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Module 6: Cash Flow Analysis

Topic 113: Cash Flow Analysis-Introduction

Cash Flows

• Cash Inflows

• Revenues

• Borrowings

• Equity

• Cash Outflows

• Expenses

• Repayments

• Dividends

Cash flow or Cash flow Analysis in Financial Analysis and ultimately in Financial
Management, is an important aspect and its importance is from which reference
that we will discuss in this lectures and also in next lectures.

Cash flow simply means the movement of Cash and this movement is with
reference to any business/entity/firm/company. There is a movement of cash then
there are only two possibilities that is; whether we will be receiving cash or will
be paying cash.

If we are a part of a business so either we will be having a Cash Inflow that is the
receipt of cash or the Cash Outflow that is a payment of cash. We make projected
statements with reference to the Cash Inflows and Cash Outflows which are known
as Cash Budgets. In Cash Budgets, we also see Cash Inflows and Cash Outflows
but these are predicted or anticipated values and in contrast to them we make a
statement which is one of the five major Financial Statements that is called the
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Statement of Cashflows. This Statement is actually based on the real and actual
Cash Inflows and Cash Outflows.

Now, lets see from where Cash Inflows and Cash Outflows can be in any business.

Cash Inflows:
Revenues or sales or income: When we sell any product or service against which
we get cash. So, the major Cash Inflow in any business which is actually a regular
Cash Inflow is through the Revenue or Sales which are generated by that business.
And this is a continuous source of Cash Inflow because when we are doing
business operations, we are doing regular sales and we are doing regular income.
So, Revenue is the major and a continuous source of Cash Inflows.

Borrowings: A business can take loan or borrow or financing to get cash. So,
whenever a business takes a loan in most of the cases and that results into a Cash
Inflows. It is possible that we finance any asset from any bank or financial
institution and as a result we don’t have Cash Inflow e.g., in the case of lease or
Murabaha where we have not Cash Inflow but that creates the condition of
financing or borrowing.

But borrowing is one way or reason of Cash Inflows. Here it is necessary to keep
in mind that borrowing is not a regular feature like Revenue or Sales and when we
need then we will borrow and there will be different forms of it also.

Equity: The Equity is the third source of Cash Inflows meaning that when we
issue shares and people purchases these shares of our company and against which
we get Cash Inflow. Similarly, if we sell any asset then we get Cash Inflow against
it also.

Cash Outflow:
Expenses: We have Cost or Expenses against Revenue or Sales. So, there is an
Cash Outflow because of an Expense i.e., when we pay an electricity bill, pay
salaries, pay traveling or utility expenses then Cash Outflow occurs.

When we purchase goods that is a Cash outflow. Similarly all other Cost and
Expenses generally results into Cash Outflow.
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Repayments: Whenever we purchase any new asset that also creates Cash
Outflow. When we return any amount that we have borrowed (I.e., when we are
paying the installments, we are paying markup on those installments also) that also
results in an Outflow of Cash. So, we can say that there is an outflow of cash when
we are making the Repayments of our loans

Dividends: We can say that there is an outflow of cash when the liabilities that we
have got. There is an outflow of cash when we pay Dividend. It means that when a
company pays Dividend then it also creates Cash Outflow.

Module 6: Cash Flow Analysis

Topic 114: Statement of Cash Flows

Cash Flows Statement Methods

• Indirect Method

• Direct Method

Cash Flows from Operations

• Cash Flows from Operating Activities

• Profit

• Non-Cash Expenses

• Changes in Receivables

• Changes in Inventory

• Changes in Prepayments

• Changes in Current Liabilities

Cash Flows from Investment

• Cash Flows from Investment

• Fixed Assets Change

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• Long Term Investments Change

• Intangible Assets Change

Cash Flows from Financing

• Cash Flows from Financing Activities

• Loans

• Bonds

• Share Capital

• Dividend

We have discussed in previous lecture as Cash Flow Analysis can be done for the
future or it can also be done for the past. It means that those values that are actual
values which are the values of our previous one year or one month on which we
can also do Cash Flow Analysis.

And the statement that we will make for the last year or last month’s Cash flows is
called the Cash Flow Statement.

Cash Flows Statements Methods:

There are two basic methods to make Cash Flow Statements: Direct Method and
Indirect Method.

In these two methods, there are ordinary changes when we move from one method
to another method. But the purpose of both methods is to calculate that how much
Cash Inflows and how much Cash Outflows have been occurred in any
business/firm/entity.

Cash Flow Statement is divided into how many segments?

There are mainly three components of Cash Flow Statement or we can say that the
Cash Flows of the whole year or the month are actually divided into three parts
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(Cash Flows from Operations, Cash Flows from Investment and Cash Flows form
Financing).

Cash Flows form Financing:

Cash Flow Statement from Operating Activities: First one is related to the
Operations we call it the Cash Flows from Operating Activities.

What are the operations? In any business, when we perform those activities
through which we earn revenue or generate sales then we call them Operations. It
means that the process to earn revenue, pay expenses, incur cost for earning profit
is called Operations.

So, in the first part of the Cash Flow Statement, we see that how much is the Cash
Inflow or Outflow from the operations of the business.

In this Indirect Method, because first we will be focusing on the Indirect Method of
making a Cash Flow Statement which is also a common method of making this
statement.

Profit: We will start from the Net Income or Profit figure. This figure of Net
Income or Profit is not equal to Net Cash Inflow meaning that if we say that a
company has a net loss then will it be equal to net Outflow ?
No, and similarly, Profit is also not equal to the Net inflow. And there are some
reasons for that we will discuss here.

