Cash Flow Statement

Introduction
The balance sheet provides information about the enterprises assets and
how they have been financed. However, it does not explain the changes
during a period in the assets liabilities and equity resulting from the
enterprises activity. The statement of profit & loss provides information
about enterprises financial performance. However, since the earnings are
measured by accrual accounting, they do not show the cash generated
through the enterprises operations.

There may be a huge difference between a company's earnings and the cash
generated from operations. Accrual basis statements consider items which
have no effect on enterprises cash flows such as depreciation and
amortization, revenues earned but not received and expenses incurred but
not paid. Also, earnings suffer from measurement error and bias resulting
from the management's ability to choose from a range of methods and
estimates. In contrast, reporting cash flows involves no allocations and
estimates and presents few recognition problems because all the cash
receipts and payments are recognised when they occur. In times of
recession, the ability of the enterprise to meet its obligations, especially, in
the short term is of paramount importance.

1. Purpose & structure of statement of cash flows:

The main purpose of statement of cash flows is to provide relevant

information about enterprises cash receipts and cash payments.
a. This information helps users of financial statements to assess the
amounts, timing and uncertainty of an enterprise's prospective cash
flows.
 b. Investors, lenders, suppliers, employees are directly concerned with
the enterprise's ability to generate cash.
c. Statement of cash flows provides information that enables them to
evaluate the enterprises liquidity, financial flexibility, profitability and
risk.
d. It also provides feedback about the previous assessments of these
factors.

Users of financial statements will find the information in the statement of

cash flows useful in assessing their enterprises ability to generate positive
future net cash flows, meet its obligations, pay dividend and identify its
needs for external financing.

As a part of its cash management activities, enterprises generally keep

cash in excess of immediate needs in short-term highly liquid investments
that can be quickly converted into definite amounts of cash. Generally, a
cash flow for cases on the aggregate of cash and cash equivalents.

What can we learn from the statement of cash flows about the company?
Our questions would include:

1. Why did the cash balance decrease when the company made a net
profit for period?
2. How did the company finance acquisition of plant and machinery?
3. How does the company utilise the proceeds of the equity issue?
4. Is the capacity expansion straining the company's cash?
5. Does company enjoy a fair degree of financial flexibility?
6. What inferences can we draw from the statement about the
company's ability to generate future cash flows, repay its borrowings
and pay dividends?

2.Components of CASH FLOW STATEMENT

Cash flow statement is the summary of Cash inflows and Cash outflows
(cash and bank) for a particular period.
Broadly, the Statement of cash flows classifies cash flows into operating,
investing and financing categories. Such a classification enables significant
relationships within and among the three kinds of activities to be evaluated.

COMPANY NAME
Statement of Cash Flows
Cash Flows from Operating
Activities
(List of individual inflows and XXX
outflows)
Net Cash Flow from Operating XXX
Activities
Cash Flows from Investing
Activities
(List of individual inflows and XXX
outflows)
Net Cash Flow from Investing XXX
Activities
Cash Flows from Financing
Activities
(List of individual inflows and XXX
outflows)
Net Cash Flow from Financing XXX
Activities
Net Increase (Decrease) in Cash XXX
and Cash Equivalents
Cash and Cash Equivalents at XXX
Beginning of Period
 Cash and Cash Equivalents at End XXX
of Period

Cash and Cash Equivalents: Includes bank and cash balances. Cash
equivalents include short term investments that have a maturity
period of less than 3 months.

