Cash Flows

Question 1

What is the objective of the Statement of Cash Flows, and explain what each section of the statement represents.

Answer 1

The Statement of Cash Flows analyses the movement of cash during the year. This is important as cash is the oxygen of an organisation. It is also a tool for liquidity analysis. More so, this statement bridges the gap between the SOPL and the SOFP, as it provides information that is absent in other statement. The cash flows statement includes cash movement from investing and financing activities whereas the income statement excludes these items since it focuses on operations.

It is split into 3 section:
1. Operating activities - the section where we switch from an accrual to a cash basis. This is done by adjusting PBIT with depreciation, working capital changes and cash used to pay interest and dividends.

2. Investing activities - focuses on purchases and disposals of NCA
3. Financing activities - focuses on proceeds/repayments of loans, capital or debentures

Question 2

Give TWO reasons why the Statement of Cash Flows is important to stakeholders.

Answer 2

1. Shows the availability of cash for the payment of dividends
2. Shows liquidity - the short-term survival of the business
3. Helps in the diagnoses where cash problems stem from, whether they are attributable to operating activities, investing or financing activities.
4. Corrects liquidity problems by planning action to remedy particular cash flow difficulties.

Question 3

How can a firm is making a profit, but have a diminishing bank/cash account?

Answer 3

A business may be earning a profit but the cash and cash equivalents balances diminishes. The reasons are:

• Net Profit is calculated on an accrual basis and therefore, to arrive at the cash generated from operations adjustments are required for:

1. Non-cash SOPL, like depreciation
2. Working capital changes, such as inventories receivable and payments.

• Cash payments for investing activities diminish the cash but only depreciation is entered in the calculation of profits
• Cash flows from financing activities will not affect Net Profit. Revenue generated from an issue of shares will only increase the cash, whilst the payment of a NCA will only decrease the cash.