Cash flow statements (2024)

This article considers the statement of cash flows of which it assumes no prior knowledge. It is relevant to the FA (Financial Accounting) and FR (Financial Reporting) exams. The article will explain how to calculate cash flows and where those cash flows are presented in the statement of cash flows.

Computing cash flows

Cash flows are either receipts (ie cash inflows and so are represented as a positive number in a statement of cash flows) or payments (ie cash out flows and so are represented as a negative number using brackets in a statement of cash flows).

Cash flows are usually calculated as a missing figure. For example, when the opening balance of an asset, liability or equity item is reconciled to its closing balance using information from the statement of profit or loss and/or additional notes, the balancing figure is usually the cash flow.

Common cash flow calculations include the tax paid, which is an operating activity cash out flow, the payment to buy property plant and equipment (PPE) which is an investing activity cash out flow and dividends paid, which is a financing activity cash out flow. The following examples illustrate all three of these examples.

Exercise calculating the tax paid

At the start of the accounting period the company has a tax liability of $50 and at the reporting date a tax liability of $90. During the year the tax charged in the statement of profit or loss was $100.

Required: Calculate the tax paid.

Solution
It is necessary to reconcile the opening tax liability to the closing tax liability to reveal the cash flow – the tax paid - as the balancing figure. A vertical presentation of the numbers lends itself to noting the source of the numbers.

Tax liability

$

Explanation

Opening balance

50

Credit balance

Tax charge

100

The tax charged in the profit or loss means that the entity now owes more tax. The debit charged as the expense in profit or loss is posted and a credit to the tax liability account reflects the effect of increase in the tax liability

_____

Sub-total

150

This sub-total represents the amount of the tax liability that there would have been at the reporting date in the event that no tax had been paid

Cash flow – the payment of tax

60

This is the last figure written in the reconciliation. It is the balancing figure and explains why the actual year-end tax liability is smaller than the sub-total


_____

Closing balance

90

This is the closing balance of the tax liability

_____

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This simple technique of taking the opening balance of an item (in this case the tax liability) and adding (or subtracting) the non-cash transactions that have caused it to change, to then reveal the actual cash flow as the balancing figure, has wide application.

Exercise calculating the payments to buy PPE

At the start of the accounting period the company has PPE with a carrying amount of $100. At the reporting date the carrying amount of the PPE is $300. During the year depreciation charged was $20, a revaluation surplus of $60 was recorded and PPE with a carrying amount of $15 was sold for $20.

Required: Calculate the cash paid to buy new PPE.

Solution
Here we can take the opening balance of PPE and reconcile it to the closing balance by adjusting it for the changes that have arisen in period that are not cash flows. The balancing figure is the cash spent to buy new PPE.

PPE

$

Explanation

Opening balance

100

Debit balance

Deprecation

(20)

Deprecation reduces the carrying amount of the PPE without being a cash flow. The double entry for depreciation is a debit to statement of profit or loss to reflect the expense and to credit the asset to reflect its consumption.

Revaluation surplus

60

The revaluation gain increases PPE without being a cash flow. The double entry is a credit to the revaluation surplus to reflect the gain and to debit the asset to reflect its increase

Disposal

(15)

The carrying amount of the PPE that has been disposed of reduces the PPE thus a credit to the asset account which is then posted as a debit in the disposals account

_____

Sub-total

125

This sub-total represents the balance of the PPE if no PPE had been bought for cash

Cash flow – the payment to buy PPE

175

This is the last figure written in the reconciliation This balancing figure explains why the actual PPE at the reporting date is greater than the sub-total

_____

Closing balance

300

_____

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Note that the cash proceeds ffrom the disposal of PPE ($20) would be shown separately as a cash inflow under investing activities. The profit on disposal of $5 ($20–$15) would be adjusted for as a non-cash item under the operating activities (see later).

Exercise calculating the dividend paid

At the start of the accounting period the company has retained earnings of $500 and at the reporting date retained earnings are $700. During the reporting period a profit for the year of $450 was reported.

Required: Calculate the dividend paid.

Solution
As before, to ascertain the cash flow – in this case dividends paid - we can reconcile an opening to closing balance – in this case retained earnings. This working is in effect an extract from the statement of changes in equity.

Retained earnings

$

Explanation

Opening balance

500

Credit balance

Profit for the year

450

The profit for the year is a credit and increases the retained earnings

_____

950

This sub-total represents the balance on retained earnings in the event that no dividends have been paid

Cash flow – the dividends paid

250

This is the last figure written in the reconciliation. This balancing figure of dividends paid explains why the actual year-end retained earnings is less

_____

Closing balance

700

_____

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Classification of cash flows

IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flow classifies and presents cash flows under three headings:

(i) Operating activities
(ii) Investing activities and
(iii) Financing activities

Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit. Under both of these methods the interest paid and taxation paid are then presented as cash outflows deducted from the cash generated from operations.

