Topic: Cash Flow Statement (Statement of Cash Flows)

Financial Statements
Financial statements are:
Income statement (Profit & loss account) – shows the calculation of
gross and net profits; demonstrates how well the company performed
during the reporting period.

Statement of financial position (Balance Sheet) – shows the assets,

liabilities and capital of the business; demonstrations the financial
strength of the company

Statement of cash flows (Cash flow statement) – shows how cash

was generated and how cash was used.

Statement of changes in equity - shows the summary of the changes

in shareholders’ equity accounts over the reporting period. (NOT
STUDIED IN THIS MODULE)
Learning objectives
By the end of the session you will be able to:

• Understand the importance and purpose of cash flow statements

• Understand and explain the 3 sections: operating activities, investing activities
and financing activities
• Convert net profit (loss) to operating cash flow
• Calculate operating cash flow before movement in working capital
• Calculate movement in working capital
• Calculate cash generated from operations
• Calculate net cash from (used in) operating activities
• Calculate net cash from (used in) investing activities
• Calculate net cash from (used in) financing activities
• Understand what is meant by cash and cash equivalents
• Determine net increase (decrease) in cash and cash equivalents
• Identify cash and cash equivalents at the start / beginning of the year
• Explain the structure of cash flow statements
• Prepare the cash flow statement of a sole trader
Profit vs. Cash

‘Profit is not Cash’

‘Profits do not equal Cash
‘Cash is King!’
Introduction

Although the Statement of Financial Position shows the cash and

bank balances at a given date, it does not show us how we have
used our cash funds during the accounting period.

What we really need is a statement that shows us exactly where the

cash has come from during the year and exactly what we have done
with it.
Need for cash flow statements

For any business it is important to ensure that:

• Sufficient cash are made to finance the business activities.

• Sufficient cash funds are available as and when needed.
Purpose of cash flow statements

• The primary purpose of the cash flow statement is to provide

information about the cash receipts and cash payments of an
entity during a period.
• A secondary objective is to provide information about its:
– Operating activities – a company’s primary revenue-producing activities
– Investing activities – activities associated with the changes in company’s
non-current assets or company’s investments in other organisations
– Financing activities – activities associated with funding company’s
operations either through owner’s investment or borrowing
Note

• As part of this module students are assessed on how to prepare

the Statement of Cash Flow for a Sole Trader only
How to begin:

Name of the business

Cash flow Statement for the year ended…..(Date as per question)
Introduction

• A cash flow statement uses information from the accounting

records (including income statement and statement of financial
position), and shows an overall view of money flowing in and
out of a business during an accounting period.

• Such a statement concentrates on the liquidity of a business and

explains to the owner or shareholder why, after a year of good
profits for example, there is a reduced balance at the bank or a
larger bank overdraft at the year-end than there was at the
beginning of the year.
Liquidity

• Ability of the business to generate cash and pay their debts as

and when they fall due.
Importance of Cash Flow Statements

Cash Flow Statements are important because:

✓ They evaluate how management generates and uses cash

✓ They determine a company’s ability to pay interest, dividends, and debts
when they are due
✓ They identify specific increases and decreases in a firm’s productive assets
✓ The information is key to the owner(s).
✓ The information is key to the lenders, for example, banks.
✓ Cash Flow Statement looks at the past and can be used to forecast the
future cash position.
✓ Shortage of money will cause business to fail
✓ Financial Reporting Standards No 1 (FRS 1) requires all companies, except
for small companies, to include this statement as part of their financial
statements published to shareholders.
 The Idea
As at 30 November 2019 As at 30 November 2020
£ £ £ £
Current Assets
Inventory 7,500 10,500
Accounts receivable 6,000 8,000
Bank 0 1,210
Cash 800 200
14,300 19,910

Current Liabilities
Accounts payable 5,900 9,200
Bank overdraft 4,100 0
(10,000) (9,200)

The Question to be answered by the cash flow statement: How did the business go from negative
£3,300 at the start of the year to positive £1,410 at the end of the year? What cash inflows and cash
outflows occurred during the year?
Format of the Cash Flow Statement

A Cash Flow Statement is divided into three sections:

1. Operating Activities

2. Investing Activities

3. Financing Activities
Operating Activities

Cash flow from operating activities - cash inflows and outflows

from ongoing, regular business activities. They are cash inflows and
outflows directly related to company’s normal operations.
Cash Flow from Operating Activities

Two methods:

➢ Direct method (not used in this module)

➢ Indirect method
Cash Flow from Operating Activities – Direct method (not used in this
module)

• The direct method to calculate cash flow from operating

activities involves determination of various types of cash receipts
and payments such as cash receipts from customers, cash paid to
suppliers, cash paid for salaries, etc. and then putting them
together under the cash flow from operating activities section
of cash flow statement.
Cash Flow from Operating Activities – Direct method (not used in this
module)

This method uses information contained in the ledger accounts to

calculate cash from operations
£ £
Cash sales X
X
Cash received from receivables
––––
X
Less:
Cash purchases X
Cash paid to credit suppliers X
Cash expenses _X_
(X)
––––
Cash flow from operating activities X
Cash Flow from Operating Activities – Indirect Method

• Most reporting entities use the indirect method to report cash

flows from operating activities.
• When the indirect method of presenting the statement of cash
flows is used, the net profit or loss for the period is adjusted for
the following items: non-cash transactions; changes in working
capital; items related to investing activities.
Cash Flow from Operating Activities – Indirect Method

• The idea is to convert Net profit/loss to net CASH from operating

activities. This is done because some items included in the
calculation of Net profit/loss are non-cash or non-operating
activities therefore must be adjusted.

• Remember Profit is NOT Cash!

 Cash Flow from Operating Activities – Indirect method – Items
included
The cash inflow from operating activities is calculated by using figures from the Income
Statement for the current year and Statements of Financial Position for two consecutive
years as follows:
 Net profit/loss
Adjustments for:
 Add depreciation for the year
 Add Increase in Provision for Doubtful Debts and Deduct Reduction in Provision for Doubtful Debts
 Add Loss on the Disposal of Non-current Asset and Deduct Gain on the Disposal of Non-current
Asset
 Add interest expense, Deduct any interest received, investment income, rent received
Movement in working capital:
 Add Decrease in Debtors, or Deduct increase in Debtors
 Add Increase in Creditors, or Deduct decrease in Creditors
 Add Decrease in Inventory, or Deduct increase in Inventory
Items paid from operating cash:
 Deduct Interest Paid
 Deduct Tax (if a Limited Company)

= Net Cash from / (used in) Operating Activities

 As mentioned, the net profit or loss is converted to operating
cash by:

➢ Adjustment of items in the calculation of net profit (loss), that

do not involve the movement of cash

➢ Adjustment of items in the calculation of net profit (loss), that

are not operating activities
Adjustment of items that do not involve the movement of cash

When net profit (loss) is included as a source of cash funds, the

profit (loss) figure has to be adjusted to take account of items
included which DO NOT involve a MOVEMENT OF CASH in the
period covered by the statement of cash flows.

Most common examples of non-cash adjustments:

❖Depreciation Expense
❖Provision (Allowance) for Doubtful Debts
❖Gain and losses on disposal of non-current assets
Depreciation

Add back depreciation expense to net profit (loss) figure if it was

deducted as an expense in the Income Statement

Reason: Even though it is deducted as an expense in the Income

Statement when calculating net profit, depreciation does not involve
the flow of cash. It is simply, a decrease in value of the non-current
asset
Provision (allowance) for doubtful debts

Add back to the net profit (loss) any increase in allowance for
doubtful debts OR deduct from net profit (loss) any reduction /
decrease in allowance for doubtful debts.

Reason: Provisions are made in case debts go bad in the future but
they do not involve the flow of cash.
Gain (profit) / Loss on disposal (sale) of non-current assets

Add back any loss on disposal of non-current assets and/or

deduct any gain (profit) on disposal of non-current assets.

Reason: When a non-current asset is sold the only cash flow is the
money received from sale. The gain on disposal does not provide
any more cash. Similarly, the loss on disposal does not reduce cash.
Gain or loss on disposal reflect the difference between the amount
the asset was sold for and net book value of the asset at the time of
disposal.
Adjustment of items that are not operating activities

When net profit is included as a source of cash funds, the profit figure has
to be adjusted to take account of items included which ARE NOT
OPERATING ACTIVITIES in the period covered by the statement of cash
flows.

