MOD – 5: CASH FLOW STATEMENT

Definition

“A statement of changes in the financial position of a firm on cash basis is called a cash flow statement.”

In other words, a statement of cash flows is essentially a list of cash in and cash out reconciling opening
and closing cash balances.

A cash flow statement summarises the causes of changes in cash position of a business enterprise
between two balance sheet dates.

Cash comprises cash on hand and demand deposits with banks.

Cash equivalents are short term, highly liquid investments that are readily convertible into known
amounts of cash and which are subject to an insignificant risk of changes in value.

An investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three
months or less from the date of acquisition. Equity investments are excluded from cash equivalents
unless they are, in substance, cash equivalents, for example in the case of preference shares acquired
within a short period of their maturity and with a specified redemption date.

Cash flows are inflows and outflows of cash and cash equivalents.

Operating activities are the principal revenue-producing activities of the enterprise and other activities
that are not investing or financing activities.

Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the owners’
capital (including preference share capital in the case of a company) and borrowings of the enterprise.

Uses and Significance of the Cash Flow Statement:

1. It is useful for evaluating the cash position of a firm.

2. A projected Cash Flow Statement can be prepared to know the future cash position of a concern so
as to enable the firm to plan and co-ordinate its financial operations properly.

3. A comparison of historical and projected cash flow will reveal variations in the performances so
that the firm can take effective action.

4. It indicates whether the firm’s short –term paying capacity is improving or deteriorating over a
period of time.

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5. It helps in planning for repayment of loans, replacement of fixed assets etc. It helps in capital
budgeting decisions.

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6. It explains the causes for poor cash position in spite of substantial profits of the firm.

7. Not all profitable companies are successful; many fail due to a lack of cash.

8. A major function of the statement of cash flows is to inform the users of accounts whether or not
the reported profits are being realised (e.g. that trade receivables are being recovered).

9. The statement also helps to identify the availability of cash to:

pay dividends;
finance further investment (which will generate more cash).

10. Useful in assessing ability to generate cash and cash equivalents.

11. Historical cash flow information may provide an indicator of the amount, timing and certainty of
future cash flows.
12. A focus on cash management can improve results (e.g. with lower interest charges) and lead to
having cash resources available on a timely basis (e.g. for investment).
13. Cash flows allow more meaningful comparison between companies. Profits can be manipulated and
different accounting policies may lead to different outcomes. It is more difficult, although not
impossible, to manipulate cash.
14. Cash is more relevant to creditors and providers of loan finance than profits. Creditors are
concerned with the availability of cash to meet the debt and interest payments. The statement of
profit or loss provides no information about the availability of cash.

Classification of Cash Flows.

1. Cash flows from operating activities.

2. Cash flows from investing activities.

3. Cash flows from financing activities.

1. Cash Flows From Operating Activities:

Operating activities are the principal revenue-producing activities of the enterprise.

The amount of cash flows arising from operating activities is a key indicator of the extent to which the
operations of the enterprise have generated sufficient cash flows to maintain the operating capability of
the enterprise, pay dividends, repay loans, and make new investments without recourse to external
sources of financing.

Cash flows from operating activities are primarily derived from the principal revenue -producing
activities of the enterprise. Therefore, they generally result from the transactions and other events that
enter into the determination of net profit or loss.

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Examples of cash flows from operating activities are:

a. Cash receipts from the sale of goods and the rendering of services;

b. Cash receipts from royalties, fees, commissions and other revenue;

c. Cash payments to suppliers of goods and services;

d. Cash payments to and on behalf of employees;

e. Cash receipts and payments of insurance enterprise for premiums and claims, annuities and other
policy benefits;

f. Cash payments or refunds of income taxes unless they can be specifically identified with financing and
investing activities; and

g. Cash receipts and payments relating to futures contracts forward contracts, when the contracts are
held for dealing or trading purposes.

Cash Flows from Operating Activities may be reported either under:

a) Direct Method or
b) Indirect Method

Direct Method: Under Direct Method, major classes of gross cash receipts and gross cash payments
are disclosed as under:

The following is the direct method formula to calculate net cash flow from operating activities:
Cash receipts from customers xxx

(–) Cash paid to suppliers and employees (xxx)

= Cash generated from operations xxx

(–) Income tax paid (xxx)

= Net cash flow from operating activities xxxx

Indirect Method: Under this method, profit or loss is adjusted for non-cash items, changes in working
capital and other items of income and expenses that are classifiable as financing or investing activities.
The following is the indirect method formula to calculate net cash flow from operating activities:
Net Profit/Loss before Tax xxx

+ Deductions already made in Statement of Profit and Loss on account of xxx

Non-cash items such as Depreciation, Goodwill Written-off.

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+ Deductions already made in Statement of Profit and Loss on Account of xxx

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Non-operating items such as Interest.

– Additions (incomes) made in Statement of Profit and Loss on xxx

Account of Non-operating items such as Dividend received,
Profit on sale of Fixed Assets.