Non-Cash Expenses: When we take the definition of any expense then it qualifies
as an expense but Cash Outflow does not occur from that expense such that
Depreciation because we know that for Depreciation, the general entry that we pass
in the accounting which is Depreciation Expense Debit and Accumulated
Depreciation Credit and there is no Cash outflow in it. So, we have to adjust this
Depreciation or similar kind of Non-Cash Expenses.

Changes in Receivables, Inventory, Prepayments and Current Liabilities: We

calculate the profit by subtracting the cost from our Revenue but has Cash Inflow
been done from all the Revenue? No, some part of our Revenue remains in our
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Receivables. Some amount of profit absorbs in the change in Inventory, similarly

our cash has adjusted in our prepayments and current liabilities.

Cash Flows from Investment:

Cash Flows from Investing Activities: The second part of Cash Flow Statement
is related to the Investment that we call Cash Flows from Investing Activities. This
portion is mainly about the Fixed assets or non-current assets.

It means that in Operating activities, we have taken Profit and Loss Account and
Currents assets and Current Liabilities meaning that on whole statement (Profit and
Loss Account) and only the part of Balance Sheet in which the Current assets and
Current Liabilities are involved.

Fixed Assets Change, Long Term Investments Change, Intangible Assets

Change:

And now we are coming in Investing Activities, here we consider the second part
of the Assets that is Fixed Assets, Operating, Non-Operating, Tangible, Intangible,
Non-Current Assets meaning that all those assets which are not current assets
through their increase and decrease we see that how much cash inflow and cash
outflow has occurred. We will also consider in this discussion the element of
Accumulated Depreciation.

Cash Flows from Financing:

Cash Flows from Financing Activities: The third part of Cash Flow Statement is
Cash Flow from Financing that we call Cash Flows from Financing Activities.

If we see that we have taken the whole Profit and Loss Account and Current assets
and Current Liabilities in Operating Activities. And the second part which was
related to Fixed assets that we have taken in Investing Activities. Now we have
left with the Long term Liabilities and Shareholders’ Equity and certainly this is
the portion that we consider in Financing Activities.

Financing means the amount that we generate from different sources Debt or
equity to run our business. There is one exception that we need to consider that in
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current liabilities, some of the liabilities are those which are related to our
Operation and some part of the current liabilities is the form of financing.

So, that portion in the current liabilities which are related to financing that we take
in the head of financing activities meaning that it may be short term financing or
may be the current portion of long term financing.

A term that we need to remember is the Current Portion of Long Term

Liabilities means that portion which the payment of any long term liability within
one year, we pick it from the long term liabilities and make the part of current
liabilities.

So, with the exception of the financing which is related to the current year that is in
the current liability which we take in the financing activities along with the long
term financing, long term debts, bonds, debentures, loans, leases, all these are part
of financing activities and with it Shareholder ‘equity meaning that we take the
changes occurred in the shareholder’s equity in the financing activities.

What can be that change?

Possibly it is the issuance of shares or may be it is the payment of dividend or it

may be the purchase of treasury stock.

Module 6: Cash Flow Analysis

Topic 115: Cash Flows and Profits

Cash Flows Vs Profits

• Profits

• Non-Cash Expenses

• Changes in Methods of Valuation

• Capitalizing Expenses

• Receivables: Revenue

• Payables: Costs and Expenses

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Cash and Profit

• Profit is not cash

• Profits but not cash!

• Cash but no profit!

• Cash flow is the actual movement of cash in and out

• Profit is the difference of revenue and expenses

We have discussed that Cash Flows and Profits are not the same or they are not the
same name of two things. Cash Flow and Profit are two different things. Although
there is a rare possibility that Cash Flow may be equal to our Profit. That is our Net
Cash Inflow and our Profit amounts become equal but it is very rare.

Why it is so? Why the amounts of Cash Flows and Profits are not equal?

In this lecture, we will try to understand that why does it happen. And this is very
important to understand because doing the Cash Flow Analysis is basically for the
purpose for the reason that Profits at times do not reflect the true picture.

It means that many times Profit does not show the actual circumstances or
conditions of any business that Cash Flow can show us. The reason for that is;
Profit and loss account has been made on accrual bases which mean that if we got
or not got any income in the form of cash but we consider it our income and which
increases our profit.

Similarly, any expense has been paid or not in the form of cash and we record it as
an expense and it reduces our amount of profit. So, there is a possibility if we take
an extreme condition or example then we can say that it is possible that we do not
receive the cash against our all the sales but still our Profit and Loss account will
show an amount of profit.

Therefore it is necessary for us that we need to do Cash Flow Analysis with the
Profit and Loss Account.
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Non-Cash Expenses:
There are some Expenses which are Non-Cash Expenses through which Cash
Outflow does not occur and to reconcile them we make Cash Flow Statement.

Changes in Methods of Valuation:

In accounting, there are many accounting methods that we can use to determine the
value of assets (i.e., Depreciation methods, Inventory Evaluation Methods etc.)
through which we can sometimes increase or sometimes decrease the value of
profit but by changing these methods, we cannot increase or decrease the
movement of cash.

Capitalizing Expenses:
Some Expenses are those which cause Cash Outflow but we do not take them as an
Expense in our Profit and Loss Account. And the term we use for this is
Capitalizing Expenses. The Capitalizing Expenses simply means that showing an
Expense as an asset in our Financial Statements. So, we have taken an expense as
an asset so it will not be reflected in the Profit and Loss account. And hence it will
not affect the amount of profit but the Cash Flow will certainly be there.

