What is a Cash Flow Statement?

A cash flow statement is a financial document typically used to understand the solvency of your
business. When combined with other financial statements, it can give you a clear perspective on the
financial health of your small business.

From a financial point of view, a firm basically generates cash and spends cash. It generates cash when it issues
securities, raises a bank loan, sells a product, disposes an asset, so on and so forth. It spends cash when it
redeems securities, pays interest and dividends, purchases materials, acquires an asset, etc. The activities that
generate cash are called sources of cash and the activities that absorb cash are called uses of cash. To
understand how a firm has obtained cash and how it has spent cash during a given period, we need to look at
the changes in each of the items in the balance sheet over that period.
Our common sense tells us that a firm generates cash when it increases its liabilities (as well as owners’ equity);
on the other hand it uses cash when it buys assets or reduces its liabilities (as well owners’ equity). Thus, the
following picture emerges.

What Does a Cash Flow Statement Show?

The cash flow statement shows changes in your cash on hand, including cash in your bank account
and short-term investments that you can easily convert to cash. Cash flow statement examples might
reflect activities such as:

Operating activities involve producing and selling goods and services. Cash inflows from operating
activities include monies received from customers for sales of goods and services. Cash outflows from
operating activities include payments to suppliers for materials, to employees for
services, and to the government for taxes.
Investing activities involve acquiring and disposing fixed assets, buying and selling financial securities
and disbursing and collecting loans. Cash inflows from investing activities include receipts from the sale
of assets (real as well financial), recovery of loans, and collection of dividend and interest.
Cash outflows from investing activities include payments for the purchase of assets (real and financial)
and disbursement of loans.
Financing activities involve raising money from lenders and shareholders, paying interest and dividend
and redeeming loans and share capital. Cash inflows from financing activities include receipts from
issue of securities and from loans and deposits. Cash outflows from financing activities include
payment of interest on various forms of borrowings, payment of dividend, retirement of borrowings, and
redemption of capital.
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.
6.2 Benefits of Cash Flow Statement
Cash flow statement provides the following benefits :
l 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 in order to adapt to changing circumstances and opportunities.

l 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.

l 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.

l It also helps in balancing its cash inflow and cash outflow, keeping in response to changing condition. 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.

Classification of Activities for the Preparation of Cash Flow

Statement
You know that various activities of an enterprise result into cash flows (inflows or receipts and outflows or payments)
which is the subject matter of a cash flow statement. As per AS-3, 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. This helps the users of cash flow statement to assess the impact of these activities on the financial
position of an enterprise and also on its cash and cash equivalents.
6.5.1 Cash from Operating Activities
Operating activities are the activities that constitute the primary or main activities of an enterprise. For example, for a
company manufacturing garments, operating activities are procurement of raw material, incurrence of manufacturing
expenses, sale of garments, etc. These are the principal revenue generating activities (or the main activities) of the
enterprise and these activities are not investing or financing activities. The amount of cash from operations’ indicates
the internal solvency level of the company, and is regarded as the 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, paying
dividends, making of new investments and repaying of loans without recourse to external source of
financing.
Cash flows from operating activities are primarily derived from the main activities of the enterprise. They generally
result from the transactions and other events that enter into the determination of net profit or loss. Examples of cash
flows from operating activities are:
Cash Inflows from operating activities
l cash receipts from sale of goods and the rendering of services.
l cash receipts from royalties, fees, commissions and other revenues.
Cash Outflows from operating activities
l Cash payments to suppliers for goods and services.
l Cash payments to and on behalf of the employees.
l Cash payments to an insurance enterprise for premiums and claims,
annuities, and other policy benefits.
l Cash payments of income taxes unless they can be specifically identified
with financing and investing activities.
The net position is shown in case of operating cash flows.
An enterprise may hold securities and loans for dealing or for trading
purposes. In either case they represent Inventory specifically held for resale.
Therefore, cash flows arising from the purchase and sale of dealing or trading
securities are classified as operating activities. Similarly, cash advances and
loans made by financial enterprises are usually classified as operating activities
since they relate to main activity of that enterprise.