I. Cash Flow from Financing Activities

Computing Net Cash Flows from Financing activities:

The first step in preparation of statement of cash flows is computing the net
cash flow from financing activities. These involve raising and repayment of
capital and loans. Cash inflows and cash outflows from financing activities
are calculated by analysing changes in the balance sheet amounts for equity
and financial liabilities and considering the cash effects of the transactions
during the period. Interest and earnestly are part of the cash flows from
financing activities.
Examples are: Issue of shares , dividends paid, new borrowings and
repayment of borrowings.
Interest paid ( It is a direct consequence of a financing decision and should
therefore be classified as cash outflow from financing activities as per
Indian Accounting Standards. )

Cash flows from financing activities:

Share issue proceeds……………..100,000

Dividends paid……. …………….. (25,000)
Debenture redemption…………… (27,000)
Borrowings repayment… ………..(1,000)
Borrowings taken 0
Interest paid………… ……………(22,000)

Net cash from financing activities……………...25,000

 II. CASH FLOW FROM INVESTING ACTIVITIES

Computing Net Cash Flows from Investing Activities:

The second step in preparing the statement of cash flows is computing net
cash flow from investing activities. Investing activities involve purchases
and sales of property, plant and equipment and Investments. Receipts from
disposal of property, plant and equipment include directly related proceeds
of insurance settlements. Cash receipts and cash payments from investing
activities are computed by analyzing changes in the balance sheet
amounts for property plant equipment and Investments and considering the
cash effects of the related transactions that took place during the period.
interest and dividend received are also part of cash inflows from investing
activities.

Example :

1. Purchased equipment for cash Rs 173,000

2. Sale of equipment for cash Rs 22,000
3. Purchase investments for cash Rs 26,000
4. Sold investments for cash Rs 42,000 (cost Rs 51,000)
5. Interest received Rs, 7000

Examining these transactions:

Purchase of PPE……………..(173,000)
Sale of PPE…………………….22,000
Purchase of investment………(26,000)
Sale of investments…………...42,000
Interest received………………..7,000
Dividend Received 4444

Net cash used in investing activities……………(128,000)

 III. Cashflow from Operating Activities

Cashflow from operating activity relates to the day today operations of the
business. These include buying and selling of goods, incurring expenses
etc.

There are two ways of computing and reporting cash flow from Operating
activities:

● Direct method
● Indirect method

The direct method shows major classes of operating cash receipts and
payments such as cash received from customers, cash paid to suppliers
and employees, and income tax paid, the sum of which is net cash flow
from Operating activities. This is a simple summarization of all the
operating activity receipts and payments.

Cash received from customers (Elaboration)

Cash received from customers consists of cash sales and collections from
customers. Cash sales results in cash inflows in current period. However,
collections require additional calculations. Sales from earlier period may be
collected in the current period, sales from current period may be collected in
a future period, and some receivables may not be collected at all. As a result,
collections are seldom equal to credit sales.
Following equation states the relationship between credit sales, change in
trade receivables and collections:
Ending balance = beginning balance + credit sales + cash received from
customers - write offs

For Example
Cash flows from Operating activities for year ended March 31, 2015 - Direct
method

Cash flows from Operating activities

Cash received from customers……...881,000

Cash pd to suppliers/employees.. (797,000)
Cash generated from operations ……..84,000
Income tax paid…….. ...(12,000)

Net cash from operating activities………………...72,000

Example

Big Bus had the following transactions in its first month of operations.

 Introduced capital of Rs. 50000 and Borrowings of 10000

 Purchased goods for Rs. 50000: paid in cash Rs. 30000 and
credit Rs.20000
 Sold goods costing 40000, for Rs. 100,000 on credit
 Bought furniture for Rs.15000 paid cash.
 Made an Investment of Rs. 2000
 Depreciation of Rs. 3000 on Equipment
 Interest paid Rs. 1000
 Dividend received from investments Rs. 400
Prepare the cash flow statement

Cash flow statement using the Direct method

Cash flow from operating activities

Paid Creditors -30000 -30000

Cash flow from investing activities

 Equipment -15000
investments -2000
Dividend 400 -16600

Cash flow from financing activities

Capital 50000
Borrowings 10000
Interest paid -1000 59000

Cash balance 12400

Indirect method of cash flow statement

The indirect method starts with net profit before tax and adjusts it for 3
items

a) Non cash items: depreciation and bad debt expense do not require
cash outflows. Hence, we add them back.
Certain expenses do not entail cash payment and must not be
considered for calculating expenses paid on cash. Depreciation,
amortization do not involve cash outflows, but are allocations of past
expenditures for purchase of long term assets. For example, the
Compass company records depreciation for year as:

