Topic 3:Measuring and reporting

cash flows

Chapter 6
LEARNING OUTCOMES

You should be able to:

Discuss the crucial importance of

cash to a business

Explain the nature of the statement of

cash flows and discuss how it can be
helpful in identifying cash flow problems

Prepare a statement of cash flows

Interpret a statement of cash flows

 What is a Cash Flow statement?
The cash flow statement shows:
• movements/reasons in the cash balance of the company
during the accounting period.
• the manner in which cash has been generated and used during
the year.
• the effects on cash flows of an entity’s operating, investing
and financing activities for a given period.
• provides information that assists in the assessment of
liquidity, solvency and financial adaptability.

Cash inflows
Less: Cash outflow
= Increase (or decrease) in cash over the period
 The Nature of Cash and Cash Equivalents
Cash flows - ‘inflows and outflows of cash and cash equivalent’
Cash - ‘cash on hand or in bank deposits’
Cash equivalents - ‘short-term, highly liquid investments that are readily
convertible to known amounts of cash and which are subject to an insignificant
risk of changes in value’ (IASB, IAS 7, 2018)

Are the investments short-term? No

Yes

Are they readily convertible to cash? No

Yes

Is there an insignificant risk or changes in value? No

Yes

Cash equivalent Not a cash equivalent

 The Relationship between Statement of Cash
Flows and:
STATEMENT OF PROFIT or LOSS – the statement of P/L
shows the profit, whereas the SCF shows the reasons for the
change in cash. Profit is not the same as an increase in cash, it is
only one source of cash;

STATEMENT OF FINANCIAL POSITION – the SFP is a list

of the assets, liabilities and capital at the end of the year, whereas
the SCF identifies the changes in assets, liabilities and capital
during the year and the resulting effect on cash.
 The relationship between the statement of financial
position, the income statement and the statement
of cash flows

Owner’s Income statement Owner’s

claim claim

Statement of Statement of
financial position financial position
at the start of the at the end of the
accounting period accounting period

Cash and Cash and

Statement of
cash cash
cash flows
equivalents equivalents
 Profit v Cash
Effect

on profit on cash

1 Repayment of borrowings

2 Making a profitable sale on credit

3 Buying a non-current asset on credit

4 Receiving cash from a credit

customer (trade receivable)

5 Depreciating a non-current asset

6 Buying some inventories for cash

7 Making a share issue for cash

Figure 6.3 Standard presentation for the statement of
cash flows

Cash flows
from operating activities
plus or
minus

Cash flows
from investing activities
plus or
minus

Cash flows
from financing activities
equals

Net increase (or decrease) in

cash and cash equivalents
over the period
 Cash Flows from Operating Activities
• Operating activities are the principal revenue-producing
activities of the entity and other activities that are not
investing or financial activities.

• Cash flows from operating activities are primarily made up

of the net increase (or decrease) in cash that results from a
company’s normal trading activities.

There are two approaches that can be taken:

• The direct method
• The indirect method (more popular and we
will concentrate on this)
 Investing Activities
For a business, long-term assets are investments. Cash flows
related to acquiring or disposing of long-term assets are therefore
reported in the investing activities section of the statement of cash
flows.

1. Cash receipts (inflows) from selling property,

plant, equipment or marketable securities,
2. Cash payments (outflows) for purchasing property, plant,
equipment or marketable securities.
 Financing Activities
Cash flows related to borrowing (short - or long-term) and
stockholders’ equity are reported in the financing activities
section of the statement of cash flows.

1. Cash receipts (inflows) from borrowing money and

issuing stock.

2. Cash payments (outflows) to repay debt and purchase stock.

 Direct Method
• Involves analysing the cash records of the business for
the accounting period identifying all cash payments
and receipts related to operating activities.
• It shows the cash received from customers, cash paid
to suppliers, and cash paid in wages and for operating
expenses.
 Cash Flows from Operating Activities

The indirect method involves adjusting the profit or loss before

tax for:
• The effects of transactions of a non-cash nature, such
as depreciation.
• Cash receipts or payments related to the changes in
working capital; and
• Items of income or expense associated with investing
or financial cash flows.

Basic principle:
If Assets go up – cash flow goes down and vice-versa
If Liabilities (including Equity) go up – cash flow goes up
and vice-versa.
 The indirect method of deducing the net cash flows
from operating activities
Profit before taxation
plus
Depreciation expense
plus
Interest expense
plus or minus
Increase (minus) or decrease (plus) in inventories

plus or minus
Increase (minus) or decrease (plus) in
trade receivables
plus or minus
Increase (plus) or decrease (minus) in trade payables

less
Interest paid
less
Taxation paid
less
Dividend paid*
equals

Net cash flows from operating activities

* Note that dividends could alternatively be included under the heading ‘Cash flows from financing activities’.
 Cash Flows from Investing Activities
•Investing activities – ‘the acquisition and disposal of non-current
assets and other investments not included in cash equivalents’.

•Cash flows from the acquisition/disposal of non-current assets and

the ownership of investments and payments to the providers of
non-current finance.

•In terms of investments in financial assets cash flows comprise

the purchase/sale of financial assets (not classed as cash
equivalents) and interest and dividends received on these assets.

•The separate disclosure of cash flows arising from investing

activities is important because the cash flows represent the
extent to which expenditures have been made for resources
intended to generate future income and cash flows.
 Cash Flows from Financing Activities
• Financial activities - ‘activities that result in changes in the size
and composition of the contributed equity and borrowings of
the entity’.

• This encapsulates cash received and paid to external providers of

finance in respect of the principal amounts of finance and the
payments required to service these principal amounts (interest
and dividends).

• The most common external providers of finance are equity

shareholders, preference shareholders, bank loans and bondholders
(borrowing direct from the public via issue of bonds).

• The separate disclosure of cash flows from financial activities is

important because it is useful in predicting claims on future
cash flows by providers of capital to the entity.
 Uses of Statements of Cash Flows
1. To enable users to see how the various activities have been
financed.
2. To allow users to check the accuracy of past assessments.
3. To assist users in making judgements on the amount,
timing and degree of certainty of future cash flows, and
thus the ability of the entity to:
(a) pay its debts (loans, payables, etc);
(b) pay interest and dividends;
(c) continue without the need for extra external finance.
4. To explain how there can be a profit but a decrease in cash
(or vice versa), and thus why the dividend may be small.
5. To show the reasons for the difference between profit and its
associated cash inflows and outflows.
The Advantages of the Statement of Cash Flows over
the Statement of P/L and the SFP
• Easier to understand.
• Permit more meaningful comparisons of performance.
• The survival of the entity depends on cash, which is thus
more relevant than profit.
• Future dividends, the repayment of loans and trade
creditors depends on cash. It thus permits better predictions
of future dividends, insolvency, etc.
The Limitations of the Statement of Cash Flows
• Being easier to understand doesn’t necessarily mean it is
more relevant/useful.
• It also involves subjective judgements about the classification
of items.
• Performance comparisons can be misleading because cash flows
are often erratic.
• The survival of the entity also depends on profitability.
• Future dividends also depend on profit.
 Summary – Some Key Points
• The purpose of the statement of cash flows is to show the
reasons for the change in cash and cash equivalents over
a period
• It shows how cash has been generated and used
• IAS 7 – splits the analysis into three categories
(operating activities, investing activities and financing
activities)
• Cash flows from operating activities can be obtained using the
direct or indirect method (the latter is the more commonly
used)