=Operating Profit before Working Capital changes xxx

+ Increase in Current liabilities xxx

+ Decrease in Current assets xxx

– Increase in Current assets xxx

– Decrease in Current Liabilities xxx

=Cash Flows from Operating Activities before Tax and Extraordinary Items xxx

– Income Tax Paid xxx

=Net Cash from Operating Activities xxx

Ind AS 7 encourages entities to report cash flows from operating activities under direct method since
the information provided can be useful in making future projections.

2. Cash Flows from Investing Activities:

Investing activities are the acquisition and disposal of long term assets and other investments
not included in cash equivalents. 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.

Examples of cash flows arising from investing activities are:

a. Cash payments to acquire fixed assets (including intangibles). These payments include those relating
to capitalised research & development costs and self constructed fixed assets;

b. Cash receipts from disposal of fixed assets (including intangibles);

c. Cash payments to acquire shares, warrants, or debt instruments of other enterprises.

d. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises.

e. Cash advances and loans made to third parties.

f. Cash receipts from the repayment of advances and loans made to third parties.
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g. Cash payments for futures contracts, forward contract, option contracts, and swap contracts except
when the contracts are held for dealing or trading purposes, or the payments are classified as financing
activities; and

h. Cash receipts from futures contracts, forward contracts and swap contracts except when the
contracts are held for dealing or trading purposes, or the receipts are classified as financing activities.

The following is the formula to calculate net cash flow from investing activities:
Cash from investing activities

Add :

Proceeds from sale of fixed assets xxx

Proceeds from sale of investments xxx

Proceeds from sale of intangible assets xxx

Interest and dividend received xxx

Less :

Purchase of fixed assets xxx

Purchase of investment xxx

Purchase of intangible assets like goodwill xxx

Net cash from (or used in) investing activities xxx

3. Cash Flows from Financing Activities.

Financing activities are activities that result in changes in the size and composition of the owner’ capital
(including preference share capital in the case of a company) and borrowings of the enterprise.

Examples of Cash Flows arising from Financing Activities are:

a) Cash proceeds from issuing shares or other similar instruments:

b) Cash proceeds from issuing debentures, loans ,notes, bonds, and other Short-or long-term
borrowings and
c) Cash repayments of amounts borrowed such as redemption of debentures, bonds,
preference shares.

The following is the formula to calculate net cash flow from financing activities:
Cash from financing activities

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Add:

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 St. Joseph’s College of Commerce, Bangalore (Autonomous)

Proceeds from issue of shares and debentures xxx

Proceeds from other long term borrowings xxx

Less :

Final dividend paid xxx

Interim dividend paid xxx

Interest on debentures and loans paid xxx

Repayment of loans xxx

Redemption of debentures, preference shares xxx

Net cash from (or used in) financing activities xxx

Where bank overdrafts are repayable on demand and form an integral part of cash management
(characteristically balance fluctuates from positive to overdraft) they are included in cash and cash
equivalents.

Points to remember:

1. Banks, Investment Companies and Mutual Funds are financing companies. All trading
companies, Manufacturing companies and other business establishments are non-financing
companies.
Sl.No. Items Financing Enterprise Non Financing Enterprise
1 Interest Received Operating Activities Investing Activities
2 Dividend Received Operating Activities Investing Activities
3 Interest paid Operating Activities Financing Activities
4 Dividend paid Financing Activities Financing Activities

2. An Investment Company is a Financial Enterprise since purchase and sale of securities (i.e.,
shares, debentures) are its main revenue-producing activities.
3. For Insurance Company, accepting premium and payment of claim shall be classified as
Operating Activities since they relate to main revenue producing activity for it.
4. For a Real Estate Enterprise, purchase and sale of land and rent received shall be classified as
Operating activities since they relate to its main revenue producing activity.

Deferred Tax: It is the difference between tax on Accounting Income and Taxable Income.

Deferred Tax Liability: It occurs due to excess of Accounting Income over Taxable Income.

Deferred Tax Asset: It occurs due to excess of Taxable Income over Accounting Income.

Compiled by Dr. Suganthi and CA. Jayakumar Nair. Page 9

 St. Joseph’s College of Commerce, Bangalore (Autonomous)

Treatment of Deferred Tax Liability and Deferred Tax Asset in Cash Flow Statement:

Sl.No. DTA/DTL Treatment

1 Increase in Deferred Tax Liability Increase in Deferred Tax Liability reduces current year’s
profits; hence, it is added back to profit to arrive at
current year’s profit before tax.
2 Decrease in Deferred Tax Liability Decrease in Deferred Tax Liability increases current
year’s profits; hence, it is deducted from profit to arrive
at current year’s profit before tax.
3 Increase in Deferred Tax Asset Increase in Deferred Tax Asset increases current year’s
profits; hence, it is deducted from profit to arrive at
current year’s profit before tax.
4 Decrease in Deferred Tax Asset Decrease in Deferred Tax Asset reduces current year’s
profits; hence, it is added back to profit to arrive at
current year’s profit before tax.

Compiled by Dr. Suganthi and CA. Jayakumar Nair. Page

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