Statements of Cash Flows

CIMA-BA3 · Chapter 17

Statements of Cash Flows

A statement of cash flows (IAS 7) summarises the cash a company received and paid in the year under three headings: operating activities, investing activities and financing activities. The net total explains the change in cash and cash equivalents between the two statements of financial position. Under the indirect method the operating cash flow starts from operating profit, adds back non-cash items (depreciation, a loss on sale; a profit on sale is deducted), adjusts for the changes in inventories, receivables and payables, and then deducts interest, tax and dividends paid. The direct method reaches the same cash generated from operations from the cash received from customers less the cash paid to suppliers, employees and for other expenses.

1 Introduction

Companies are required by IAS 7 Statement of Cash Flows to include a Statement of Cash Flows in their financial statements.

In this chapter we will look at the required format and explain how to prepare a Statement of Cash Flows.

2 Description

In the first lecture the tutor gives shares bought for the short term as an example of a cash equivalent. Shares are not cash equivalents: their price can go up or down, so they cannot be turned into a known amount of cash. The definition is at the end of this section.

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A Statement of Cash Flows is simply a summary of the cash receipts and payments. The purpose is to provide users of the financial statements with more information than is provided just by the Statement of Profit or Loss and Statement of Financial Position.

For example, the company may have issued shares during the year, but the cash balance at the end of the year may be lower than at the end of the previous year. An ordinary shareholder may be puzzled by this, but maybe the explanation is that the company had very large expenditure on non-current assets. To you as an accountant, this may be obvious from inspection of the Statement of Financial Position, but a Statement of Cash Flows will make it more obvious to the shareholder.

Every cash receipt and payment falls under one of three headings. Learn them, and what goes under each:

Heading	What it shows	Typical items
Cash flows from operating activities	The cash generated by the ordinary trading of the business	Cash generated from operations (profit adjusted to cash); interest paid; income tax paid; dividends paid (or under financing)
Cash flows from investing activities	Cash spent on, and received from, non-current assets and investments	Purchase of non-current assets; proceeds from the sale of non-current assets; interest and dividends received
Cash flows from financing activities	Cash raised from, and repaid to, the providers of long-term finance	Proceeds from issuing shares; new long-term loans; repayment of loans; dividends paid (if not shown under operating activities)

The total of the three headings is the net increase or decrease in cash and cash equivalents. Cash means all cash and bank balances, less any bank overdraft; cash equivalents are short-term investments that can be turned into a known amount of cash almost at once — in BA3 questions you can treat the figure as simply cash. The increase or decrease, added to the opening balance, gives the closing balance in the statement of financial position.

3 The indirect method

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There are two approaches allowed in preparing a Statement of Cash Flows – the direct method and the indirect method. We will look at the indirect method first which is more common in practice.

Statement of Cash Flows — proforma

X plc Statement of Cash Flows for the year ended 31 December 2008

	$	$
Cash flows from operating activities
Operating profit	x
Adjustments for:
Depreciation	x
Profit on sale of non-current assets	(x)
	x
(Increase)/decrease in trade receivables	(x)
(Increase)/decrease in inventories	(x)
Increase/(decrease) in trade payables	x
Cash generated from operations	x
Interest paid	(x)
Dividends paid	(x)
Taxation paid	(x)
Net cash from operating activities		x
Cash flows from investing activities
Purchase of non-current assets	(x)
Sale proceeds of non-current assets	x
Interest received	x
Dividends received	x
Net cash from investing activities		x
Cash flows from financing activities
Proceeds from issue of shares	x
Repayment of loans	(x)
Net cash from financing activities		x
Net increase/(decrease) in cash and cash equivalents		x
Cash and cash equivalents b/f		x
Cash and cash equivalents c/f		x

The statement starts from operating profit — the profit before interest and tax. Some statements start one line lower, from profit before tax, and then add back the interest expense; the cash generated from operations is the same either way. Interest paid and tax paid are then shown as separate cash payments.

Profit is not the same as cash, for two reasons, and the operating section adjusts for both:

Non-cash items. Depreciation is an expense that involves no payment, so it is added back. A profit on the sale of a non-current asset is not a cash flow (the cash received is the sale proceeds, shown under investing activities), so it is deducted; a loss on sale is added back.
Changes in working capital. More inventory means cash spent on goods not yet used, and more receivables mean sales not yet paid for: an increase in either is deducted. More payables mean the business has kept cash by paying suppliers later: an increase is added. A decrease works the other way round.

Three figures often have to be worked out from the two statements of financial position:

Figure needed	Working
Tax paid	Tax owing at the start + tax charge for the year (statement of profit or loss) − tax owing at the end
Purchase of non-current assets	A working account for non-current assets (at carrying amount): opening balance − depreciation − carrying amount of disposals (+ any revaluation) = closing balance; purchases are the balancing figure
Proceeds from issue of shares	Increase in share capital + increase in share premium (ignoring any bonus issue, which raises no cash)

IAS 7 allows dividends paid to be shown either in operating activities, as in the proforma, or in financing activities; interest paid may also be shown under financing activities. Choose one and use it consistently.

Blair Limited — Statement of Financial Position as at 31 December

	$	2008 $	$	2007 $
ASSETS
Non-current assets		545,000		410,000
Current assets:
Inventories	90,000		81,000
Receivables	83,000		75,000
Cash	45,000		64,000
		218,000		220,000
		763,000		630,000
EQUITY AND LIABILITIES
Capital and reserves:
$1 ordinary shares		150,000		100,000
Share premium account		20,000		–
Retained earnings		476,000		431,000
		646,000		531,000
Current liabilities:
Trade payables	97,000		69,000
Tax payable	20,000		30,000
		117,000		99,000
		763,000		630,000

Statement of Profit or Loss for the year ended 31 December 2008

	$
Revenue	1,000,000
Cost of sales	(700,000)
Gross profit	300,000
Administrative expenses	(199,000)
Operating profit	101,000
Interest	(1,000)
Profit before tax	100,000
Tax	(39,000)
Profit for the year	61,000

The following information is relevant:

Administrative expenses include depreciation of $40,000.
During the year there had been sales of non-current assets for $30,000. The assets sold had originally cost $50,000 and had a carrying amount of $20,000.
Dividends paid during the year were $16,000.