Examples of such adjustments in this module will be:

❖ Interest Expense
❖ Interest income (received)
❖ Investment income
❖ Rent received / rental income
Adjustment of items that are not operating activities

Remember the point is to convert net profit to operating cash

flow
Interest Expense: This involves cash but it is not an operating
activity. Add back because it is an expense. The interest will
eventually be paid from operating cash.

Interest income (received),Investment income, Rent received /

rental income: These involve cash but are non-operating activities.
Deduct because they are income. They are investing activities
therefore will be included in that section.
INCOME STATEMENTdOF A SOLE TRADER
XXX £ £
Sales XXX
Less Cost of goods sold:
Opening Inventory XXX
Purchases XXX
Total Cost of Goods Available for sale XXX
Closing Inventory (XXX)
(XXX)
Gross Profit XXX
Add other income:
Decrease (Reduction) in provision for doubtful debts XXX
Interest received /rental income or rent received /investment income XXX
Profit on disposal (sale) of non-current asset A XXX
Total Income XXX
Less Expenses:
Wages and Salaries XXX
Depreciation XXX
Loss on disposal (sale) of non-current asset B XXX
Interest paid XXX
Total expenses (XXX)
Net Profit XXX
Movement in working capital (year-on-year)

In this module, the movement in working capital will involve, year-

on-year (previous year vs. current year) difference in following 3
items:

• Inventory
• Accounts receivable (Debtors)
• Accounts payable (Creditors)
 Movement in working capital (year-on-year) : Where from: where to –
General mind map

Cash Resources
Profits Losses

Decrease in Inventory Increase in Inventory

In Out
Decrease in Trade Receivable Increase in Trade Receivable

Increase in Trade Payables Decrease in Trade Payables

Source: Adapted from Sangster, A. (2018). Frank

Wood’s Business Accounting. Volume 1. Fourteenth
Edition. Pearson Education Limited.
Movement in working capital: Mind map can be explained as
follows:

• Reducing inventory in the normal course of business means

turning it into cash. An increase in inventory ties up cash funds.
Movement in working capital: Mind Map can be explained as follows:

• A decrease in accounts receivable means that the extra

amount received comes into the business as cash. An increase
in accounts receivable stops that extra amount of cash coming
in.

• An increase in accounts payable keeps the extra cash in the

business. A decrease in accounts payable means that the extra
payments take cash out.
Changes in the Working Capital

• Changes in the working capital are included in the cash flow from
operating activities section as working capital is a core part of
company’s daily operations
• The following changes (year on year) are included:
– Changes in the inventory
– Changes in Accounts Receivable (before the deduction of provision for
doubtful debts)
– Changes in Accounts Payable (Creditors)
• The changes in working capital can be calculated based on the
Statements of Financial Position for two consecutive year –
by looking at difference between the current and previous financial
year
Effect of Changes (year on year) in Working Capital on Cash
Flow from Operating Activities

 Add Decrease in Debtors, or Deduct increase in Debtors

 Add Increase in Creditors, or Deduct decrease in Creditors
 Add Decrease in Inventory, or Deduct increase in Inventory
 Example: Extract from Statements of Financial Position:
As at 31 December As at 31 December
2019 2020
£ £
Current Assets:
Inventory 1,000 6,300
Accounts receivable (Debtors) 6,000 4,000

Current Liabilities:
Accounts payable (Creditors) 8,000 2,500
Increase in Inventory of £5,300 (from £1,000 to £6,300), an outflow of cash, therefore deduct

Decrease in Accounts receivable of £2,000 (from £6,000 to £4,000), an inflow of cash, therefore add

Decrease in Accounts payable of £5,500 (from £8,000 to £2,500), an outflow of cash, therefore deduct
 Cash Flow from Operating Activities – Indirect method – Structure (Format)
Cash Flow Statement for the year ended………… £ £

