2- The Role of Profit and Statement of Cash flows

Question 1

What is the definition of cash?

Answer 1

Cash is defined as notes and coins in hand and deposits in banks and similar institutions

Question 2

What is the definition of cash equivalents?

Answer 2

Cash equivalents are short-term, highly liquid investments that are readily convertible to cash which are subject to an insignificant risk of change in value

Question 3

What are 4 main things cash is needed for?

Answer 3

• Pay day-to-day expenses
• Pay dividends, interest and taxes
• Repay loans
• Make investments in non-current assets, acquisitions

Question 4

What are 3 main differences between profit and cash?

Answer 4

• Cash flows arising from financing activities are not recorded in the income statement
• Revenues include sales made on credit not yet paid in cash
• Expenses are recorded when costs are incurred not when paid for

Question 5

What are 3 main things users can determine from the information in a cash flow statement?

Answer 5

• The ability of an enterprise to generate cash from its operations
• The cash consequences of investing and financing decisions
• The sustainability of an enterprise’s cash-generating capability

Question 6

What does the cash flow statement fundamentally explain?

Answer 6

The cash flow statement explains how the level of cash and cash equivalents has changed from one statement of financial position to the next

Question 7

What are the 2 methods for identifying and presenting the operating cash flow?

Answer 7

• Direct method

- Indirect method

Question 8

Describe the direct method of presenting the operating cash flow

Answer 8

Discloses separately the most important classes of gross operating cash inflows and cash outflows

Question 9

Describe the indirect method of presenting the operating cash flow

Answer 9

Net operating cash flow is determined by adjusting the net profit or loss on an accrual basis to reflect only cash receipts and outlays

Question 10

How are depreciation and amortisation handled in cash flow statements?

Answer 10

They are an allocation of a historical expense so do not entail a current outflow of cash. Therefore they are added to the profit before tax to compute cash flow (using the indirect method) simply to offset the original deduction in calculating the profit in the income statement

Question 11

How is interest expense handled in cash flow statements?

Answer 11

Interest expense is calculated on the accrual basis and so is added back to profit before tax and interest paid is deducted to compute cash flow and shown separately for clarity

Question 12

Describe cash flow from investing activities

Answer 12

Cash flow from investing activities relates to the acquisition and disposal of long term (tangible and intangible) assets and financial investments

Question 13

What is cash flow from financing activities?

Answer 13

Activities that results in changes in the size and composition of the contributed equity and borrowings of the company

Question 14

Give 3 main examples of cash flow from financing activities

Answer 14

– Proceeds from the issue of shares, bonds and loans
– Payments to redeem shares, bonds and repay loans
– Dividends paid if not included in operating activities

Question 15

What are 3 main advantages of cash flow accounting?

Answer 15

• Cash flow accounting avoids the arbitrary accounting estimates and allocations of accruals and is thus more objectively based
• Cash flow statements highlight 2 of the most vital aspects of the business: The efficiency of its financial management and its liquidity
• Cash flow statements are one of the most objective and understandable statements and are equally valuable to sophisticated and less sophisticated users

Question 16

What are 3 main disadvantages of cash flow accounting?

Answer 16

• Additional primary statements create the possibility of information overload
• Confusion over the difference between (and meanings of) cash flows and profitability
• A potential effect on organisational behaviour: maximisation of cash position for the year end accounts

Question 17

What is the fundamental difference between profit and cash flow?

Answer 17

Profit is derived on an accruals basis and not on a cash basis so will not necessarily match with the cash inflows and outflows

Question 18

What is the definition of working capital?

Answer 18

Working capital is calculated as current assets minus current liabilities and so represents a net investment in short term assets. It is also a measure of liquidity as it demonstrates a company’s ability to pay its current liabilities with its current assets