Receivables: Revenue
There are Receivables which are related to the previous year’s Revenue and we get
Cash Inflow from them but they have not been seen in the Profit and Loss account.

Payables: Costs and Expenses

Our Payables or our liabilities that causes Cash Outflow but have not been seen in
the current Profit and Loss account.

Difference between Cash and Profit:

 We can say that Profit is not Cash and Cash is not Profit although many part
of the profit is in the form of cash and many cash inflow has seen in the form
of profit.
 There is a possibility that in any business there has been seen profit but does
not have cash or have shortage of cash and reaches at a point that it goes into
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the condition on Insolvency although in its Profit and Loss statement there
has seen profit.
And it may be that in any business, Cash Inflows are reflected but its Profit
and Loss Account has showing loss.
So, these conditions are possible and that is a reason why we make a
Cashflow Statement in addition to this Profit and Loss Account.
 Here it will be pertinent to mention that before Cash flow Statements we use
to make a statement which was called the Funds Flow Statement. In this
Funds Flow Statement, we took different definitions of funds (i.e., we take
sometimes Working Capital or sometimes Cash) but now we will have to
make only Cash Flow Statements.
 So, the Cashflow in the actual movement is the actual movement of cash in
and cash out, we can summarize it.
 Profit is the difference of Revenue and Expenses.

So, in this way, we can differentiate both Cash and Profit and this is actually
the justification of making a Cashflow Statement in addition to a Profit and
Loss Account.

Module 6: Cash Flow Analysis

Topic 116: Sources and Application of Cash

Sources of Cash

• Revenue

• Collection from Receivables

• Sales of Assets

• Borrowing

• Loans

• Bonds

• Equity
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• Common Shares

• Preferred Shares

Application of Cash

• Expenses and Costs

• Purchasing Fixed Assets

• Payment to Payables

• Accrued Expenses

• Payment of Liabilities

• Dividend

• Treasury Stock

We have talked about Cash Flow Statements and Inflows & Outflows of Cash. The
Inflow of cash is also termed as a Source of Cash or the Sources of Cash.
Similarly, Outflow of Cash is also called the Applications of Cash. That
means from where we may or have to get cash and where we may or have to pay
cash.

So, sources and applications of cash need to be understood in detail in order to

understand the Cash flow Statement and also to make the Cash flow Statement.

Sources of Cash:
It means that from where cash inflow occurs.

Revenue:
When we talk about sales or revenue, it is certainly a source of cash inflow. So, if
we are in a service business, lets say we are selling our services as a lawyer,
accountant, architect etc. whatever fees we are charging is our Revenue.

And when we are selling some goods to generate Revenue (which is called Sales or
Income) then there is a possibility that all of the sales that we are generating, there
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may be some sales discount. Then the actual amount of sales or gross sales will not
be that cash inflow because we will get fewer amounts due to the discount.

So, Revenue or Sales need to be adjusted for some discounts.

There may be some sales returns so, if there is a return of sales so whatever is
appearing in the gross sales figure will then not be collected because a part of that
is returns. So, that both things we need to see at the time of cash inflow or sources
of cash.

Collection from Receivables:

When we make credit sales as a result, the sales are not collected in the form of
cash therein then rather it is first converted into Accounts Receivables and then
later on cash is received from those debtors or accounts receivables. So, another
source of cash will then be Accounts Receivables or Debtors.

Sales of Assets:

If a business sells some of its fixed assets i.e., land, building, machinery and
equipment which is also quite common because at times we need to replace some
of our assets. At times when we have some assets which are not of any use to the
business or at times we also use some of the assets as a source of financing. It
means that we generate financing by selling some assets.

So, in nutshell whenever we sell our fixed assets certainly this sale generates cash
inflow and it becomes a source of cash.

Borrowing:

Whenever we do borrowing, borrowings can be in the form of loans or can be in

the form of issuing at debt to the general public or it may be in any other form but
these are the sources of cash.

Equity:

Likewise equity whether we are talking about Common Shares or Preferred Shares.
It means that whether we issue common share or preferred share but there will be
cash inflow from both of their issuance and these are the sources of our cash
inflow.
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Applications of Cash:
It means that from where cash outflow occurs.

Expenses and Costs:

Whenever we incur some expense or cost (i.e., salaries, utility bills, repair and
maintenance, travelling etc.) all these expenses require cash outflow.

Purchasing Fixed Assets:

When we purchase goods that requires cash outflow. Similarly, if we purchase

fixed assets (i.e., plant, building, equipment, vehicles etc.) then the purchase of
fixed assets is also an application of cash because purchase actually leads to cash
outflow.

Payment to Payables:

When we pay our liabilities (i.e., accounts payables, notes payables etc.) all these
payables result into application of cash that is a cash outflow.

Accrued Expenses:

The accrued expenses are those expenses which were incurred earlier but not paid
in cash whenever we pay these outstanding or accrued expenses which are also
application of cash.

Payment of long liabilities:

Whether we pay the whole liability or we are returning it in the form installments,
the both of them basically are applications of cash.

Dividend:

When we distribute profit in the form of dividend then the payment of dividend
requires cash outflow and it is also an application of cash.

Treasury Stock:
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Some companies and although it is very rare that companies repurchase their
shares and when they do, it is called the Treasury Stock. So, purchasing their own
stocks from the market actually also requires an application of cash.

So, this give us a good idea about what are the major sources of cash and what are
the major applications of cash.