Produce a Statement of Cash Flows for the year ended 31 December 2008.

Workings

Debit	(W1) Non-current assets (carrying amount)		Credit
Balance b/f	410,000	Depreciation	40,000
Acquisitions (balancing figure)	195,000	Disposals (carrying amount)	20,000
		Balance c/f	545,000
	605,000		605,000

(W2) Profit on sale = proceeds 30,000 − carrying amount 20,000 = $10,000.

(W3) Tax paid = owing at the start 30,000 + charge for the year 39,000 − owing at the end 20,000 = $49,000.

(W4) Proceeds from issue of shares = increase in share capital (150,000 − 100,000) 50,000 + share premium 20,000 = $70,000.

Blair Limited — Statement of Cash Flows for the year ended 31 December 2008

	$	$
Cash flows from operating activities
Operating profit	101,000
Depreciation	40,000
Profit on sale of non-current assets (W2)	(10,000)
	131,000
Increase in inventories (90,000 − 81,000)	(9,000)
Increase in receivables (83,000 − 75,000)	(8,000)
Increase in payables (97,000 − 69,000)	28,000
Cash generated from operations	142,000
Interest paid	(1,000)
Taxation paid (W3)	(49,000)
Dividends paid	(16,000)
Net cash from operating activities		76,000
Cash flows from investing activities
Purchase of non-current assets (W1)	(195,000)
Sale of non-current assets	30,000
Net cash used in investing activities		(165,000)
Cash flows from financing activities
Proceeds from issue of shares (W4)	70,000
Net cash from financing activities		70,000
Net decrease in cash and cash equivalents		(19,000)
Cash and cash equivalents b/f		64,000
Cash and cash equivalents c/f		45,000

The statement explains why cash fell by $19,000 (from $64,000 to $45,000) in a year with a profit of $61,000: the company spent $195,000 on non-current assets. As a check, retained earnings 431,000 + profit 61,000 − dividends 16,000 = 476,000, as in the statement of financial position.

4 The direct method

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In the previous paragraph, where we used the indirect method, we established the cash flow from operations by taking the profit from the Statement of Profit or Loss and working backwards – eliminating non-cash items and adjusting for changes in working capital.

The alternative approach is to calculate the cash flow from operations directly by taking the cash receipts from customers and deducting the cash payments. This is known as the direct method. (Note that the rest of the Statement of Cash Flows stays the same as before.)

The layout for arriving at the cash flow from operations is as follows:

	$
Cash received from customers	x
Cash payments to suppliers	(x)
Cash paid to and on behalf of employees	(x)
Other cash payments	(x)
Cash generated from operations	x

Both methods give the same cash generated from operations. Most companies use the indirect method, and almost every examination question uses it; for the direct method you need to understand what it shows and how the figures are found.

Gatis has the following Statement of Profit or Loss for the year ended 31 December 2007:

	$
Revenue	1,200,000
Cost of sales	(840,000)
Gross profit	360,000
Distribution and administrative expenses	(120,000)
Net profit before tax	240,000

The following are extracts from Gatis’s Statements of Financial Position:

	2007 $	2006 $
Current assets
Inventory	160,000	140,000
Trade receivables	259,000	235,000
Current liabilities
Trade payables	168,000	138,000

You are given the following further information:

expenses include depreciation of $36,000, irrecoverable debts written off of $14,000 and employment costs of $42,000
during the year Gatis disposed of a non-current asset for $24,000 which had a carrying amount of $18,000, the profit on which had been netted off expenses.

You are required to show:

how the cash generated from operations would be presented on the Statement of Cash Flows using the indirect method.
how the cash generated from operations would be presented on the Statement of Cash Flows under the direct method.

(a) Indirect method

	$
Operating profit (equal to profit before tax — there are no finance costs)	240,000
Depreciation	36,000
Profit on sale (24,000 − 18,000)	(6,000)
	270,000
Increase in inventory (160,000 − 140,000)	(20,000)
Increase in receivables (259,000 − 235,000)	(24,000)
Increase in payables (168,000 − 138,000)	30,000
Cash generated from operations	256,000

The irrecoverable debts are not adjusted separately: the receivables figures are already after the write-off, so the change in receivables takes care of them.

(b) Direct method

	$
Cash received from customers (235,000 + 1,200,000 − 259,000 − 14,000)	1,162,000
Cash paid to suppliers (W)	(830,000)
Cash paid to employees	(42,000)
Other cash payments (120,000 − 36,000 − 14,000 − 42,000 + 6,000)	(34,000)
Cash generated from operations	256,000

(W) Purchases = cost of sales 840,000 + closing inventory 160,000 − opening inventory 140,000 = 860,000. Cash paid to suppliers = opening payables 138,000 + purchases 860,000 − closing payables 168,000 = $830,000.

Other cash payments: of the $120,000 expenses, depreciation (36,000) and irrecoverable debts (14,000, already deducted from cash received) involve no payment, and employment costs (42,000) are shown on their own line; the $6,000 profit on sale had been netted off the expenses, so it is added back to find the cash actually paid. Both methods give $256,000.

5 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.

Answer the questions one at a time. Your progress is saved so you can leave and come back.

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