Statement of
Cash Flows
A statement of cash flows-SCF- (also
referred to as the cash flow
statement) is a financial statement showing how changes in balance
sheet accounts and income affect cash & cash equivalents, and this means financial
statements that report the cash generated and spent during a specific
period of time.
In
financial accounting, a cash flow statement is a financial statement that shows
how changes in balance sheet accounts and income affect cash and cash
equivalents and breaks the analysis down to operating, investing, and financing
activities. A statement of cash flows required for each income statement
period, when a balance sheet and income statement are presented. International
Accounting Standard 7 (IAS 7).
Therefore, the purpose of the cash flows
statement is to provide
information about the cash receipt and cash disbursements.
The cash flow statement is intended to provide information
on a firm’s liquidity and solvency, improve the comparability of different
firms’ operating performance, and to indicate the amount, timing, and
probability of future cash flows.
The cash
flow statement has been adopted as a standard financial statement, because it
eliminates allocations, which might be derived from different accounting
methods, such as various timeframes for depreciating fixed assets.
The Structure of the Cash Flow Statement
and Classification of Cash Flows:
According to IASB rules cash flow statement are set out in
two standards: IAS 1 and IAS 7. Which's lays down a formal structure for the
cash flow statement. Cash flows classified under the following three standard
headings:
·
Operating activities (the inflows and outflows of cash that
result from activities in the income statement).
Inflows
of cash include the production, sales of goods or services, and delivery of
the company’s product as well as collecting payments from its customers,
interest and dividends from investment.
Outflows of cash including cash paid for purchases
inventory, salaries, wages, and other operating expenses, interest on debit,
income taxes.
Note: some revenues and expenses
(deprecation exp., don’t affect cash and not included as cash outflows from
operating activities.
The difference between inflows and
outflows is called net cash flows from operating activities.
·
Investing activities, include the inflows and outflows of cash
that related to the acquisition and disposition of long-lived assets used in
the operation of business.
Inflows of cash such as purchases of assets (land,
building, equipment, marketable securities, etc.).
Outflows of cash such as purchase of marketable
securities, acquisitions, net of cash acquired, purchases of assets (land,
building, equipment, marketable securities, etc.
Note: Net cash flows from investing
activities represents the difference between inflows and outflows.
·
Financing activities, relate to the external financing of
the company, include:
Inflows
of cash, include cash from investors, such as banks and shareholders (proceeds
from issuing long-term debt).
Outflows of cash, include cash to shareholders as
dividends as the company generates income.
In general, financing activities include,
issuance of equity, repayment of equity, payment of dividends, issuance of
debt, repayment of debt, capital/finance lease payments.
non-cash financing activities: Non-cash financing activities may
include leasing to purchase an asset, converting debt to equity, exchanging
non-cash assets or liabilities for other non-cash assets or liabilities, and
issuing shares in exchange for assets.
Purpose of Cash Flow Statement
Preparation of a
cash flow statement serves various purposes like:
·
Provide information on a firm’s liquidity and solvency and
its ability to change cash flows in future circumstances provide additional
information for evaluating changes in assets, liabilities, and equity in the
forms of cash outflows, cash inflows, and cash being held.
·
Improve the comparability of different firms’ operating
performance by eliminating the effects of different accounting methods; and
·
Indicate the amount, timing, and probability of future cash
flows.
·
Provide a view of management strategy. The information
about inflows and outflows is used by the management to discern the ability of
an organization to generate cash,
and how the funds are then used. That’s important for making long term business
plans.
·
Legal requirement. The statement of cash flows is part of
the financial statements, which also include the income statement and balance sheet.
Direct and Indirect Cash Flow Methods
Direct Method: According
to this method, the net cash flow represents the difference between the amounts
of cash received and the amounts of cash paid out from operating activities, the
direct method shows the actual cash flows from operating activities.
Indirect Method: According to this method, the net income
figure appearing in the income statement is amended by adding or subtracting
the non-cash operating activities items from the net income with
the aim of converting the net income number from the accrual basis of the cash
basis (changes in assets and liabilities accounts is adjusted in the net income
to arrive cash flows from the operating activities). Indirect method
reconciles profit before tax to cash generated from operating profit.
|
Both methods result in the
SAME AMOUNT of cash flow from operating activities. They differ in the way
they report cash flows from operating activities. |
|
|
Companies favor the INDIRECT METHOD for two reasons: 1.
Easier and less costly to prepare. 2. Focuses on differences
between net income and net cash flow from operating activities. |
|
Statement of cash flows:
Statement of cash flows includes cash flows from operating, financing and
investing activities.
Cash Flow Statement: Example
of cash flow statement (indirect method)
It is important to note that investing activity does not concern
cash from outside investors, such as bondholders or shareholders. For example,
a company may decide to pay out a dividend. A dividend is often thought of as a
payment to those who invested in the company by buying its stock. However, this
cash flow is not representative of an investing activity on the part of the
company. The investing activity was undertaken by the shareholder. Therefore,
paying out a dividend is a financing activity.
Some examples of investment activity from the company’s
perspective would include:
·
Cash outflow from the purchase of an asset
(land, building, equipment, etc.).
·
Cash inflow from the sale of an asset.