Module 6: Cash Flow Analysis

Topic 117: Cash Flow from Operating Activities-1

Operating Activities

• Three parts of a Cash Flow Statement

• Operations

• Investments

• Financing

• Operating Activities

• Profit and Loss Account

• Current Assets

• Current Liabilities

Operating Activities Format

• Net Income

• Add Non-cash Expenses

• Add Decrease in Current Assets

• Subtract Increase in Current Assets

• Add Increase in Current Liabilities

• Subtract Decrease in Current Liabilities

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We have discussed that Cash Flow Statement is made in three parts; Cash flow
from Operating Activities, Cash Flow from Investing Activities and Cash Flow
from Financing. We examine our cash inflows and cash outflows in these three
parts. We will discuss them one by one.

Now, we will talk about the Cash Flow from Operating Activities.

In Operating Activities, we take three things basically with a minor exception

meaning that we consider the inflow and outflow occurring through the accounts
that comes in Profit & Loss Account in the Operating Activities.

Similarly, we also consider the cash inflow and cash outflow occurred through the
changes taking place in current assets in the Operating Activities and also in
current liabilities except short term financing.

Operating Activities Format:

Net Income/Net Profit:

• Add Non-cash Expenses

• Add Decrease in Current Assets

• Subtract Increase in Current Assets

• Add Increase in Current Liabilities

• Subtract Decrease in Current Liabilities

This means that when we make the first part of Cash Flow Statement which is
about Cash Flow from Operating Activities, we start it with the amount of Net
Profit or Net Income. It means that we can say that we start from the figure of
Profit after Tax.

If the figure of Profit after Tax and Cash Inflow becomes equal then we don’t need
to make any adjustment in it. But as we have discussed that it is very rare that the
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amount of Profit becomes equal to the amount of Net Cash Inflow. And as a result,
we need to make some adjustments.

To begin with, we talk about Non-Cash Expenses. During making Profit and
Loss Account, we subtract the Depreciation which is Non-Cash Expense in order
to calculate the figure of profit. But actually our cash outflow does not happen
through this expense.

So, in this indirect method of making a Cash Flow Statement when we are starting
from the figure of profit then that expense through which cash outflow does not
happened, added it back in the amount of Profit in order to determine the
amount of cash inflow. It means that an expense which is not causing a cash
outflow for us then we should not consider the cash outflow through that expense.

But as during making Profit and Loss Account, we have subtracted it from the
Revenue and in order to adjust that expense we add back in order to go from the
profit to the figure of cash.

The second one is about Current Assets; we try to understand it through the
example of one current asset. For example, Accounts Receivables or Debtors;
when we do sales and as a result of which Accounts Receivables arise then cash
inflow occurs through it.

If we compare that what was the balance of accounts receivables at the start of the
year and what is the balance of accounts receivables at the end of the year then we
came to know that this balance increases or decreases.

For example, receivables have been increased from the amount of Rs.10,000 so in
other words we can say that we have not received Rs.10,000 in the form of cash
from the Sales instead they are present in the form of receivables in the Balance
Sheet.

And if the balance of receivables has been decreased then it indirectly means that
the revenue we have earned through the sales is not only we have got in the form
of cash but also we have got some amount of cash flow from the payments which
we have taken from the people at the start of the year.
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So, when our current assets are less then we add it in the profit and if our
current assets have increased then we subtract from the profit.

Similarly, if we take examine of current liabilities and here we can take an example
of accounts payable. It the accounts payable has increased which means that we
have not paid some amount from the money that we have to pay in the form of cost
of goods but this whole amount as an expense or cost is subtracted from our
revenue.

But here increase in the amount of payables is telling us that some amount from the
amount which was of cost has not been paid in the form of cash.

So, if our liability increases which means that we add it in our profit to calculate
the amount of cash and if our liability decreases that we subtract it form our profit
which means that we have paid some other amount which is more than the amount
for which we have purchased the goods.

So, these are the adjustments that we make in the amount of Net Profit and Net
Income in order to calculate the cash flow from operating activities.

Module 6: Cash Flow Analysis

Topic 118: Cash Flow from Operating Activities-2

Non-Cash Expenses

• Depreciation

• Amortization

• Writing-off of Assets

• Provision of Bad Debts

• Other Provisions for Expenses

• Effect on Net Profit

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In this lecture, we will focus our discussion on Non-Cash Expenses that is;
what are various Non-Cash Expenses and what is the effect of these Non-Cash
Expenses on cash inflows and cash outflows.

Depreciation:
By definition, Depreciation is the systematic allocation of cost of an asset over its
useful life. To understand, we need to see that what happens when we charge a
depreciation expense. It means that when we purchase an asset, suppose we have
purchased an asset 5 years ago from today and cash outflow has been occurred
when we had purchased that asset. And afterwards, we convert every year, the
some components of that asset into expense little by little which we call
Depreciation Expense.
So, afterward every year when we will charge depreciation, a small component of
the total value of the asset is converted into expense but the cash flow took place 5
years back. And that cash would never be paid or outflow in the coming months or
years.

So, depreciation is such a Non-cash expense from which there is no cash outflow
in that year for which we are making cash flow statement and also will not be any
cash outflow generated in the coming years. Because the cash outflow related to
that asset had been paid or outflowed when had purchased it.

Amortization:
Amortization is an expense and we generally link the term of Amortization with
the intangible assets meaning that if there is any intangible asset which we have
purchased in the past that we amortize over the period of its life.

For example, if we take an example of any patent right where patent is such a
formula which a person or lab has invented and our business had purchased it by
paying a certain amount. And now we will produce a medicine or anything through
this formula whose right has not been of anyone.

But what amount of time this patent will be useful for us that we estimate it and the
cost of patent apportion on that useful life by calling it its useful life.
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It means that if we have purchased a patent for Rs.100,000 a few years ago then
every year then its 1/5 will be expense out. But again this expense will be seen in
the Profit & Loss account but there will not be any cash outflow from it.