Investing activity cash flows are those that relate to non-current assets including investments . Examples of investing cash flows include the cash outflow on buying property plant and equipment, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings from third parties (debt) and by the shareholders (equity). Examples of financing cash flows include the cash received from new borrowings or the cash repayment of debt as well as the cash flows with shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.

This topic is examined in much more depth in the FR examination than it is at FA. For example, in FA, an extract, or the whole statement of cash flow might be required in the multi-task questions but it could also be constructed as an OT question. FR, however, is more likely to ask for an extract from the statement of cash flows using more complex transactions (for example, the purchase of PPE using right-of-use asset leases). However, that does not mean that FR will never require the preparation of a complete statement of cash flows so be prepared.

Operating activities – the indirect method and direct method

There are two different ways of starting the cash flow statement, as IAS 7,Statement of Cash Flowspermits using either the 'direct' or 'indirect' method for operating activities.

The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash out flows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally the payments for interest and tax are deducted.

Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial reconciliation the profit before tax is adjusted for expenses that have been charged against profit that are not cash out flows; for example depreciation and losses on disposal of non-current assets, have to be added back, and non-cash income; for example, investment income and profits on disposal of non-current assets are deducted. The changes in inventory, trade receivables and trade payables (working capital) do not impact on the measurement profit but these changes will have impacted on cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will have not impacted on profit before tax but will have had an adverse impact on the cash flow of the business. Thus, in the reconciliation process, the increases in inventory and trade receivables are deducted from profit before tax. Conversely, decreases in inventory and trade receivables are added back to the profit before tax. The opposite is applicable for trade payables. Finally, the payments for interest and tax are presented – usually as a further deduction.

The following exercise illustrates both the direct and indirect methods operating activities section.

Exercise: The direct and indirect method

Extracts from the financial statements are as follows

$

Operating profit

80,000

Investment income

12,000

Finance costs

(10,000)

Profit before tax

82,000

Tax

(32,000)

Profit for the year

50,000

Other comprehensive income

Revaluation gain

40,000

Total comprehensive income

90,000

Additional information
During the year depreciation of $50,000 and amortisation of $40,000 was charged to profit.

Receipts from customers, combined with cash sales, were $800,000, payments to suppliers of raw materials $400,000, other operating cash payments were $100,000 and cash paid on behalf and to employees was $126,000.

Interest paid is $12,000 and taxation paid is $13,000.

Required:
(a)Using the direct method prepare the operating activities section of the statement of cash flows.
(b)Using the indirect method determine the operating activities section of the statement of cash flows.

Answer (a) direct method
The direct method is relatively straightforward in that all the data are cash flows so it is really just a case of listing the receipts as positive and the payments as negative.

Answer (b) indirect method
The indirect method is more commonly examined. Here as we start with profit before tax we have to add back all the non-cash expenses charged, deduct the non-cash income and adjust for the changes in working capital. Only then are the two actual cash flows of interest paid and tax paid presented. Having a good understanding of the format of the statement of cash flows is key to a successful attempt at these questions.

Note how whichever method is used that the same cash is generated from operating activities.

Format of the cash flow statement –
indirect method

You may be asked to prepare a statement of cash flows. The following is a pro forma showing the indirect method.

Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value. A bank overdraft should be treated as a negative cash balance when arriving at the cash and cash equivalents.

Tom Clendon FCCA is a senior lecturer based in Singapore and he lectures for FTMS Global in their South East Asia colleges

I'm Tom Clendon, FCCA, a senior lecturer with a focus on Financial Accounting, based in Singapore. I have extensive experience and knowledge in the field, particularly in preparing financial statements and understanding the intricacies of cash flow calculations. My expertise lies not only in theory but also in practical application, making complex accounting concepts accessible.

Now, let's delve into the key concepts discussed in the article about the statement of cash flows:

  1. Cash Flows Basics:

    • Cash flows are categorized as either receipts (inflows) or payments (outflows).
    • Represented in a statement of cash flows as positive or negative numbers.
    • Common cash flow calculations include tax paid (operating activity), payment for property plant and equipment (investing activity), and dividends paid (financing activity).
  2. Exercise: Calculating Tax Paid:

    • The article illustrates how to calculate tax paid by reconciling the opening and closing tax liabilities.
    • It emphasizes the balancing figure as the actual cash flow and demonstrates the vertical presentation of numbers.
  3. Exercise: Calculating Payments to Buy PPE (Property Plant and Equipment):

    • Similar reconciliation approach is applied to calculate cash spent on buying new PPE.
    • Depreciation and revaluation surplus are adjusted to find the actual cash flow for purchasing PPE.
  4. Exercise: Calculating Dividend Paid:

    • The process of reconciling opening and closing retained earnings is demonstrated to calculate dividends paid.
    • The balancing figure represents the cash flow related to dividend payments.
  5. Classification of Cash Flows:

    • IAS 7 requires a statement of cash flows with three classifications: Operating activities, Investing activities, and Financing activities.
    • Operating activities can be presented using either the direct or indirect method.
  6. Operating Activities – Direct and Indirect Method:

    • The direct method involves presenting actual cash flows from operating activities.
    • The indirect method starts with profit before tax and reconciles to show cash generated from operating profit.
  7. Exercise: Direct and Indirect Method Example:

    • An example is provided, demonstrating both the direct and indirect methods for the operating activities section of the statement of cash flows.
  8. Format of Cash Flow Statement – Indirect Method:

    • A pro forma is presented for the indirect method, emphasizing the importance of understanding the format for successful attempts at related questions.

These concepts are crucial for Financial Accounting (FA) and Financial Reporting (FR) exams, with FR delving deeper into complex transactions. It's essential to be prepared for both comprehensive statement preparation and specific extract-based questions.

Cash flow statements (2024)

FAQs

What is on a cash flow statement? ›

A cash flow statement is a financial statement that provides aggregate data regarding all cash inflows that a company receives from its ongoing operations and external investment sources. It also includes all cash outflows that pay for business activities and investments during a given period.

What are the 3 types of cash flow statement? ›

There are three cash flow types that companies should track and analyze to determine the liquidity and solvency of the business: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. All three are included on a company's cash flow statement.

What are the 3 components of cash flow statement? ›

The main components of the cash flow statement are: Cash flow from operating activities. Cash flow from investing activities. Cash flow from financing activities.

What is the formula for the cash flow statement? ›

Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure. Net Income is the company's profit or loss after all its expenses have been deducted.

What should not be included in a cash flow statement? ›

Format of a cash flow statement

Operational business activities include inventory transactions, interest payments, tax payments, wages to employees, and payments for rent. Any other form of cash flow, such as investments, debts, and dividends are not included in this section.

What is an example of a cash flow? ›

What is a cash flow example? Examples of cash flow include: receiving payments from customers for goods or services, paying employees' wages, investing in new equipment or property, taking out a loan, and receiving dividends from investments.

Is cash flow same as profit? ›

So, is cash flow the same as profit? No, there are stark differences between the two metrics. Cash flow is the money that flows in and out of your business throughout a given period, while profit is whatever remains from your revenue after costs are deducted.

What is a good cash flow? ›

If a business's cash acquired exceeds its cash spent, it has a positive cash flow. In other words, positive cash flow means more cash is coming in than going out, which is essential for a business to sustain long-term growth.

What is a good cash flow ratio? ›

A high number, greater than one, indicates that a company has generated more cash in a period than what is needed to pay off its current liabilities. An operating cash flow ratio of less than one indicates the opposite—the firm has not generated enough cash to cover its current liabilities.

How do you analyze cash flow? ›

Prepare your cash flow analysis: Step by step
  1. Identify all sources of income. The first step to understanding how money flows through your business is to identify the income that regularly comes in. ...
  2. Identify all business expenses. ...
  3. Create your cash flow statement. ...
  4. Analyze your cash flow statement.

What is the most important number on a statement of cash flows? ›

Regardless of whether the direct or the indirect method is used, the operating section of the cash flow statement ends with net cash provided (used) by operating activities. This is the most important line item on the cash flow statement.

How do you know if a cash flow statement is correct? ›

How can you ensure cash flow statement accuracy?
  1. Review your income statement and balance sheet.
  2. Categorize your cash flows correctly. ...
  3. Use the indirect method for operating cash flows. ...
  4. Reconcile your cash flows with your bank statements. ...
  5. Use accounting software and tools. ...
  6. Here's what else to consider.
Sep 14, 2023

Can cash flow be negative? ›

Negative cash flow is when more money is flowing out of a business than into the business during a specific period. Positive cash flow is simply the opposite — more money is flowing in than flowing out.

What is the difference between a balance sheet and a cash flow statement? ›

A balance sheet shows what a company owns in the form of assets and what it owes in the form of liabilities. A balance sheet also shows the amount of money invested by shareholders listed under shareholders' equity. The cash flow statement shows the cash inflows and outflows for a company during a period.

What are the four parts of cash flow statement? ›

Format Of The Statement Of Cash Flows

Cash involving operating activities. Cash involving investing activities. Cash involving financing activities. Supplemental information.

Does office supplies go on statement of cash flows? ›

Cash flow from operations

This part of a cash flow statement covers the cash flow from operating activities. This includes buying and selling inventory and supplies, salaries, office space rent, income tax payments, and all other operational expenses.

References

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