INTRODUCTION TO BUSINESS ACCOUNTING

STATEMENT OF CASH FLOW

After you have studied this chapter, you should:

Understand how cash flow is different from profits

Understand and implement the format to be used for preparing statements of cash flows

Understand direct and indirect methods of preparing the statement of cash flow

Be able to draw up a statement of cash flow for any type of organization

Understanding Financial Statements

Income StatementIncome Statement

Balance SheetBalance Sheet

Cash-Flow StatementCash-Flow Statement

Why do we need cash flow statements?

HOW MUCH CASH

DO WE HAVE?

CAN WE FINANCE

OUR ACTIVITY?

CAN WE FINANCE

OUR ACTIVITY?How much can we spend on fixed assets?

What does the statement of cash flows provide?It reports cash receipts and cash

payments of the business for a particular period.

It explains why the cash has increased or decreased.

It shows the sources of cash and how this cash has been spent.

It talks about actual cash received and actual cash paid

Cash is cash and everything else is accounting…

What is Cash indeed?

◦ Cash includes: cash in hand, cash at bank and cash equivalents.

◦ Cash equivalents are short- term, highly liquid instruments that can be quickly converted into cash.

Manufacturing account

Trading account

Profit and Loss account

Profit and Loss

appropriation account

Balance sheet

Cash flow

statement

Capital income

Capital expenditur

e

Types of Business Activities

Normally any business engages itself in three types of activities.

Operating ActivitiesInvesting ActivitiesFinancing Activities

The Financial Statements

The statement of cash flows reportsthe company’s cash inflows and

outflows from operating, investing,and financing activities.

Operating ActivitiesCash receipts from sale of goods.Cash receipts from rendering a serviceCash receipts from royalty,

commission and other revenueReceipts from interest on loan,

dividends and stock investments.Cash payment to supplier of goods.Cash payment to employeesPayment of TaxCash payment for services like power,

electricity etc.

Investing Activities

These activities affect asset accounts (such as Plant assets, Investments and Notes Receivable).

They increase and decrease the long-term assets of the business

Financing Activities They affect liability and stock-

holder's equity account. (notes' payable, long-term debt, bonds payable etc.)

Financing activities include issuing stock, borrowing money, paying dividends, selling stock etc.

Format of the Statement of Cash Flow

According to FASB No. 95, Cash flow statements can be reported under two formats:

The Direct MethodThe Indirect Method

Typical Cash Inflows

Decrease in Accounts

Receivables

Profits

Loans received

Decrease in inventory

What are Cash Outflows?

LOSSES Cash outflows

Typical Cash Outflows

Purchase of fixed assets

Loans repaid, dividends paid

Increase in Accounts

Receivables

Increase in Inventory

The Direct MethodThis method lists cash receipts

from specific operating activities and cash payments each major operating activity.

It is used by most government organizations and some insurance companies.

Cash Flows from Operating Activities

Under this method it is required to disclose the following operating cash receipts and payments:

Cash collected from customersCash paid to employeesPayment to suppliersInterest expense and paymentsTax expense and paymentsDividends paymentsInterest and Dividend received

The Indirect MethodThis method starts with net income

and reconciles to cash flows from operating activities. Hence, it also called as reconciliation method.

It makes easy computing cash flow from operating activities by a shortcut method.

It shows the link between net income and operating cash flow better than the direct method.

Cash Flows from Operating Activities

Operating Profit/ Net income + Depreciation + Loss on sale of Fixed Assets + Increase in provision for bad

debts + Decrease in stock + Decrease in debtors + Increase in creditors Net Cash Inflow/ (Outflow)

from Operating Activities

Constructing a Cash Flow Statement-I Extract the operating (or trading) profit from

the profit and loss account (or balance sheet) for the current year

Referring to the two balance sheet periods, calculate the movement between the following operating working capital balances:

(a) Stock(b) debtors(c) prepayments(d) creditors(e) accruals

Constructing a Cash Flow Statement-II

Next, determine whether in respect of each movement, there has been either an increase or a decrease in cash during the period. (Refer Table)

If the cash movement has had the effect of increasing the cash for the period, add the difference to the operating for the year. If it has had the effect of decreasing the cash then deduct it from the operating profit.

Constructing a Cash Flow Statement-III

Inspect the profit and loss account for any non-cash items. These should either be added to, or deducted from, the operating profit.

Total the items included in the reconciliation. The balance should now represent the net cash inflow (or outflow) from operating activities.