So, this is a Non-Cash Expense which needs to be adjusted.

Writing-off of Assets:
When we write-off an asset where writing-off means that any asset was present in
our books of accounts but now we recognize that there is no value of that asset and
we delete or write-off it from our books.

By doing this write-off, there comes an effect on our profit that we must keep it in
our Profit and Loss account as an extraordinary item. Our profit is also decreases
from writing-off but cash outflow does not happen. Therefore we consider it in the
Non-Cash Expense.

Provision of Bad Debts:

The Bad debts means that those accounts receivables which do not give us
payments and it is a kind of loss for us that we create an expense which we call
Bad Debts expense. But there is also no cash outflow against these Bad Debts
because we create an allowance or provision against these bad debts. As there is no
cash outflow from these bad debts and we have to adjust them in our Cash Flow
Statement.

Other Provisions for Expenses:

If we create allowances or provisions for some other expenses other than bad debts
meaning that we guess that this will be how much expense and take it in the Profit
& Loss Account by using this guess and against which there has not been cash
outflow then we adjust it by considering it in Non-Cash Expenses during making
cash flow statement.

Effect on Net Profit:

What will be the effect of all these Non-Cash Expenses on the profit?
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It means that all these are those expenses which are subtracted during calculating
the profit but actually there is no cash outflow from them. Therefore we add back
all these expenses which are called Non-Cash Expenses in order to reach to the
cash amount from the amount of the profit.

Module 6: Cash Flow Analysis

Topic 119: Cash Flow from Operating Activities-3

Impact of Current Assets’ Change

• Opening and Closing Balances

• Changes in Current Assets

• Accounts Receivable

• Inventories

• Prepayments

• Why not consider Cash?

Impact of Current Liabilities’ Change

• Changes in Current Liabilities

• Accounts Payable

• Notes Payable

• Accrued Expenses

• Short Term Financing?

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We have seen that in Cash Flow from Operating Activities, we consider the profit
which is taken from Profit and Loss Account and we also consider the current
assets and current liabilities and adjust the amount of profit for that.

Now, we will try to understand in more detail that why we do so meaning that why
we add or subtract the current assets or current liabilities in profit for the
adjustment of cash flow.

Opening and Closing Balances:

For this, we need to have two balances; the Opening Balance of Current Assets and
liabilities is also there in Closing Balance.

Opening Balance is actually the Closing Balance of the last year meaning that if
we want to make our cash flow statement in 2019 then the closing balance of 2018
will be taken as Opening Balance in 2019 cash flow statement and obviously the
Closing Balance of 2019 will be taken as the Closing Balance.

Now, if the closing balance is more than the opening balance of any current asset
or current liability simply means that there is an increase in that current asset or
that current liability.

Changes in Current Assets:

Accounts Receivables: There are two things that we need to keep in our mind; if
we have discussed earlier that purchasing an asset actually requires cash outflow
and similarly if we purchase any current asset then there will also be our cash
outflow. But there are current assets i.e., Accounts Receivables as we know that
whenever there is credit sales that will result into Accounts Receivables.

So, when we say that the balance of Accounts Receivables has gone up this means
that the amount of sales which is shown as inflow of the cash is not the actual cash
inflow.

For example, if we say that there has been occurred cash inflow of $1000 through
sales and the Accounts Receivables were equal in the Opening and Closing
balances then it means that we got $1000 in the form of cash.
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But if the balance of Accounts Receivables has been increased from $100 then it
means that we have not received $100 in the form of cash from that $1000 revenue
or sales. And that is why, increase in the Accounts Receivables is deducted out of
the profit amount.
Inventories: The Inventories or Stock that we call Stock in trade. The increase of
inventory means that we have increased our inventory from the inventory which
we had at the start but we cannot sell it in that year and that is why the balance of
an inventory has gone up.

And to purchase that inventory certainly we have paid cash. So, when our
inventories’ balance has been increased which means that our cash outflow has
occurred. Therefore we subtract it from the figure of our profit.

Prepayments: The Prepayments are prepaid expenses that as we have done

expense out of which some amount has been converted into expense but those
expenses which are not converted into expenses yet and but we have paid cash
against these expenses. So, this outflow of cash is so accordingly deducted from
the amount of profit.

Why not consider Cash?

We adjust all these current assets in the amount of profit but there is another
current asset is also the cash in the current assets but as we are making the
statement for the movement of cash inflow and cash outflow therefore certainly we
do not adjust the change of cash in the amount of profit as do the adjustments of
accounts receivables, prepayments etc.

There is another thing that is very important which we should keep in mind that
when we use the word Cash then it does not only mean the cash in hand but it also
means the cash in hand, cash at bank and all those cash equivalences which may be
regarded as cash.

So, the total amount that we have as cash in hand, cash at bank and the cash
equivalent is then termed as cash and we consider it in cash inflow and cash
outflow.
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Change in Current liabilities:

If we see the change of current liabilities, if current liabilities have been increased
than the opening balance in the closing balance then it means that there will be any
expense or cost that we have to pay in the form of cash but it has not been paid in
the form of cash due to the increase of liability.

It means that if we have purchased goods and if we have not paid cash against
some of these goods then our Account Payables will become increased. So, the
increase of Accounts Payables actually telling us that there has not been cash
outflow of some amount which we have taken in our cost as cash outflow in our
Profit & Loss Account.

Therefore we add it to the figure of profit in order to adjust that profit as there is
not outflow occurring but we have already taken cash outflow.