Net Profit XXX

Adjustments for:
Add Depreciation XXX
Add Interest paid XXX
Less Interest Received/ Rental Income/Investment Income (XXX)
Less: Decrease in provision for doubtful debts (Add if Increase in provision for doubtful debts (XXX)
Add: Loss on disposal of Non-current Asset A XXX
Less: Gain on disposal of Non-current Asset B (XXX) XXX/(XXX)
Operating cash flows before movement in working capital XXX
Add/Less decrease/increase in inventory XXX/(XXX)
Add/Less decrease/increase in debtors XXX/(XXX)
Add/Less decrease/increase in creditors (XXX)/XXX
(XXX)/XXX
Cash generated from operating activities XXX
Tax paid (for limited companies) (XXX)
Interest paid (XXX)
(XXX)
Net Cash from (used in) operating activities XXX/(XXX)
Example
The relevant information from the financial statements of Mrs Peter, a sole trader for the year to 31 March 2020 is as
follows:
£
Information from Income Statement for the year ended 31 March 2020
Net Profit 13,500
Depreciation charge for the year - Vans 1,000
Interest paid 2,500
Reduction / Decrease in provision for doubtful debts 200
Loss on disposal of Equipment 800
Profit (Gain) on disposal of a van 300
Rent received 650

Information extracted from Statement of financial position:

As at 31 March 2019:
Inventory 1,000
Accounts receivable 6,000
Accounts payable 8,000

As at 31 March 2020:
Inventory 6,300
Accounts receivable 4,000
Accounts payable 2,500
Prepare the first section of Mrs Peter’s Cash flow Statement showing up to ‘Net cash from / (used in) operating
activities’ for the year ended 31 March 2020
 Example Solution: Cash Flow from Operating Activities
Mrs Peter Cash Flow Statement (Operating Activities section) for the year ended 31/03/20 £ £
Net Profit 13,500
Adjustments for:
Add: Depreciation expense - Vans 1,000
Add: Interest paid 2,500
Less: Decrease in provision for doubtful debts (200)
Add: Loss on disposal of Equipment 800
Less: Profit (Gain) on disposal of a van (300)
Less: Rent received (650) 3,150
Operating cash flows before movement in working capital 16,650
Less: increase in inventory (£1,000 to £6,300) (5,300)
Add: decrease in accounts receivable (£6,000 to £4,000) 2,000
Less: decrease in accounts payable (£8,000 to £2,500) (5,500)
(8,800)
Cash generated from operations 7,850
Tax paid (for limited companies) 0
Interest paid (2,500)
(2,500)
Net Cash from operating activities 5,350
Note:

• Net Cash from operating activities when the figure is positive

• Net Cash used in operating activities when the figure is

negative
Note:

• Add: Inflow of Cash

• Less: Outflow of Cash

Cash Flow from Investing Activities

Cash flows from investing activities - are cash inflows and cash
outflows related to the acquisition and sale of non-current assets
and investment in the share markets and other companies
Cash Flow from Investing Activities

For this module, the possible items in this section are :

• Less: Acquisition of Non-Current Asset

• Add: Proceeds from Sale (disposal) of Non-Current Asset

• Add: Investment Income

• Add: Interest Income / interest received

• Add: Rental Income / rent received

= Net Cash from (used in) Investing Activities

 Cash Flow from Investing Activities

£ £
Cash flows from investing activities
Acquisition of non-current assets (XXX)
Proceeds from disposal (sale) of non-current assets XXX
Interest received XXX
Rental Income / rent received XXX
Investment Income XXX
Net cash from (used in) investing activities XXX/(XXX)

Note:
Net Cash from investing activities when the figure is positive
Net Cash used in investing activities when the figure is negative

*Proceeds* from disposal of non-current assets refers to actual cash or cheque received from the sale
Cash Flow from Financing Activities

Cash flows from financing activities - are cash inflows and

outflows related to sources of finance (provision of funding). This
relates to capital (equity) and loans.
Cash Flow from Financing Activities

For this module, the possible items in this section are :

• Add: Proceeds from the additional capital introduced in the form of

cash/cheque in the current year

• Less: Drawings in the current year

• Add: Additional Borrowing of Loan (year on year)

• Less: Loan paid back by business over the year to Lenders (year on year)

= Net Cash from (used in) Financing Activities

Cash Flow from Financing Activities

£ £
Cash flows from financing activities
Additional capital introduced in the form of cash/cheque XXX
Receipt of long-term loan XXX
Repayment of long-term loan (XXX)
Drawings (XXX)
Net cash from (used in) financing activities XXX/(XXX)

