32 Cash Flow Statement: Meaning, Needs, Preparation and Interpretation

Deepika Gautam

LEARNING OBJECTIVES:

After going through the module, students may be able to gain clarity on the meaning of cash flow statement, its need and ways of preparation. Interpretation of cash flow statement will also be made clear in the minds along with the limitations of cash flow statement.

INTRODUCTION:

Cash, the life blood of any organisation is considered a vital part in the working, smooth functioning and entire economic life of any organisation. A firm needs cash for day to day operations (such as payment to its suppliers, payment of wages, salaries, interest, dividend etc), as well as for the long term operations. Without cash any firm will not be able to survive for long and will collapse within some period itself. It is essential that every firm maintains an adequate balance of cash for its smooth functioning. But, sometimes even though a concern is showing profits, it may not be able to pay its dividends and taxes. This may be due to- (i) profits earned but cash not received as yet. (ii) cash may be drained out (used) for some other purpose.

In order to avoid this situation, proper record of cash is maintained by every concern, to see the changes in the cash balances between two balance sheet dates. This recorded statement is termed as a cash flow statement. It is prepared as a complementing information with the income statement and balance sheet.

MEANING OF CASH FLOW STATEMENT:

Cash flow statement is a record of inflows and outflows of cash and cash equivalents in an enterprise during a specified period of time. Cash comprises of cash in hand and demand deposits with banks. Whereas, cash equivalents are short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to insignificant risk of changes in value. Example: marketable securities, short term investments.

A cash flow statement also known as statement of cash flows summarises the causes of changes in cash position of a business enterprise (both inflow and outflow), and breaks the analysis down to operating, investing and financing activities. The cash flow statement reports the cash generated and used by an enterprise during a specified time interval. Time interval may vary from 3 months to one complete year. In short, cash flow statement reveals the flow of cash. Flow of cash is said to have taken place when any transaction modifies the amount of cash and cash equivalents as compared to that available before the happening of that transaction. If the cash amount increases, it is said to have cash inflow and vice verse.

CLASSIFICATION OF CASH FLOWS:

Cash flow statement is prepared by classifying the incoming and outgoing of cash in an organisation into three different categories. The statement of cash has three distinct sections:

1) Operating Activities: includes revenue producing activities.

2) Investing Activities: includes activities from purchase/sale of long term investments and property.

3) Financing Activities: reports issuance and repurchase of companies own bonds and stocks and the payment of dividends.

QUICK REVISION

▪What blood is to human body, cash is to an organisation.

▪Cash flow statement is a statement reflecting inflows/outflows of cash and cash equivalents within a specified time period.

▪Cash flow statement is prepared on cash basis of accounting.

▪Cash flow statement is prepared as a complementary information to income statement and balance sheet.

▪Cash flows are classified into operating, investing and financing activities.

NEED FOR PREPARING CASH FLOW STATEMENT:

Unlike the income statement i.e. prepared under the accrual basis of accounting, means the revenue reported may not have been collected and expenses reported may not have been paid. The cash flow statement is prepared on cash basis of accounting and these facts are clearly integrated and presented in the cash flow statement.

Moreover, the need to prepare cash flow statement arose to know the frequent changes in cash (inflows and outflows both ways) and hence deciding upon the short term cash planning of the firm. Further, in order to judge the liquidity position of the firm i.e. the short term paying capacity, Cash flow statement is prepared and the information so presented is used up by the company as well as the investors.

In order to know how various activities such as building inventory, letting receivables grow, paying suppliers more quickly and paying bank loans, affect the cash, CFS (cash flow statement) is prepared as it reveals the current cash position of the organisation, and serves as a map that reveals where cash came from and where it went.

Cash flow statement preparation is also needed to find whether a business is running out of money, even if it is profitable at the same time. This may happen, if cash is tied up in accounts receivables or company is relying too much on bank financing.

QUICK REVISION

▪Cash flow statement is prepared as per AS 3 (revised).

▪cash flow statement is needed:

To know the liquidity position

To find how frequently cash is changing

To reveal if business is running short of money

To study the effect of various activities on cash

PREPARATION OF CASH FLOW STATEMENT:

Cash flow statement is not a substitute for profit and loss account and balance sheet, but serves as a complementing information with these accounts and by giving additional information explains the reasons for the changes in cash and cash equivalents.

Earlier under Companies Act, 1956, presentation of cash flow statement along with the final accounts was not mandatory, but the revised Companies Act, 2013 made cash flow statement a mandatory part of the financial statement. As per section 2(40) of the Companies Act, 2013 “financial statements” in relation to a company, includes-

1) A balance sheet as at the end of the financial year.