Similarly, other liabilities like Notes Payables, Accrued Expenses are also treated
likewise. Accrued Expenses means that one amount as an expense is taken in
Profit & Loss account and it is assumed that there will have been cash outflow
from it but there has not been cash outflow from it because the balance of expense
payables or accrued expenses has increased. So, we adjust it in the figure of profit
and increase in the amount of profit.

So, we can say that if liabilities have been increased then there has not been cash
outflow that we supposed during the time of calculating expense then we add back
and if current assets have been increased then it means that we supposed that cash
inflow has been occurred but that cash inflow does not occurred so we will
subtract it.

So, in nutshell we can say that increase in current assets is deducted from the
profit and increase in current liabilities is added in the amount of profit. And
opposite of that; decrease in current assets is added in the amount of profit and
decrease in current liabilities is subtracted from the amount of profit.

Short Term Financing?

It may be a loan or any other form of financing that we have taken for short term is
not taken in the cash flow from operating activities and we take it in the cash
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flow from financing activities or we consider the cash inflow and cash outflow
occurred from short term financing in the cash flow from financing activities
which is actually the third part of a cash flow statement.

Module 6: Cash Flow Analysis

Topic 120: Cash Flow from Operating Activities-4

Let’s have a recap, we have talked that in Operating Activities in the indirect
method of making Cash Flow Statement, we start with the Net profit figure. And
then in the Net profit figure, we make adjustments. We adjust non-cash expenses,
changes in current assets and in current liabilities excluding short term financing.

Example of Operating Activities

• Net Income = Rs. 100,000

• Depreciation = 20,000

• Inc. in Acc. Rec. = 18,000

• Decrease in Inv. = 6,000

• Inc. in Acc. Pay. = 7,000

• Dec. in Accrued Exp. = 5,000

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Module 6: Cash Flow Analysis

Topic 121: Cash Flow from Investing Activities-1

Investing Activities

• Investing Activities

• Purchasing a Fixed Asset

• Acquiring a Non-Current Asset

• Selling a Fixed or Non-Current Asset

Investing Activities
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• Changes in Fixed Assets

• Changes in Accumulated Depreciation

We have discussed that Cash Flow Statement is divided into three parts; Cash flow
from Operating Activities, Cash Flow from Investing Activities and Cash Flow
from Financing Activities.

What we consider in the Investing Activities?

Cash flow from Investing Activities actually is about non-current or fixed assets.
Current assets are taken in Operating activities so, on the Balance sheet on asset
side we are left with fixed assets or non-current assets.

Purchasing a Fixed Asset:

Generally we have two types of assets in it; those Operating fixed assets that we
call property, plant and equipment meaning that these are the assets which we use
for our business operations (i.e., land, building, equipment, machinery, vehicles,
furniture and fixtures, computers etc.) so these are assets which we name them
Operating Fixed Assets. Here we also consider the cash inflow and cash outflow
resulted from the increase or decrease of such assets.

Meaning that if there is an increase in any of our asset which show that there will
be cash outflow i.e., there was a piece of land that was showing as 100,000 but at
the end of the year it becomes 200,000. Then its one reason can be that we have
purchased further land for 100,000 and other reason can be that we increase the
value of it by revaluing the asset.

Acquiring a Non-Current Asset:

So, we see that unless it is given or mentioned that the value has been increased
without purchasing the asset, we consider every increase in asset as the purchase of
an asset and hence we consider it an outflow.
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Selling a Fixed or Non-Current Asset:

When we are selling an asset, the sale of an asset generate cash inflow so whatever
is the amount of decrease in the asset that is taken as the cash inflow. Similarly, in
non-cash expenses we have such loans which our company or business has been
given to others or those debts or equity which have been purchased as a part of
investment and in it we also consider that increase of asset causes cash outflow and
decrease of asset causes the cash inflow.

Changes in Accumulated Depreciation:

There is another account related to fixed assets that we have to keep in mind and
understand when we are actually trying to calculate the cash flow from investments
that is fixed assets. That account is Accumulated Depreciation Account. This
account is actually a Contra-asset account meaning that actually it is not any
account by itself but we create an opposite or contra account of that asset in order
to decrease the value of that asset. It will be useful because asset remains
maintained on historical cost but the net value of that asset also decrease due to the
increase of its depreciation every year.

So, when we see the increase or decrease in the net value of asset to see the cash
flow, we also have to see the change in the amount of Accumulated Depreciation.

Investing Activities

• Changes in Fixed Assets

• Changes in Accumulated Depreciation

• Example:

2018 2019

• Net Asset 500 600 (it means that we further acquire the
assets of Rs.100 then there will be cash outflow)

Note: if there is no Acc. Dep. Account then we will consider that there
occurs cash outflow of Rs.100

• Acc. Dep. 100 140

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• Cash Outflow = 140*

*600 - 500 + 40 = 140

Module 6: Cash Flow Analysis

Topic 122: Cash Flow from Investing Activities-2

We have seen in our previous lecture that in Investing Activities of a cash flow
statement, we consider the cash flow from the sale or purchase of non-current or
fixed assets. Basically whenever we purchase a fixed asset that is an outflow of
cash unless there is something else that is mentioned. And likewise, when we sell
an asset, it is inflow of cash.

