CASH FLOW STATEMENT

• The third financial statement to compliment the

balance sheet & Income statement by providing
information on major sources of cash receipts &
payments.

• Purpose of CFS is to identify cash flows

associated with the period’s operations and also
about the investing & financing activities during
the period.
Income Statement & Balance sheet
are prepared on Accrual Basis

• Income Statement

• Key concepts in measurement of period’s

income are ‘Revenue Recognition’ & the
‘Matching of Expenses’.
 Income Statement (Revenue
Recognition)…….
• i) Revenue is recognized in the period in
which the entity performs revenue-
generating tasks (e.g.: delivering goods &
rendering services);

• ii) irrespective of the fact that customer

pays cash at that time or agrees to pay
later.
 Income Statement (Expense
Measure)…….

• Expenses measure the resources

consumed in generating periods revenue
and in administering the entity during the
period irrespective of when cash was used
to pay for these resources.
 Income Statement …….

• Thus, period’s income through I/S bears

no direct relationship to the cash flows
associated with period’s operating,
investing of financing activities of the
organization.
 Observations
• Companies collapsed only months after their
financial statements showed that they were
managing good profits.
• (Nirlon & Machinery Manufacturer Corpn. In
1980s, W.T.Grant Company in 1970s).

• It is because there has always been a great

difference between a company’s earnings &
cash generated from operations.
 Cash Flow Statement
• Requirement of Cash Flow Statement
• FASB, USA – 1988
• ASB, UK – 1992
• ASB, India – 1997 – (AS-3)
• International Accounting Standard - 1992
 Sources & Uses of Cash
• Activities that the CFS describes can be
categorized to (1) activities that generate cash
i.e. Sources; & (2) activities that spend cash i.e.
Uses of cash.
• Sources: Operations, New borrowings, New
issue of stocks, Sale of fixed assets i.e. property,
plant & equipment etc.
• Uses: Cash dividends, Repayment of
borrowings, Repurchase of stocks, Purchase of
fixed assets etc.
 Important Terms
• CASH: refers to currency on hand,
demand deposits with banks or F.I.s &
other accounts that let the customers
deposit & withdraw funds at any time.

• CASH EQUIVALENTS: Refers to short-

term, highly liquid investments when it has
an original maturity of 3 months or less.
 OPERATING ACTIVITIES
• Principal revenue generating activities of the
firm.

• Operating cash inflows: Include receipts from

customers for sale of goods or services
(including collection of debtors).

• Operating cash Outflows: Include payments to

suppliers for purchase of materials & services,
payments to employees for services, &
payments to government for taxes & duties.
 Computation of Cash flow from
Operating Activities
• DIRECT METHOD
• Cash received from customers
• Less, Cash paid to suppliers & employees
• Cash generated from operations
• Less, Income Tax paid
• Cash flow before extra-ordinary item
• Less, Extra-ordinary item
• Net cash flow from Operating Activities
 Notes to Computation
(Direct Method)

• Cash Received from Customers:

• (Sales + Decrease in Debtors (Gross) –
Bad Debts written off – Increase in
debtors)
 Notes to Computation
(Direct Method)
• Cash Paid to Suppliers & Employees:
• COGS + Selling & Admn. Exp –
Depreciation Exp (if included in COGS) –
Bad Debts Exp (if included in S&A Exp) +
Increase in Inventory / Prepaid exp -
Decrease in Inventory / Prepaid exp –
Increase in B.P/ Creditors + Decrease in
B.P/ Creditors
 Notes to Computation
(Direct Method)
• Income Tax Paid:
• Income tax expenses + Decrease in
Income Tax Payable – Increase in Income
Tax Payable
• Extra ordinary item should be shown
separately, from operating cash inflows
and outflows.
 Computation of Cash flow from Operating
Activities
INDIRECT METHOD

• It starts with net profit & adjusts it for

revenue & expense items that did not
involve operating cash receipts or
payments in the current period to arrive at
Net Cash flows from Operating Activities.
 INDIRECT METHOD
• To use Indirect Method, start with net income and adjust
it for non-cash items like gains, losses & depreciation
expenses.

• Then, make adjustments for all of the changes in CAs &

CLs that occurred during the year (except Dividends
Payable, which will be related to Financing Cash flows).

• Increase in CA (-) from Net Income

• Decrease in CA (+) to Net Income
• Increase in CL (+) to Net Income
• Decrease in CL (-) from Net Income
 INDIRECT METHOD

• Net Profit
• ADD: Depreciation/Amortization, Bad Debts; Loss on
Sale of Fixed assets/ Investments; Decrease in
(Inv/A.R/Pre-paid Expenses); Increase in (Creditors/
Payables*)
• DEDUCT: Excess provision for Depreciation written
back; Gain on Sale of Fixed assets/ Investments;
Increase in (Inv/A.R/Pre-paid Expenses); Decrease in
(Creditors/ Payables*)
• Net Cash flows from operating Activities
• * Includes Accounts, Wages, Interest and Taxes
payables but does not include Notes Payable or Current
portion of long-term debt.
DIRECT vs. INDIRECT Method
• ASB recommends Direct method as:
• It is easier to understand, &
• Provides information useful in estimating
future cash flows.
• On the contrary, Indirect method is
followed by a majority of firm as it is easier
to prepare.
 INVESTING ACTIVITIES
• Involve purchase & sale of fixed assets &
investments.
• Cash receipts & payments are calculated
by analyzing changes in the two Balance
sheet amounts for F.As & Investments &
the cash effect of transactions took place
during the year.
• Interest & dividends received are also
cash inflows from investing activities.
 FINANCING ACTIVITIES
• Involve raising of capital & repayment of
loan.
• Cash inflows & outflows are computed by
analyzing the changes in the B/S items for
shareholders’ equity & loan funds; &
considering cash effect of transactions
took place during the year.
• Interest & dividends paid are a part of
Financing activities of a firm.
 PREPARATION OF CASH FLOW
STATEMENT
• CFS is prepared by putting together the cash
flows from Operating, Investing & Financing
activities.
• The CFS does not include certain financing and
investing activities that do not cause a change in
cash, viz. purchase of fixed assets with a long-
term mortgage note or the conversion of
debenture into common stock.
• However, these non-cash transactions are
supplementally disclosed so as to give a full
picture to investing and financing activities.
 Summary of Preparation
Procedures - Steps
1. From the company’s balance sheet, enter the
beginning and ending balance of each account & the
change in each account’s balance on a worksheet.
2. For each account (other than Cash), analyze the
nature of the transactions causing the amount of net
change, &
3. Classify the change from each such transaction as
either Cash from Operations, Cash from Investment, or
Cash from financing activities.
4. This analysis will require reference to the Income
Statement (e.g., to explain the change in Retained
Earnings), and, in some cases, to other financial
records of the company.
5. Put them in appropriate format.
 Using Cash flows to Evaluate
Performance
1. Free Cash Flow: Provides a measure of firm’s
ability to engage in long-term investment
opportunities & a firm’s financial flexibility.
• Net Cash flow from Operating Activities - Cash
Dividends - Capital Expenditure = Free Cash
flow.
2. Cash Flow Adequacy Ratio: defined as cash
from operating activities divided by net cash
required for investing activities – measures firm’s
ability to generate the cash it needs for investing
activities from operations.
 Using Cash flows to Evaluate
Performance
3. Current Cash Debt Coverage Ratio:
measures firm’s ability to generate the
cash it needs in the short-run; calculated
as net cash provided by operations divided
by average current liabilities.