Chapter 15: The Cash flow statement Flashcards
15.1 Introduction
The cash flow statement shows a business generated and spent cash during the period, it may be referred to as the statement of cash flows. As the balance sheet and P+L are accruals based, it does not show how much cash is in the business. The cash flow statement shows this.
15.2 Cash flows
The cash flow statement shows what cash has been received (cash inflows) by a business and what has been paid out (cash outflows) by a business during an accounting period. Some transactions are easy to deal with:
• Cash sales – inflow of cash into the business when received from the customer
• Cash purchases – cash outflow straight away since the business is paying for goods
• Receipt of a loan from the bank – funds direct into a bank account, cash inflow
• Repayment of a loan to the bank – outflow of cash out of the business
• Paying dividends – results in an outflow of cash from the business to its shareholders
• Receipt of dividends – inflow of cash to business from investing in activities
Other transactions have no impact on cash:
• Depreciation charges – this simply spreads the cost of a fixed asset over its useful life. Depreciation is an expense on the profit and loss account, it has no effect on cash as there is no actual outflow of cash from the business
• Credit sales – the sales income is recorded straight away but the cash in respect of the transaction is not received from the debtor until a future date. There is no receipt of cash on the point of sale, making it a non cash transaction
• Credit purchases – the purchase expense is recorded straight away but no cash is paid, the amount owed is recorded as a trade creditor. The outflow of cash will not take place until the trade creditor is paid at a future date
15.3 The purpose of the cash flow statement
Most common reason for business failure is due to the lack of cash availability rather than the lack of profitability. The cash flow statement is easy to understand and shows the liquidity of the business, shows if the business has enough cash to meets its debts. Only companies are required to produce a cash flow statement, although sole traders and partnerships can. The cash flow statement is a link between the profit in the P+L and the changes in assets and liabilities in the balance sheet.
15.4 The contents of the cash flow statement - cash flow from operating activities
Has three headings, cash flows from operating activities, investing activities and financial activities. The three headings are then compared to the change in cash and cash equivalents during the accounting period at the bottom of the cash flow statement
Cash flows from operating activities – main source of company’s cash. Cash flows from operating activities represent the cash received from sales less the cash paid for purchases of goods and other expenses relating to trade. The cash flow from operating activities is calculated using figures from the P+L and changes to the balance sheet. This working is converting the profit figure which has been calculated on the accruals basis into a profit figure calculated on a cash basis by removing any non-cash transactions. The entry is:
Cash flows from operating activities:
£
Profit before tax X
Add Depreciation expense X
Add loss on sale of fixed assets / less profits X
Add interest expense X
Less dividends received (X)
Add decrease in debtors / less increase X
Add decrease in stock/ less increase X
Add increase in creditors/ less decrease X
Cash generated from operations x
Less interest paid X
Less taxation paid X
Net cash from operating activities x
15.4 The contents of the cash flow statement - cash flow from investing activities
Cash flows from investing activities – these are acquisition and disposal of long-term assets and other investments. This includes the purchase and sale of fixed assets as well as the purchase and sale of investments such as shares or debentures in other companies.
Cash flows from investing activities £
Proceeds from sale of fixed assets and investments X
Purchases of fixed assets and investments (X)
Interest received X
Dividends received X
Net cash from investing activities x
Cash inflows such as cash proceeds from the sale of fixed assets, are shown as positive numbers and cash outflows, such as the cash purchase of a fixed asset are shown as negative numbers.
15.4 The contents of the cash flow statement - cash flow from financing activities
Cash flows from financing activities – these are activities that result in changes to the company’s equity and borrowings. This heading includes proceeds from share issues, cash proceeds from issuing debentures or increasing loans and cash payments to repay debentures and loans.
Cash flows from financing activities £
Proceeds from share issues X
Repayment of share capital (X)
Proceeds from issuing debentures/ X
increasing loans
Repayment of debentures/loans (X)
Dividends paid (X)
Net cash used in financing activities X
The cash inflow from share issues or the cash outflow from the repayment of share capital to shareholders is calculated by comparing the share capital and share premium account balances in the balance sheet at the end of this year versus last year. The cash inflows or outflows from increasing or repaying debentures and loans are also identified by comparing the debenture and loan account balances in the balance sheet year on year.
Cash and cash equivalents – the subtotals of these sections are added together to provide a figure for the net increase or decrease in cash and cash equivalents during the year. This is checked by comparing the opening figure for cash and cash equivalents with the closing figure. For exam purposes the cash and cash equivalents figure are simply the figure for bank in the balance sheet.
15.7 The Sale of fixed assets
When a fixed asset is sold the cost and accumulated depreciation of that fixed asset are removed from the books of the company and taken to a disposals T account along with sale proceeds to determine a profit or loss made on the sale. From a cash flow point of view an adjustment needs to be made for the profit or loss on the sale of a fixed asset because it is a non-cash transaction. The adjustments are in the cash flows from operating activities section where you add the depreciation expense and add the loss on the sale of the fixed asset or less the profit on the sale.
The actual sale proceeds from the fixed asset are included as a cash inflow in the cash flows from investing activities section. You add the proceeds from the sale of the fixed asset and investment and deduct the purchases of fixed assets and investments.
If fixed assets have been sold the depreciation expense is calculated as follows:
£
Accumulated depreciation on the X
balance sheet
Add: accumulated depreciation on X
fixed assets sold in the year
Less: accumulated depreciation on last (X)
year’s balance sheet
Depreciation expense X
The cost of fixed assets in the year is calculated as follows:
£
Fixed Asset cost on the balance sheet X
Add cost of fixed assets sold during the year X
Less fixed asset cost on last year’s balance (X)
sheet
Fixed asset additions during the year X
15.8 Interpreting the cash flow statement
Cash flow statement shows how a company raised cash and how it spent the cash during an accounting period. The net cash flow from operating activities shows if a company is able to generate cash from its trading activities. If the figure is not positive the company is failing to convert income into cash. A company should also be able to fund its dividend payments to shareholders from its net cash inflow from operating activities, if not the dividend payment should be reduced.
There should not be large increases in stock, debtors or creditors in the balance sheet, especially if profits are decreasing. This would put a strain on the liquidity of the business.
The investing activities section shows fixed assets and investments bought during the year. when this has been bought, we expect to see an increase in the issued share capital and/or loan finance in the financing section of the cash flow statement to fund these acquisitions. The use of short-term finance like a bank overdraft to finance such acquisitions is an inefficient use of cash within the company, as short-term finance can be expense.
An increase in share capital or loan finance without acquisitions of fixed assets or investments would be a cause for concern. If the funds have been used to finance the working capital of the company (stock, creditors and debtors), this will bring concern of the liquidity of the company.
