01 · Explore
Introduction and Meaning of Cash Flow Statement
Financial statements traditionally include the Position Statement (Balance Sheet) and the Income Statement (Profit and Loss Account). However, a third crucial statement is the Cash Flow Statement.
A Cash Flow Statement shows the inflows and outflows of cash and cash equivalents of an enterprise over a specific period. It is prepared in accordance with Accounting Standard-3 (AS-3), which is mandatory under Section 133 of the Companies Act, 2013. This statement helps users evaluate the ability of an enterprise to generate cash and the timing and certainty of its generation.
The statement classifies cash flows into three main categories: Operating, Investing, and Financing activities. This classification allows users to assess the impact of these activities on the financial position of the enterprise and its liquidity.
Cash comprises cash in hand and demand deposits with banks. Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and carry an insignificant risk of changes in value. Typically, an investment qualifies as a cash equivalent only if it has a maturity of three months or less from the acquisition date.
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What is the primary objective of a Cash Flow Statement?
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Define 'Cash Equivalents' as per AS-3.
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02 · Explore
Cash from Operating Activities
Operating activities are the principal revenue-generating activities of the enterprise that are not investing or financing activities.
Operating activities represent the core business functions. For a manufacturing company, this includes buying raw materials and selling finished goods. The amount of cash from operations is a key indicator of whether the company can generate sufficient cash to maintain operations, pay dividends, and repay loans without external financing.
Cash inflows from operating activities include cash receipts from the sale of goods, rendering of services, and receipts from royalties, fees, or commissions. Cash outflows include payments to suppliers for goods/services, payments to employees, and payments for insurance premiums or claims.
Income tax payments are generally classified as operating activities unless they can be specifically identified with financing or investing activities. For financial enterprises, items like interest and dividends received are classified as operating activities because they relate to their main business of lending and borrowing.
| Activity Type | Examples of Inflows | Examples of Outflows |
|---|---|---|
| Operating | Cash sales, Commission received | Cash purchases, Salary payments |
| Investing | Sale of Fixed Assets, Interest received | Purchase of Machinery, Investment in shares |
| Financing | Issue of Shares, Raising Loans | Repayment of Loans, Dividend paid |
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Why is 'Cash from Operations' considered a key indicator of solvency?
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03 · Explore
Investing and Financing Activities
Beyond daily operations, companies engage in long-term asset management and capital structure adjustments.
Investing activities involve the acquisition and disposal of long-term assets and other investments not included in cash equivalents. These represent expenditures made for resources intended to generate future income. Examples include purchasing or selling machinery, land, buildings, and non-current investments like shares or debentures of other companies.
Financing activities are those that result in changes in the size and composition of the owners' capital and borrowings of the enterprise. This includes proceeds from issuing shares or debentures, raising long-term loans, and the subsequent repayment of these borrowings or payment of dividends.
It is important to note that a single transaction can involve multiple activities. For example, an installment payment for a fixed asset includes both interest (financing) and principal (investing). Similarly, the classification of an activity depends on the nature of the business; buying shares is an operating activity for a brokerage firm but an investing activity for a manufacturing firm.
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Classify 'Interest received on debentures held as investment' and 'Interest paid on long-term borrowings'.
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04 · Explore
Ascertaining Operating Cash Flow: The Indirect Method
The indirect method is the most common approach used by companies to calculate net cash flow from operating activities.
The indirect method starts with the 'Net Profit before Tax and Extraordinary Items'. Since the Statement of Profit and Loss is prepared on an accrual basis, it includes non-cash items (like depreciation) and non-operating items (like interest paid). These must be adjusted to arrive at the actual cash generated from operations.
Adjustments involve adding back non-cash expenses like depreciation, goodwill amortized, and losses on the sale of fixed assets. Conversely, non-operating incomes like profit on the sale of land or interest/dividend income are deducted. This results in 'Operating Profit before Working Capital Changes'.
The final step involves adjusting for changes in current assets and current liabilities. An increase in current assets (like inventory or debtors) represents a cash outflow and is deducted. A decrease in current assets or an increase in current liabilities (like creditors) represents a cash inflow and is added. Finally, income tax paid is deducted to find the Net Cash from Operating Activities.
Steps in Indirect Method for Operating Activities
- 1
Net Profit
Start with Net Profit before Tax and Extraordinary Items.
- 2
Non-Cash Adjustments
Add back Depreciation, Amortization, and Non-operating expenses; deduct Non-operating incomes.
