Cash Flow Statement — Study Notes

1. Introduction

The cash flow statement is a financial statement that summarises the cash inflows and cash outflows of a business during an accounting period and shows the resultant change in cash and cash equivalents. It is prepared in accordance with Accounting Standard 3 (AS 3), which classifies cash flows into operating, investing, and financing activities. The cash flow statement explains why the cash balance changed during the period, which the Statement of Profit and Loss and the Balance Sheet alone cannot fully reveal.

Cash includes cash in hand and demand deposits, while cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and have an insignificant risk of change in value. The statement reconciles the opening and closing cash and cash equivalent balances with the net cash flows from the three activities.

$$\text{Net Cash Flow} = \text{Operating Activities} + \text{Investing Activities} + \text{Financing Activities}$$

$$\text{Closing Cash and Cash Equivalents} = \text{Opening Balance} + \text{Net Cash Flow}$$

2. Classification of Cash Flows

2.1 Operating Activities

Operating activities are the principal revenue-producing activities of the enterprise. Cash flows from operating activities include cash received from customers and cash paid to suppliers and employees. Under AS 3, the net cash flow from operating activities is determined using either the direct method or the indirect method.

Under the indirect method, the net cash flow from operating activities is computed by adjusting the net profit before tax and extraordinary items for:

• Depreciation and amortisation (added back).
• Interest paid on borrowings (deducted, if treated as financing).
• Profit or loss on sale of assets (adjusted).
• Changes in current assets and current liabilities (increase in current assets reduces cash; increase in current liabilities increases cash).

2.2 Investing Activities

Investing activities relate to the acquisition and disposal of long-term assets and investments not included in cash equivalents. Examples are the purchase and sale of fixed assets, purchase and sale of investments, and interest received on investments and loans.

2.3 Financing Activities

Financing activities relate to changes in the size and composition of the owner's capital and the borrowings of the enterprise. Examples are the issue of shares and debentures, repayment of borrowings, payment of dividends, and interest paid on borrowings.

3. Preparation of the Cash Flow Statement

The cash flow statement is prepared from the comparative Balance Sheets and the Statement of Profit and Loss along with additional information. The steps are:

1. Compute the net profit before tax and extraordinary items.
2. Adjust for non-cash items and non-operating items to arrive at the cash flow from operating activities (indirect method).
3. Compute the cash flow from investing activities.
4. Compute the cash flow from financing activities.
5. Reconcile the net cash flow with the change in cash and cash equivalents.

4. Key Adjustment Rules in the Indirect Method

• Depreciation: Added back to net profit (non-cash expense).
• Profit on sale of fixed assets: Deducted from net profit (non-operating income).
• Loss on sale of fixed assets: Added back to net profit.
• Increase in current assets: Decreases cash, deducted.
• Decrease in current assets: Increases cash, added.
• Increase in current liabilities: Increases cash, added.
• Decrease in current liabilities: Decreases cash, deducted.
• Interest paid on borrowings: Shown in financing activities (deducted there).
• Interest received: Shown in investing activities.
• Dividend received: Shown in investing activities.
• Dividend paid: Shown in financing activities.

5. Special Cases

5.1 Proposed Dividends

Under AS 3, dividends paid are classified as financing activities, and proposed dividends are not provided for in the current year's statement.

5.2 Tax Paid

Tax paid is usually classified as operating activities, but where it relates to investing or financing, it may be classified accordingly.

5.3 Purchase of Fixed Assets

The purchase of fixed assets is an investing outflow. If a fixed asset is purchased partly by the issue of shares, only the cash portion is shown in the cash flow statement, and the non-cash part is disclosed as a significant non-cash transaction.

Quick Revision Tables

Table 1: Classification of Cash Flows

Table 2: Adjustment Rules (Indirect Method)

Table 3: Cash vs Cash Equivalents

Mind Map

Important Diagrams (SVG)

Diagram 1: Structure of the Cash Flow Statement

Diagram 2: Steps to Compute Operating Cash Flow (Indirect Method)

Common Mistakes

1. Forgetting to add back depreciation while computing cash from operating activities under the indirect method.
2. Showing the profit on the sale of fixed assets as a cash inflow from operating activities instead of adjusting it against net profit.
3. Classifying interest paid as an operating activity instead of a financing activity.
4. Deducting an increase in current liabilities from the operating cash flow instead of adding it.
5. Including the purchase of fixed assets in operating activities instead of investing activities.
6. Forgetting to reconcile the closing balance of cash and cash equivalents with the opening balance.
7. Treating non-cash transactions such as the issue of shares for assets as cash flows; they must only be disclosed.

Exam Tips

1. Prepare the comparative Balance Sheet as a working note to identify the changes in each item.
2. Present the three activities separately with subtotals so that marks are awarded for each section.
3. Add back depreciation and deduct gains, and adjust for working capital changes, in the operating activity section.
4. Remember that interest paid is financing and interest received is investing.
5. For fixed assets, prepare an asset account to compute the cash outflow on purchase or inflow on sale.
6. Show the opening and closing balances of cash and cash equivalents to prove the reconciliation.
7. Read the additional information for depreciation and dividend figures before starting the statement.

Conclusion

The cash flow statement bridges the gap between accounting profits and cash movements by classifying cash flows into operating, investing, and financing activities. It reveals the liquidity position of the enterprise and the quality of its earnings. The indirect method of computing cash from operating activities, with its adjustments for non-cash items and working capital changes, is the most frequently tested skill. A properly prepared cash flow statement, reconciled with the opening and closing cash balances, provides invaluable information for investors, creditors, and management, and completes the trio of the principal financial statements.