(dividend payable) that must be accounted for. This liability decreases when
dividends are paid .

Final vs. Interim Dividends: The board proposes final dividends based on the
year's profit after the balance sheet date, while interim dividends are declared
during the year. Both types require careful accounting .

Conclusion on Cash Flow Adjustments

Cash Flow from Operations: The goal of adjustments in the cash flow statement
is to convert profit from an accrual basis to a cash basis. This involves reversing
any extraordinary items and adjusting for provisions created during the year .

Final Notes: Understanding the relationship between current assets, current

liabilities, and cash flow is essential for accurate financial reporting. The
adjustments made in the cash flow statement reflect the true cash position of the
company .

Cash Flow Statement Adjustments

1. Machinery and Asset Transactions

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 Cash Flow from Machinery:
Purchase of Machinery is a cash outflow and recorded under investing
activities. Sale of Machinery is a cash inflow .
Loss on sale of Machinery is a non-cash item and should be reversed in the
cash flow statement .
Profit on sale of Machinery should also be reversed if it has not been included
in the profit and loss statement .

2. Depreciation Accounting

Depreciation Methods:
There are two methods for accounting depreciation: charge method and
accumulated depreciation method .
Depreciation is usually deducted in the profit and loss statement, thus it must
be added back in the cash flow statement .

3. Interest and Dividend Adjustments

Interest Paid:
Interest paid is classified as a financing activity and should be subtracted in
the cash flow statement .
Dividends:
Dividend received is considered an investing activity and should be added in
the cash flow statement .
Dividend paid is a financing activity and should be deducted .

4. Non-Cash Transactions

Non-Cash Items:
Non-cash transactions such as grants received for capital projects should be
classified under investing activities .
Items like bonus issues and conversion of debentures into shares do not
affect cash flow and should be ignored in cash flow statements .

5. Grant Received Adjustments

Grant for Capital Projects:

Grants received should be treated as investing activities. If amortized, the
amortized amount should be reversed in operating activities .

6. Equity Share Transactions

Equity Shares:
When issuing shares, only the face value is recorded in the cash flow
statement, while any premium is recorded separately .
Buybacks must consider the total amount paid, not just the face value .

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7. Summary of Cash Flow Statement Preparation

Indirect Method:
Start from net profit, adjust for non-cash items, and account for changes in
working capital .
Direct Method:
Directly list cash inflows and outflows without adjustments for non-cash
items .

This summary highlights key adjustments and considerations for preparing a cash flow
statement, focusing on the treatment of various transactions and their implications on
cash flow.

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