·
Cash outflow from the acquisition of another
company.
·
Cash inflow resulting from a merger.
·
Cash inflow resulting dividends paid on stock
owned in another company.
It is important to remember that, as with all cash flows, an
investing activity only appears on the cash flow statement if there is an
immediate exchange of cash. Therefore, extending credit to a customer (accounts
receivable) is an investing activity, but it only appears on the cash flow
statement when the customer pays off their debt.
Purpose of Cash Flow Statement
Preparation of a
cash flow statement serves various purposes like:
·
Provide information on a firm’s liquidity and solvency and
its ability to change cash flows in future circumstances provide additional
information for evaluating changes in assets, liabilities, and equity in the
forms of cash outflows, cash inflows, and cash being held.
·
Improve the comparability of different firms’ operating
performance by eliminating the effects of different accounting methods; and
·
Indicate the amount, timing, and probability of future cash
flows.
·
Provide a view of management strategy. The information
about inflows and outflows is used by the management to discern the ability of
an organization to generate cash,
and how the funds are then used. That’s important for making long term business
plans.
·
Legal requirement. The statement of cash flows is part of
the financial statements, which also include the income statement and balance sheet.
Direct and Indirect Cash Flow Methods
Direct Method: According
to this method, the net cash flow represents the difference between the amounts
of cash received and the amounts of cash paid out from operating activities, the
direct method shows the actual cash flows from operating activities.
Indirect Method: According to this method, the net income
figure appearing in the income statement is amended by adding or subtracting
the non-cash operating activities items from the net income with
the aim of converting the net income number from the accrual basis of the cash
basis (changes in assets and liabilities accounts is adjusted in the net income
to arrive cash flows from the operating activities). Indirect method
reconciles profit before tax to cash generated from operating profit.
|
Both methods result in the
SAME AMOUNT of cash flow from operating activities. They differ in the way
they report cash flows from operating activities. |
|
|
Companies favor the INDIRECT METHOD for two reasons: 1.
Easier and less costly to prepare. 2. Focuses on differences
between net income and net cash flow from operating activities. |
|
Statement of cash flows: Statement
of cash flows includes cash flows from operating, financing and investing
activities. Illustration 1
Cash Flow Statement: Example
of cash flow statement (indirect method) illustration 2.
It is important to note that investing activity does not concern
cash from outside investors, such as bondholders or shareholders. For example,
a company may decide to pay out a dividend. A dividend is often thought of as a
payment to those who invested in the company by buying its stock. However, this
cash flow is not representative of an investing activity on the part of the
company. The investing activity was undertaken by the shareholder. Therefore,
paying out a dividend is a financing activity.
Some examples of investment activity from the company’s perspective
would include:
·
Cash outflow from the purchase of an asset
(land, building, equipment, etc.).
·
Cash inflow from the sale of an asset.
·
Cash outflow from the acquisition of another
company.
·
Cash inflow resulting from a merger.
·
Cash inflow resulting dividends paid on stock
owned in another company.
It is important to remember that, as with all cash flows, an
investing activity only appears on the cash flow statement if there is an
immediate exchange of cash. Therefore, extending credit to a customer (accounts
receivable) is an investing activity, but it only appears on the cash flow
statement when the customer pays off their debt.
The step in preparing the statement of cash flows are as
follows:
Step 1. Find cash generated by operation by adjusting the net income as
reported on the income statement using the procedures summarized in
illustration 3.
Step 2. Identify any investing activities for example, purchases and
sales of assets (Property, Plant & Equipment or marketable securities,
etc.), loans made to suppliers or the ones received from the customer, and any
payments related to merger & acquisitions.
Step 3. Identify any Financing activities such as transactions involving long-term liabilities,
owner’s equity and changes to short-term borrowings. These activities involve
the flow of cash and cash equivalents between the company and its sources
of finance i.e. the investors and creditors for
non-trading liabilities such as long-term loans, bonds payable etc.
Step 4. Sum the subtotals for the three sections of the stamen to determent the
increase or decrease in cash and equivalents. Illustration 1
calculating operating cash flow from net income
|
Depreciation exp. |
|
Increase in
deferred taxes. |
|
Decreased in
accounts receivable. |
|
Decreased in inventories. |
|
Decreased in
prepaid exp. |
|
Increase in
payables. |
|
Loss on disposal. |
|
Depreciation in
deferred taxes. |
|
Increase in
accounts receivable. |
|
Increase in
inventories. |
|
Increase in prepaid
exp. |
|
Decreased in
payables. |
|
Gain on disposal. |
|
Net cash flow from
operating activities |
net income
Illustration 3.
Sources and references:
·
Intermediate Accounting, J.
David Spiceland; Mark W. Nelson; Wayne B. Thomas. McGraw-Hill Education; 9th
edition (February 15, 2017).
·
https://courses.lumenlearning.com/boundless-accounting/chapter/the-statement-of-cash-flows/
·
https://corporatefinanceinstitute.com/resources/knowledge/accounting/statement-of-cash-flows/
·
Anthony, R. N., Hawkins,
D., & Merchant, K. A. (2011). Accounting Texts and Cases (Vol. 13).
McGraw-Hill Education.