2) A profit and loss account, or in the case of a company carrying on any activity not for profit, an income and expenditure account for the financial year.

3) Cash flow statement for the financial year.

4) A statement of changes in equity, if applicable and

5) Any explanatory note annexed to or forming part of, any document.

Since the Companies Act, 2013, does not lay down any format for preparation of cash flow statement, companies will need to follow AS 3 in this regard. In case of the listed companies, the listing agreement requires the indirect method of preparing cash flow statement. Whereas, the non listed companies will have a choice of either applying direct or indirect method for preparation of cash flow statement. Cash flow statement can be prepared either by-

1) Indirect Method

2) Direct Method

INDIRECT METHOD

This method is also known as reconciliation method as it involve reconciliation of net profit or loss as given in profit and loss account and the net cash flow from operating activities as shown in the cash flow statement. Net profit or loss before taxation and dividend is adjusted for non cash and non operating items which have been debited or credited to profit and loss account.

Statement of cash flows for the year ended Dec 31, 2014 (as per AS 3)

(ii) Cash flow from Investing Activities

		xxx
Add :		xxx
Proceeds from sale of fixed assets	xxx
Proceeds from sale of investments	xxx
Proceeds from sale of intangible assets
Interest and dividend received	(xxx)
		(xxx)
Less :		(xxx)
Rent income		(xxx)	xxx
Purchase of fixed assets
Purchase of investment			XXXX
Purchase of intangible assets like goodwill
Advanced extraordinary items (+/–)
NET CASH INFLOW / OUTFLOW FROM INVESTING ACTIVITIES
		xxx
(iii)	Cash flow from financing activities:	xxx
Add :
Proceeds from issue of shares and debentures
Proceeds from other long term borrowings/ loans	(xxx)
		(xxx)
		(xxx)
Less :		(xxx)
Final dividend fund	(xxx)
Interim dividend fund	(xxx)
Interest on debentures and loans paid			XXXX
Repayment of loans
Redemption of debenture preference shares			XXXX
Adjust extraordinary items (+/–)
NET CASH INFLOW / OUTFLOW FROM FINANCING ACTIVITIES	xxx
		xxx
*(iv)*	*Net increase/Decrease in cash and cash equivalent ( i+ ii + iii)*	xxx
(v)	Add : Cash and Cash Equivalents in the beginning of the year	xxx

Explanation to the Indirect method:

1) The preparation is started with the amount of net profit as per profit and loss account or the difference between the opening and closing balance of profit and loss account.

2) Transfer to reserve (difference between current and previous year), proposed dividend (for the current year), Interim dividend and extraordinary items (if debited to profit and loss account) are added to the net profit.

3) Extraordinary items include insurance proceeds from earthquake disaster settlement, bad debt recovered, winning of lottery, loss due to theft or by fire etc.

4) Extraordinary items (if credited to profit and loss account) and refund to tax (if credited to profit and loss account) are subtracted in order to get net profit before taxation, dividend and extra ordinary items.

5) Adjustments for non cash and non operating items such as depreciation, preliminary expenses, loss on sale of fixed assets, interest received, dividend received etc are made, hence arriving at the operating profit before working capital changes.

6) Adjustments related to changes in current assets and liabilities are made to the earlier arrived operating profit.

7) Items which lead to decrease in current asset and increase in current liabilities (such as expenses accrued, increase in creditors, decrease in debtors) are added.

8) Items which increase the current assets and decreases current liabilities are subtracted (such as earned income, increase in stock, increase in bills receivable and income received in advance).

9) The net result is the cash generated from operations from which the paid income tax is subtracted.

10) The net result is the cash inflow/outflow from operating activities.

11) Next step is to find cash flows from investing activities.

12) Transactions which lead to an increase in the cash balance (such as sale of fixed assets, sale of investments, intangible assets and interest/dividend received) are added.

13) Whereas, those leading to decrease (outflow) in the cash such as purchase of fixed assets, investments, intangible assets are subtracted. The net result being net cash inflow/outflow from investing activities.

14) Next involves adjusting the financing activities by adding proceeds (inflow) from issue of shares and debentures and other long term borrowings. And subtracting those which decrease the cash balance such as dividend declaration and loan repayment.

15) Further, to find the net increase/decrease in cash and cash equivalents amounts of all the activities are summed up and to which cash and cash equivalents at the beginning and end are added and subtracted respectively.

16) By adjusting the above items, the net proceeds (inflow/outflow) of cash for one specified period are determined.

QUICK REVISION

▪ Only listed companies are required to prepare CFS under indirect method, as per AS 3

▪ As per Companies Act, 2013, preparation of CFS has been made mandatory for the companies.

▪ Indirect method is also known as reconciliation method, as it reconciles the net profit as per profit and loss account and the net cash from operating activities.