Example of Investing Activities

• Purchase of land = Rs. 5,000

• Purchase of Build = 4,000

• Sale of Equip = 3,000

• Sale of Vehicles = 4,500

• Increase in Acc. Dep. = 4,000

• Purchase/Buy Long Term Debt (Bond) of other company = 6,000

• Sale of Bonds of other Companies = 3,500

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Module 6: Cash Flow Analysis

Topic 123: Cash Flow from Financing Activities-1

Financing Activities

• Sources of Finances

• Equity

• Debt

• Cost of Financing

• Dividend

• Interest

Financing Activities-Equity

• Issue of Common Shares

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• Issue of Preferred Shares

• Additional Capital

• Treasury Stock

• Dividend

• Retained Earnings (Retained earnings/ net income are not part of financing
activities because these have already been treated under operating activities)

• Reserves

Financing Activities-Debt

• Short Term Borrowing

• Long Term Borrowing

• Bonds

• Current Portion of LTD

• Lease Payments

We have discussed in previous lectures that there are three components of Cash
Flow Statement; Cash Flow from Operating Activities (where we see the cash
inflow and outflow which is related to operations), Cash Flow from Investing
Activities (where we consider the cash inflows and outflows related to investments
there we consider the fixed assets other than the current assets and current
liabilities and also the profit & loss account) and Cash flow from Financing
Activities.

Financing means the sources of funds meaning that from where we get money or
funds or finances for any business or company (what are the sources).

Sources of Finances:
There are two external sources of financing; Equity (by issuing shares) and Debt
(by issuing bonds or taking loans). The third source of financing is termed as the
31 | P a g e

internal source of financing which is Profit Earned by Company. When a

business earns profit that we consider in first part means in operating activities so,
in the Financing Activities, we are only left with the cash flows related to equity
financing and debt financing.

Whenever we get a financing, there will always be a cash inflow and whenever we
will return a part of that financing that will be a cash outflow.

Equity: So, to calculate the net value of cash inflow and cash outflow from
financing activities. We need to consider all the elements which are part of our
equity and debt.

Debt: While considering the debt, we consider the long term debt as well as short
term debt but we do not consider the elements of working capital that is the
accrued expenses or the accounts payable.

Cost of Financing:
Dividend: So, whenever we are talking about the cash outflow as the return on this
financing that is something which is also included in this financing activity. It
means that if we generate equity by issuing shares then we pay dividend as return
to these shareholders which is also to be considered.

Interest: And similarly when we issue bond or take loan then the return taken on it
is named as Interest.

Financing Activities – Equity:

Equity financing means that the financing generated from the issue of shares. We
can issue common shares or preferred shares and whenever we issue shares, there
is an inflow of cash.

Issue of Common Shares: Common shares are those shares that are never
redeemable or never convertible meaning that when one time the common shares
are issued then they cannot be canceled till company is operational.

Issue of Preferred Shares: On the other hand, preferred shares can be redeemable
or convertible meaning that when preferred shares are issued then there can be
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cash inflow and when preferred shares are returned then there will be cash
outflow.

Additional Capital: Additional capital refers to the share premium meaning that if
any company issues its shares on the value which is more than its par value then
the additional amount of cash is received that is recorded as share premium or
additional capital.

So, having additional capital is also an inflow of cash.

Treasury Stock: Treasury Stock means the stock or the share of the company
repurchased by itself. Here it is very important to remember that Treasury stock
does not mean canceling the share by purchasing them. Treasury stock shares
remain as the issued, subscribed and paid up shares.

Whenever a company purchases Treasury stock which will result in cash outflow
and when this company will sell back this Treasury stock in the market then inflow
of cash will be generated.

Dividend: When a company pays dividend that is distributes profit among its
shareholders that is called dividend and dividend results into a cash outflow.

Retained Earnings: Retained earnings is actually the profit which is retained in

the company. So, we would see that the portion of retained earning which is
increase because of the current profit should not be considered in the financing
activities. Because that amount of profit is taken in the operating activities.

Reserves: Reserves are nothing but the appropriation of profit meaning that if we
retain profit for specific purpose that is termed as Reserves which can be general or
specific reserves, statutory reserves and likewise.

So, we have to see in equity financing in such financing activities that what are
those accounts through which cash inflow and cash outflow occurs and from which
accounts cash inflow and cash outflow does not occur.
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Financing Activities – Debt:

Short term borrowing: Short term borrowing are those borrowings or loan which
are of less than one year, whenever we do that borrowing it will result into a cash
inflow and whenever we return it then it will be a cash outflow.

Long term borrowing: When we actually do the calculations, some part of the
Long term borrowing is transferred to the Short term or current portion of that long
term liability. So, one should see that while calculating the amount of inflow or
outflow that whether the difference or decrease in the value of long term debt is
due to the transfer in the current portion or is due to the payment. Only the
payments amount should be considered as cash outflow.

Bonds: These are actually a type of debt financing issue to the general public.
Whenever bonds are issued that result into cash inflow and whenever bonds are
retired then money is paid back to the bond holder and that results into cash
outflow.

Current portion of LTD (Long term debt): It is generally what is paid in the
current year and so that change in the amount is also reflected in the cash outflow.

Lease Payments: If there are some lease payments because lease financing is also
a part of the financing of a business organization and anything that we pay against
the lease amount is also to be considered as cash outflow.

So, the Debt financing activities would result into cash inflows as well as cash
outflows.

Module 6: Cash Flow Analysis

Topic 124: Cash Flow from Financing Activities-2

We have discussed in previous lecture that Cash flow from Financing Activities
means those activities where we consider cash inflow and cash outflow while
receiving or giving financing.
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When any business arranges financing either through by issuing shares/bonds or

taking loans then it causes cash inflow. And when any business or company
returns any financing that is by returning the loan or retiring the bonds or preferred
stocks then it causes cash outflow.

So, we have cash inflows as well as cash outflow. We have discussed it in detail
that from which activities cash inflow and from which activities cash outflow can
occur.