Depreciation expense DR 98,000

To accumulated depreciation. CR 98,000
There is no cash and hence we need to adjust for it when we draw
from P&L to CFO

b) Non operating items: remove non operating items such as (a) gains
and losses on disposal of PPE, & Investments (b) interest income &
dividend income (d) interest expense (Finance Cost ). These belong
 to other activities in the cash flow statements (though part of P&L) as
appropriate. (Financing / Investing)

Do note as per the accounting standards in India, interest expenses

are classified as part of financing activities and hence need to be
adjusted from the operating cash flow

c) Changes in working capital items: We adjust the net profit for

changes in working capital items like inventory, trade receivables,
prepaid expenses and trade payables and others. The changes are
from the previous year balance sheet

For example: 2022 2021

Inventory ₹ 4500 ₹3400.

The increase in inventory is an out flow (1100)

Similar changes for other working capital items of current assets and
liabilities .

Do note:
Both the methods result in the same figure of net cash flow from operating
activities. We saw the direct method. Lets do the same problem using the
indirect method.

Big Bus had the following transactions in its first month of operations.
 Introduced capital of Rs. 50000 and Borrowings of 10000
 Purchased goods for Rs. 50000: paid in cash Rs. 30000 and
credit Rs.20000
 Sold goods costing 40000, for Rs. 100,000 on credit
 Bought furniture for Rs.15000 paid cash.
 Made an Investment of Rs. 2000
 Depreciation of Rs. 3000 on Equipment
 Interest paid Rs. 1000
 Dividend received from investments Rs. 400
 
Prepare the P& L and the cash flow statement using indirect method

Profit and Loss Statement

Revenue 1,00,000
Less COGS 40,000
Less: Depreciation 3,000
Less interest: 1,000
Add: Other income 400
Net Profit 56,400

*no adjustment of tax is made in this example

CASH FLOW USING INDIRECT METHOD

Cash Flow from Operating activities

Profit Before Tax 56,400
Add Depreciation 3000
Add: Interest 1000
Less Dividend recd 400

OPERATING CASH FLOW BEFORE WCC

60,000
Working Capital Changes
 Increase in Receivables -100000
 Increase in Inventory -10000
 Increase in Creditors + 20000
 Total -90000
Cash Flow from operations -30,000
Direct tax paid
Cash Flow from operating Activities -30,000

Cash Flow from Investing

Equipment -15000
Investments purchased -2000
Dividend Received 400
Cash flow from investing activities -16600

Cash Flow from Financing Activities:

Capital 50000
Borrowings 10000
Interest paid -1000
Cash Flow from Financing Activities: 59000

Net cash flow for the year 12,400

Add: Opening Balance 0

Net Cash and cash equivalents 12,400

Direct tax paid:

The amount of income tax paid usually differs from the income tax
expense. Since we take the P&L from before tax, actual income tax paid
needs to be reduced to arrive at the final cash flow from operating activities

Cash generated from operations... XXXX

Less: Income tax paid…………………xxx
Net CFO xxx
Interpreting the statement of cash flows:

Cash flow ratios:

• Operating cash margin:

Captures the cash generated from the revenue of organization

Net cash provided by operating activities

Net sales

A Ratio close to accrual based profit margin ratio would be an assurance

that sales and profits are not the results of earnings management. The
company's cash return on sales ratio is 7.8 % (72,000 / 925,000). This is
less than 60% of the accrual based margin ratio (43,000 / 925,000). When
combine with large percentage increase in trade receivables, it is a red flag.

• Cash Profit Ratio

Note the gap between cashflow before working capital changes
(WCC) and after WCC need to be observed for any abnormal
changes and an interesting ratio to be computed. This ratio is a
refined version of the above ratio
,
• Current liability cover:
This is a measure of firm's ability to meet its current liabilities out of cash
flow from operating activities. It is defined as:

Net cash generated by operations

Current liabilities

IF the ratio is too low and the company could default its current obligations.
The operating cash flow further confirms the company's liquidity strain.