Increase Table

Item Movement Effect on cash

Stock Increase Down (more cash has been spent on stocks)

Debtors and prepayments

Increase Down (less cash has been received)

Creditors and accruals

Increase Up (less cash has been spent)

Decrease Table

Item Movement Effect on cash

Stock Decrease Up (less cash has been spent on stocks)

Debtors and prepayments

Decrease Up (more cash has been received)

Creditors and accruals

Decrease Down (more cash has been paid)

Some examples of cash flows from investing activities are:Cash payments for the acquisition

of fixed assetsCash receipts from sale of fixed

assetsCash payments for acquiring long

term investmentsCash receipts from sale of long term

investmentsCash advances and loans made and

collected.

Cash Flows From Financing Activities

Cash from issue of stocks and debentures

Expenses on issue of stockRedemption of stocks and debentures

Payment of cash dividend

Classify each of these transactions by type of cash flow activity

1. Issued 100,000 shares of $5 par value ordinary stock for $800,000 cash.

2. Borrowed $200,000 from SL Bank, signing a 5-year note bearing 8% interest.

3. Purchased two semi-trailer trucks for $170,000 cash.

4. Paid employees $12,000 for salaries and wages.

5. Collected $20,000 cash for services rendered.

Solution1. Financing activity2. Financing activity3. Investing activity4. Operating activity5. Operating activity

ReconciliationThe reconciliation shows how the company's net income is related to net cash flow from operating activities.

State whether each of the following statements is true or false

Operating activity reflect total cash inflows.

Depreciation decreases the cash position.

Tax paid decreases the tax position.

A proposed dividend increases the cash position.

State whether each of the following statements is true or false

A decrease in debtors increases the cash position.

An increase in creditors decreases the cash position.

Cash Flow Statement, as per FRS1.

Specific headings:(a) Net cash flow from operating

activities.(b) Net cash flow from return on

investment and servicing finance.c) Net cash flow from taxation.(d) Net cash flow from investing

activities.(e) Net cash flow from financing

activities.

Note:

(i) Long term investments.These are treated as part of fixed

assets. i.e. part of net cash flow from investing activities.

(ii) Short Term investments.These are treated as current assets. These investments will be treated as

cash or cash equivalents.

Format for the cash flow statement

$

Net cash flow form operating activities xNet cash flow from Return on investment and servicing finance x

Net cash flow from taxation x Net cash flow from investing activities x Net flow before financing activities x Net cash flow from financing activities x

Increase /(decrease) in cash/cash equivalents x

Practical exampleAssets Dec. 31, 2007 Jan.1,2007Eqmt. $10,000 0A.R. 30,000 0Cash 34,000 0LiabilitiesA.P. $4,000 0Stock EquityOrd. shares 50,000 0R.E. 20,000 0

Income statementRevenues $85,000Operating exp. 40,000Income tax expense 10,000Net Income 35,000Additional Information:A dividend of $15,000 was declared

and paid.The equipment was purchased at

the end of 2007. No depreciation was taken in 2007.

Statement of cash flow. Dec. 31, 2007Cash flow from oper. activ. Net income $35,000Adjustments to reconcile net income to

net sash provided by operating activities:

Increase in A. R. $(30,000)Increase in A.P. $ 4,000

$(26,000)Net cash provided by operating activities 9,000

Cash flow from investing activitiesPurchase of equipment $(10,000)Net cash used by investing activities (10,000)Cash flow from financing activitiesIssuance of ordinary stock $50,000Payment of cash div. (15,000)Net cash provided by f-ing. activ. 35,000

Net increase in cash 34,000

Reconciliation of operating profit to net cash inflow from operating activities

Operating profit (£40-30)10

Depreciation charges20

Increase in stocks (30)Decrease in Debtors

110Decrease in creditors

(40)Net cash inflow from operating activities

70

===

Net cash flow from operating activities 70Management of liquid resources and financingIssue of debenture loan 60Purchase of investments (100)Increase in cash 30

===

Reconciliation of net cash flow to movement in net debt

Increase in cash in the period 30Cash inflow from increase in debt

(60) (30)Net debt at 1.3.08

(20)Net debt at 28.2.09

(50)

Analysis of changes in net debt

at 1.3.08 Cash flows at 28.2.09

Cash at bank (20) 30 10Debt due after 1 year - (60)

(60) ----- ------

------Total (20) (30)

(50) ==== ====

====

What does it tell to the managers of the company?I. The company increased its cash

position by £30,000;II. Its operating activities

generated £70,000 in cash;III. The company issued £60,000 of

debenture stock making the total increase in cash £130,000;

IV. £100,000 of cash was used to purchase some investments;

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