- 3
Working Capital
Add decrease in Current Assets/increase in Current Liabilities; deduct increase in Current Assets/decrease in Current Liabilities.
- 4
Tax and Net Cash
Deduct Income Tax paid to arrive at Net Cash from Operating Activities.
The sequence of adjustments required to convert accrual-based net profit into cash-based operating flow.
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If debtors increase by 10,000 during the year, how is this treated in the indirect method?
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05 · Explore
Treatment of Peculiar Items: Tax, Dividends, and Non-Cash
Certain items require specific handling under AS-3 to ensure the Cash Flow Statement remains accurate.
Extraordinary items, such as losses from earthquakes or insurance settlements, are non-recurring. They must be disclosed separately and classified under the appropriate activity (operating, investing, or financing) to help users understand their impact on cash flows.
Proposed Dividend is a contingent liability until approved by shareholders. As per AS-4, the proposed dividend of the previous year is paid in the current year. Therefore, while preparing the statement, the previous year's proposed dividend is added back to find Net Profit before Tax (as an appropriation) and shown as a cash outflow under Financing Activities.
AS-3 requires that cash flows arising from taxes on income be separately disclosed. While tax on operating profit is an operating cash flow, dividend tax (tax paid on dividend) must be classified as a financing activity, and capital gains tax paid on the sale of fixed assets should be classified under investing activities.
Non-cash transactions, such as acquiring machinery by issuing shares or converting debentures into equity, are excluded from the Cash Flow Statement entirely. However, they must be disclosed elsewhere in the financial statements as they represent significant investing and financing movements.
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Where is 'Dividend Paid' classified in a Cash Flow Statement?
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06 · Explore
Worked Example: Investing Activities
Calculating cash flow from investing activities often requires preparing ledger accounts to find hidden values like purchases or sales.
When a company sells an asset, the cash received is an inflow. When it buys an asset, the cash paid is an outflow. However, the Balance Sheet only shows the net change. We must account for depreciation and profit/loss on sale to find the actual cash spent or received.
Consider an example where Machinery opening balance is 50,000 and closing is 60,000. During the year, a machine costing 25,000 (accumulated depreciation 15,000) was sold for 13,000. We must find the total purchases made during the year using a ledger account.
Calculating Machinery Purchase
Debit Side: Opening (50,000) + Profit on Sale (3,000) + Purchases (X) = Credit Side: Sale (13,000) + Acc. Dep. on Sold (15,000) + Closing (60,000)
The book value of the sold machine is Cost (25,000) - Acc. Dep (15,000) = 10,000. Since it was sold for 13,000, there is a profit of 3,000. In the Machinery Account, the total of the credit side is 88,000 (13,000 + 15,000 + 60,000). To balance the account, the debit side must also be 88,000. Subtracting the opening balance (50,000) and profit (3,000) gives the balancing figure for purchases: 35,000.
Net Cash from Investing Activities = Sale (13,000) - Purchase (35,000) = 22,000 (Outflow).
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If a machine with a book value of 5,000 is sold for 3,000, what is the cash inflow?
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07 · Explore
Preparing the Full Cash Flow Statement
The final statement aggregates the results from all three sections to reconcile the opening and closing cash balances.
The statement is structured by listing Net Cash from Operating Activities (A), Investing Activities (B), and Financing Activities (C). The sum of A + B + C gives the 'Net Increase or Decrease in Cash and Cash Equivalents'.
To verify the accuracy of the statement, the 'Cash and Cash Equivalents at the beginning of the period' is added to the net increase/decrease. The resulting total must exactly match the 'Cash and Cash Equivalents at the end of the period' as shown in the Balance Sheet.
Classification of short-term credit facilities is specific: Bank Overdraft is classified as a Financing Activity. However, as per the textbook's classification (Page 46), Cash Credit is treated as a Cash Equivalent along with short-term deposits and marketable securities.
| Particulars | Amount (Rs.) |
|---|---|
| (A) Net Cash from Operating Activities | xxx |
| (B) Net Cash from Investing Activities | xxx |
| (C) Net Cash from Financing Activities | xxx |
| Net Increase/Decrease in Cash (A+B+C) | xxx |
| Add: Cash & Cash Equivalents at Beginning | xxx |
| Cash & Cash Equivalents at End | xxxx |
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How do you verify if your Cash Flow Statement is correct?
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