CASH FLOW STATEMENT

• The third financial statement to compliment the balance sheet & Income statement by providing information on major sources of cash receipts & payments.

• Purpose of CFS is to identify cash flows associated with the period’s operations and also about the investing & financing activities during the period.

Income Statement & Balance sheet are prepared on Accrual Basis

• Income Statement

• Key concepts in measurement of period’s income are ‘Revenue Recognition’ & the ‘Matching of Expenses’.

Income Statement (Revenue Recognition)…….

• i) Revenue is recognized in the period in which the entity performs revenue-generating tasks (e.g.: delivering goods & rendering services);

• ii) irrespective of the fact that customer pays cash at that time or agrees to pay later.

Income Statement (Expense Measure)…….

• Expenses measure the resources consumed in generating periods revenue and in administering the entity during the period irrespective of when cash was used to pay for these resources.

Income Statement …….

• Thus, period’s income through I/S bears no direct relationship to the cash flows associated with period’s operating, investing of financing activities of the organization.

Observations

• Companies collapsed only months after their financial statements showed that they were managing good profits.

• (Nirlon & Machinery Manufacturer Corpn. In 1980s, W.T.Grant Company in 1970s).

• It is because there has always been a great difference between a company’s earnings & cash generated from operations.

Cash Flow Statement

• Requirement of Cash Flow Statement• FASB, USA – 1988• ASB, UK – 1992• ASB, India – 1997 – (AS-3)• International Accounting Standard - 1992

Sources & Uses of Cash• Activities that the CFS describes can be

categorized to (1) activities that generate cash i.e. Sources; & (2) activities that spend cash i.e. Uses of cash.

• Sources: Operations, New borrowings, New issue of stocks, Sale of fixed assets i.e. property, plant & equipment etc.

• Uses: Cash dividends, Repayment of borrowings, Repurchase of stocks, Purchase of fixed assets etc.

Important Terms

• CASH: refers to currency on hand, demand deposits with banks or F.I.s & other accounts that let the customers deposit & withdraw funds at any time.

• CASH EQUIVALENTS: Refers to short-term, highly liquid investments when it has an original maturity of 3 months or less.

OPERATING ACTIVITIES• Principal revenue generating activities of the

firm.

• Operating cash inflows: Include receipts from customers for sale of goods or services (including collection of debtors).

• Operating cash Outflows: Include payments to suppliers for purchase of materials & services, payments to employees for services, & payments to government for taxes & duties.

Computation of Cash flow from Operating Activities

• DIRECT METHOD• Cash received from customers• Less, Cash paid to suppliers & employees• Cash generated from operations• Less, Income Tax paid• Cash flow before extra-ordinary item• Less, Extra-ordinary item• Net cash flow from Operating Activities

Notes to Computation (Direct Method)

• Cash Received from Customers:• (Sales + Decrease in Debtors (Gross) –

Bad Debts written off – Increase in debtors)

Notes to Computation (Direct Method)

• Cash Paid to Suppliers & Employees:• COGS + Selling & Admn. Exp –

Depreciation Exp (if included in COGS) – Bad Debts Exp (if included in S&A Exp) + Increase in Inventory / Prepaid exp - Decrease in Inventory / Prepaid exp – Increase in B.P/ Creditors + Decrease in B.P/ Creditors

Notes to Computation (Direct Method)

• Income Tax Paid:• Income tax expenses + Decrease in

Income Tax Payable – Increase in Income Tax Payable

• Extra ordinary item should be shown separately, from operating cash inflows and outflows.

Computation of Cash flow from Operating Activities

INDIRECT METHOD

• It starts with net profit & adjusts it for revenue & expense items that did not involve operating cash receipts or payments in the current period to arrive at Net Cash flows from Operating Activities.

INDIRECT METHOD

• To use Indirect Method, start with net income and adjust it for non-cash items like gains, losses & depreciation expenses.

• Then, make adjustments for all of the changes in CAs & CLs that occurred during the year (except Dividends Payable, which will be related to Financing Cash flows).

• Increase in CA (-) from Net Income• Decrease in CA (+) to Net Income• Increase in CL (+) to Net Income• Decrease in CL (-) from Net Income

INDIRECT METHOD

• Net Profit• ADD: Depreciation/Amortization, Bad Debts; Loss on

Sale of Fixed assets/ Investments; Decrease in (Inv/A.R/Pre-paid Expenses); Increase in (Creditors/ Payables*)

• DEDUCT: Excess provision for Depreciation written back; Gain on Sale of Fixed assets/ Investments; Increase in (Inv/A.R/Pre-paid Expenses); Decrease in (Creditors/ Payables*)

• Net Cash flows from operating Activities• * Includes Accounts, Wages, Interest and Taxes

payables but does not include Notes Payable or Current portion of long-term debt.

DIRECT vs. INDIRECT Method

• ASB recommends Direct method as:• It is easier to understand, &• Provides information useful in estimating

future cash flows.• On the contrary, Indirect method is

followed by a majority of firm as it is easier to prepare.

INVESTING ACTIVITIES

• Involve purchase & sale of fixed assets & investments.

• Cash receipts & payments are calculated by analyzing changes in the two Balance sheet amounts for F.As & Investments & the cash effect of transactions took place during the year.

• Interest & dividends received are also cash inflows from investing activities.

FINANCING ACTIVITIES

• Involve raising of capital & repayment of loan.

• Cash inflows & outflows are computed by analyzing the changes in the B/S items for shareholders’ equity & loan funds; & considering cash effect of transactions took place during the year.

• Interest & dividends paid are a part of Financing activities of a firm.

PREPARATION OF CASH FLOW STATEMENT

• CFS is prepared by putting together the cash flows from Operating, Investing & Financing activities.

• The CFS does not include certain financing and investing activities that do not cause a change in cash, viz. purchase of fixed assets with a long-term mortgage note or the conversion of debenture into common stock.

• However, these non-cash transactions are supplementally disclosed so as to give a full picture to investing and financing activities.

Summary of Preparation Procedures - Steps

1. From the company’s balance sheet, enter the beginning and ending balance of each account & the change in each account’s balance on a worksheet.

2. For each account (other than Cash), analyze the nature of the transactions causing the amount of net change, &

3. Classify the change from each such transaction as either Cash from Operations, Cash from Investment, or Cash from financing activities.

4. This analysis will require reference to the Income Statement (e.g., to explain the change in Retained Earnings), and, in some cases, to other financial records of the company.

5. Put them in appropriate format.

Using Cash flows to Evaluate Performance

1. Free Cash Flow: Provides a measure of firm’s ability to engage in long-term investment opportunities & a firm’s financial flexibility.

• Net Cash flow from Operating Activities - Cash Dividends - Capital Expenditure = Free Cash flow.

2. Cash Flow Adequacy Ratio: defined as cash from operating activities divided by net cash required for investing activities – measures firm’s ability to generate the cash it needs for investing activities from operations.

Using Cash flows to Evaluate Performance

3. Current Cash Debt Coverage Ratio: measures firm’s ability to generate the cash it needs in the short-run; calculated as net cash provided by operations divided by average current liabilities.