Here in this lecture, by taking an example we will try to understand that which
activities or transactions cause cash inflow and which activities cause cash outflow
that we need to show in financing activities.

Example of Financing Activities

• LT borrowing = Rs. 40,000

• Payment of LTD = 30,000

• ST borrowing = 15,000

• Issue of Bonds = 35,000

• Retirement of Bonds = 4,500

• Payment of Interest = 3,000

• Issue of Com. Shares = 20,000

• Purchase of Treasury S. = 5,000

• Dividend Paid = 10,000

• Profit Earned = 23,000

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Module 6: Cash Flow Analysis

Topic 125: Cash Flow Statement: Direct Method-1

Example of Operating Activities

• Cash collected from customers

• Cash paid to suppliers

• Cash paid to employees

• Cash paid for Prepaid Expenses

• Interest received/Dividends received

• Interest paid

• Income taxes paid

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We have discussed that Cash Flow Statement can be prepared either using direct
method or indirect method. In indirect method, we have seen that how operating
activities, investing activities and financing activities related cash flows are
calculated that is cash inflow and cash outflow.

There is another method of making a cash flow statement and this method is called
Direct Method of cash flow. The direct method is different from the indirect
method of cash flow statement only in the operating activities. It means that in both
investing activities and financing activities, calculations of cash flow is same in
both direct and indirect methods and the actual difference in both direct and
indirect methods is basically in the operating activities.

In the operating activities in the indirect method, we start with the amount of profit
and we adjust the current assets and current liabilities, difference in that and we
consider the non-cash items to get the amount of cash inflow or cash outflow from
operating activities.

Example of Operating Activities:

By using the Direct method of cash flow statement, we use some different accounts
that we take in operating activities which are given below:

Cash collected from customers: The amount of sales that we have made on credit
and as on cash also so, we see that how much cash has been collected from them
and we will see that how this amount is calculated.

Cash paid to suppliers: The second one is the amount that we take in operating
activities that is related to the cash paid to the suppliers from which we have
purchased products or services.

Cash paid to employees: It includes salaries or wages that a business pays to its
employees.

Cash paid for Prepaid Expense: We calculate the cash which is paid for expenses
in advance which we call Prepaid expenses.

Interest received/Dividends received: Then we calculate the amount of Interest

received or dividend received that is the income which is considered as the other
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income of the company is also calculated in this direct method of cash flow
statement.

Interest paid: The amount of Interest which is paid by the company is also taken
into the operating activities. Although we have discussed in the last lecture that
financing activities include the payment of Debt but the interest payment on that
Debt is not taken in the financing activities but it is taken as an operating activity.

Income taxes paid: It is the amount of tax which is paid in cash.

Let’s see one by one that how these amounts are calculated. Some of these
calculations we will discuss in this lecture and the remaining calculations we will
discuss in the second part of this lecture of Direct Method of Cash flow statement.

Cash from Customers

The customers are those people to which we sale our products or services on
credit and there is cash inflow through this credit sales after some time
period.

And cash sale is one that we get cash at that time whenever we do sale
which results in cash inflow also.

If there is some increase in the balance of our Accounts Receivables then it

means that we have not received some amount from our sales and if there is
some decrease in the balance of Accounts Receivables then it means that not
only we have received the money of sales of this year but also receive cash
inflow from the Receivables generated from sales of last year.

So, that means if there is a decrease in the amount of Accounts Receivables

then the cash inflow will be more than the amount of sales. And if there is
increase in amount of Accounts Receivables then it means that our complete
Net Sales have not been received.

• Cash Receipts from Customers

• + Net Sales (it tells us that how much amount of cash we should
receive)

• + Opening Accounts Rec.

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• − Ending Accounts Rec.

Cash to Suppliers

When we have to make payment that is related to purchases. When we purchase

things then we have to pay cash to suppliers or vendors. Now, when we purchase
something on credit, it results into Accounts Payables.

If balance of Accounts Payables becomes decreased till the end of the year then it
means that we have paid some more amounts in cash than the amount of which we
made purchases. Because the balance of Accounts Receivables decreases and
payment has been done.

And if the balance of Accounts Payables becomes increased then it means that we
have not paid some amount from the purchases of that year also. That means that
cash outflow resulting from purchases will be less than the amount of purchases
that we have made in this year.

• Cash Payments to Suppliers

• + Purchases

• + End. Stock − Open Stock

• + Opening Accounts Payable

• − Ending Accounts Payable.

Module 6: Cash Flow Analysis

Topic 126: Cash Flow Statement: Direct Method-2

Cash to Employees

The Employees are those people who work in our business or company. Most of
the amount of salaries has been paid in cash and many times some amount of
salaries is outstanding at the end of the period that is called Salaries Payable.

Cash Payments to Employees

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• + Beginning Salaries Payable

• − Ending Salaries Payable

• + Salaries Expense

Cash for Prepayments

• Cash Payments for Purchase of Prepaid Assets

• + Ending Prepaid Rent, Prepaid Insurance etc.

• + Expired Rent, Expired Insurance etc.

• − Beginning Prepaid Rent, Prepaid Insurance etc.

Interest/Dividend Received

• Interest/Dividend Received

• + Opening Interest/Dividend Receivable

• − Ending Interest/Dividend Receivable

• + Interest/Dividend Income

Cash for Interest Payment

• Interest Payments =

• + Beginning Interest Payable

• − Ending Interest Payable

• + Interest Expense

Cash for IT Payment

• Income Tax Payments

• + Beginning Income Tax Payable

• − Ending Income Tax Payable

• + Income Tax Expense

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