6.5.2 Cash from Investing Activities

As per AS-3, investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents. Investing activities relate to purchase and sale of long-term assets or fixed assets such
as machinery, furniture, land and building, etc. Transactions related to long-term investment are also investing
activities. Separate disclosure of cash flows from investing activities is important because they 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:

Cash Outflows from investing activities

l Cash payments to acquire fixed assets including intangibles and
capitalised research and development.
l Cash payments to acquire shares, warrants or debt instruments of other
enterprises other than the instruments those held for trading purposes.
l Cash advances and loans made to third party (other than advances
and loans made by a financial enterprise wherein it is operating
activities).
Cash Inflows from Investing Activities
l Cash receipt from disposal of fixed assets including intangibles.
l Cash receipt from the repayment of advances or loans made to third
parties (except in case of financial enterprise).
l Cash receipt from disposal of shares, warrants or debt instruments of
other enterprises except those held for trading purposes.
l Interest received in cash from loans and advances.
l Dividend received from investments in other enterprises.

6.5.3 Cash from Financing Activities

As the name suggests, financing activities relate to long-term funds or capital of an enterprise, e.g., cash proceeds
from issue of equity shares, debentures, raising long-term bank loans, repayment of bank loan, etc. As per AS-3,
financing activities are activities that result in changes in the size and composition of the owners’ capital (including
preference share capital in case of a company) and borrowings of the enterprise. 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 financing activities are:

Cash Inflows from financing activities
l Cash proceeds from issuing shares (equity or/and preference).
l Cash proceeds from issuing debentures, loans, bonds and other short/
long-term borrowings.
Cash Outflows from financing activities
l Cash repayments of amounts borrowed.
l Interest paid on debentures and long-term loans and advances.
l Dividends paid on equity and preference capital.
It is important to mention here that a transaction may include cash flows that are classified differently. For example,
when the instalment paid in respect of a fixed asset acquired on deferred payment basis includes both interest and
loan, the interest element is classified under financing activities and the loan element is classified under investing
activities. Moreover, same activity may be classified differently for different enterprises. For example, purchase of
shares is an operating activity for a share brokerage firm while it is investing activity in case of other enterprises.

As per AS-3, an enterprise should report cash flows from operating activities either by using :
l Direct method whereby major classes of gross cash receipts and gross
cash payments are disclosed;
or
l Indirect method whereby net profit or loss is duly adjusted for the effects of (1) transactions of a non-cash nature, (2)
any deferrals or accruals of past/future operating cash receipts, and (3) items of income or expenses associated with
investing or financing cash flows. It is important to mention here that under indirect method, the starting point is net
profit/loss before taxation and extra ordinary items as per Statement of Profit and Loss of the enterprise. Then this
amount is for non-cash items, etc., adjusted for ascertaining cash flows from operating activities.
Accordingly, cash flow from operating activities can be determined using either the Direct method or the Indirect
method. These methods are discussed in detail as follows.
6.6.1 Direct Method
As the name suggests, under direct method, major heads of cash inflows and outflows (such as cash received from
trade receivables, employee benefits expenses paid, etc.) are considered. It is important to note here that items are
recorded on accrual basis in statement of profit and loss. Hence, certain adjustments are made to convert them into
cash basis such as the following :

1. Cash receipts from customers = Revenue from operations + Trade

receivables in the beginning – Trade receivables in the end.
2. Cash payments to suppliers = Purchases + Trade Payables in the
beginning – Trade Payables in the end.
3. Purchases = Cost of Revenue from Operations – Opening Inventory +
Closing Inventory.
4. Cash expenses = Expenses on accrual basis + Prepaid expenses in the
beginning and Outstanding expenses in the end – Prepaid expenses in
the end and Outstanding expenses in the beginning.
However, the following items are not to be considered:
1. Non-cash items such as depreciation , discount on shares, etc., be writtenoff.
2. Items which are classified as investing or financing activities such as interest received, dividend paid, etc.
As per AS-3, under the direct method, information about major classes of gross cash receipts and cash payments may
be obtained either–

l from the accounting records of the enterprise, or

l by adjusting revenue from operation, cost of revenue from operations and other items in the statement of profit or loss
for the following:
l changes during the period in inventories and trade receivables
and payables;
l other non-cash items; and
l other items for which cash effects are investing or financing cash
flows.