Note:
Net Cash from financing activities when the figure is positive
Net Cash used in financing activities when the figure is negative
 Name of the Business
Statement of Cash Flow for the year ended XXX
£ £
Cash flows from operating activities
Net profit XXX
Adjustments for:
Depreciation XXX
Increase in Provision for Doubtful Debt / Reduction in Provision for Doubtful Debt XXX/(XXX)
Interest expense / Interest Received XXX/(XXX)
Loss on disposal of non-current asset / Gain on disposal of Non-current asset XXX/(XXX)
Investment income (XXX)
Rental Income (XXX) XXX/(XXX)
Operating cash flow / cash generated before movement in working capital XXX
(Increase)/Decrease in trade receivables (XXX)/XXX
(Increase)/Decrease in inventories (XXX)/XXX
Increase / (Decrease) in trade payables XXX/(XXX) XXX/(XXX)
Cash generated from operations XXX
Interest paid (XXX)
Tax paid (if a Limited Company) (XXX) (XXX)
Net Cash from /(used in) operating activities (XXX)/XXX
 ...continued
Cash Flow Statement for the year ended XXX
£ £
Cash flows from investing activities
Acquisition of non-current assets (XXX)
Proceeds from disposal of non-current assets XXX
Interest received XXX
Rental Income
Investment Income XXX
Net cash from / (used in) investing activities XXX/(XXX)
Cash flows from financing activities
Additional capital introduced in the form of cash / cheque XXX
Receipt / (Repayment) of long-term loan XXX/ (XXX)
Drawings (XXX)
Net cash from / (used in) financing activities XXX/(XXX)
Net increase (decrease) in cash and cash equivalents XXX/(XXX)
Cash and cash equivalents at the beginning of the year XXX/(XXX)
Cash and cash equivalents at end of the year XXX/(XXX)
• Net increase (decrease) in cash and cash equivalents = Net cash
from (used in) operating activities + Net cash from (used in) investing
activities + Net cash from (used in) financing activities

• Cash and cash equivalents at the beginning / start of the year =

Cash + Bank (Bank overdraft) balances in the Statement of
Financial Position at the end of the previous financial year

• Cash and cash equivalents at end of the year = Net increase

(decrease) in cash and cash equivalents + Cash and cash
equivalents at the beginning / start of the year

Note: Cash and cash equivalents at end of the year = Cash + Bank
(Bank overdraft) balances in the Statement of Financial Position at the end of the
current financial year
 Cash and cash equivalents at the beginning / start of the year
As at 30 November 2019 As at 30 November 2020
£ £ £ £
Current Assets
Inventory 7,500 10,500
Accounts receivable 6,000 8,000
Bank 0 1,210
Cash 800 200
14,300 19,910

Current Liabilities
Accounts payable 5,900 9,200
Bank overdraft 4,100 0
(10,000) (9,200)

Cash and cash equivalents at the beginning / start of the year = negative £3,300 i.e. (£4,100) bank
overdraft + £800 cash
What to look for in a Statement of Cash Flows
 Has the company’s cash balance increased or decreased?
 Does the cash generated from operations easily cover any
interest, tax?
 What happened to the long-term funding of the company over
the course of the accounting period?
 Did the company make any significant investment in non-
current assets during the a/c period? – This should be funded
by long-term sources of fund or share issue.
 How well has the company managed its working capital over
the period?
 Does the company have enough cash to operate on a daily
basis?
Note

• As part of this module students are assessed on how to prepare

the Statement of Cash Flow for a Sole Trader only
 References
• Sangster, A. (2018). Frank Wood’s Business Accounting.
Volume 1. Fourteenth Edition. Pearson Education Limited.
• Wood, F., Horner, D. (2010), Frank Wood’s Business
Accounting Basics. Pearson Education Limited.
• Carey, M. et al (2011), Accounting, A Smart Approach, Oxford
University Press
• Cox, D. & Fardon, M. (2007), Accounting: A general
introduction to financial and management accounting. Osborn
Books
• Nobles et al. (2015) Horngren’s Accounting. Tenth Edition.
Pearson
• https://accountingexplained.com/financial/statements/cash-
flow-operating-activities-direct-method
intostudy.com/city