▪ The accounting period for the cash flow statement is the same for which profit and loss account and balance sheet are prepared.

DIRECT METHOD

As per AS 3 (revised) non listed companies are given a choice to follow direct method or indirect method. This method is straightforward and easy to follow. It sorts all the company transactions and summarises them into categories of operating cash receipts and operating cash payments.

Statement of cash flows for the year ended Dec 31, 2014 (Direct Method)

Explanation to the direct method:

1) While following the direct method, net profit as per profit and loss account is not taken into consideration. The sum total of operating cash receipts subtracted from cash payments brings us to the cash generated from operations.

2) Cash receipts include cash received from customers, royalties received, trading commission received etc.

3) Cash payments include cash paid for office expenses, manufacturing expenses and selling and distribution expenses.

4) Adjustments for depreciation, amortisation of fictitious & intangible assets, gain or loss on sale of fixed assets & investments, and transfer of general reserve are not made because operating cash receipts and payments are reported directly on the cash flow statement.

5) The remaining steps for calculating cash flows from investing and financing activities are same as that under the indirect method. The only difference between these two methods is the dealing with the operating activities and the steps involved in obtaining the cash inflow/outflow from operating activities.

QUICK REVISION

▪Under direct method cash receipts from operating revenues and cash payments from operating expenses are calculated to arrive at cash flows from operating activities.

▪The gross cash receipts and payments may be obtained from accounting records of the enterprise.

▪There is no need to make any adjustments for depreciation, amortisation of fictitious & intangible assets, transfer to general reserve etc under direct method.

TREATMENT OF SOME SPECIAL ITEMS:

1) Payment of Interim Dividends: the amount of interim dividend paid during the year is shown as cash outflow. It will be added back to the profits for the purpose of calculating cash inflow/outflow from operating activities.

2) Proposed Dividend: it is always declared in the general meeting after the balance sheet preparation. As it is a non operating item, it is added back to the current year profit and payment paid during the year in respect of dividends is shown as cash outflow.

3) Purchase/Sale of fixed assets: the balance of fixed asset appearing on two balance sheet dates

helps in deciding whether the asset has been sold or purchased. Example: if plant and machinery appears at Rs 80000 in the current year and Rs 60000 in the previous year. In absence of any additional information it would mean purchase of fixed asset. And Rs 20000 would be shown as outflow of cash.

4) Provision for taxation: it is a non operating expense in the income statement and profit and loss account. If the profit is given after tax and provision for taxation is made during the year, the amount would be added back to the current year profit. Tax paid would be recorded separately as an outflow of cash. Sometime the only information about provision for taxation is the amount in opening and closing balance sheet. In such a case, the figures appearing in the opening balance sheet is treated as an outflow of cash hence subtracted, while figure in closing balance sheet is considered as a non cash expense and added back to the net income, to find cash from operating activities.

5) Acquisition & Disposals of subsidiaries and other business units: the cash flows arising from acquisitions and disposals of subsidiaries or other business units should be presented separately and presented under investing activities. Business unit should disclose the total purchase or disposal consideration & portion of the purchase or disposal consideration by means of cash and cash equivalents.

INTERPRETATION OF CASH FLOW STATEMENT:

Cash flow statement provides us with an important information about firm’s financial health and reveals from where the cash is coming in and where it is being utilised. It shows how a firm raises capital and how it spends funds during a given period.

Certain points of interpretation are listed below:

1) If a firm has more inflows than outflows, it is an indication that the firm has an ability to increase its dividend payments, repurchase its stocks or reduce its debts. All this is a positive indication for the firm.

2) Higher “operating cash flow to net sales” reveals that the company is earning more cash by selling its products during a given period.

3) Cash flow from operating activities is a key indicator of the extent to whether the operations have generated sufficient cash to maintain the operating capability of any enterprise or not. So the positive and higher the cash flow from operating activities, the better it is for the firm and thus indicating a good sign of potential growth.

4) In case the firm reports growth on its income statement, but has a negative cash flow, it may be interpreted as the firm lacking the ability to translate its growth into cash. Hence the firm may face liquidity problems and default on their short term liabilities.

5) If cash flows from investing activities shows a negative balance, it would mean that enough cash is generated to invest in non-current assets and that the firm is aiming to replace its obsolete technology and trying to keep up with latest trends.

6) Cash flows from financing activities is an indicator about the increase/decrease in the debt over the firm and also about its dividend paying capacity. A positive balance would mean cash is raised by issuing share capital or through long term borrowings and less emphasis is laid on repaying the debts or declaring the dividends.

7) Basically, if a firm is generating more cash than it is using, that firm is considered to be of good financial standing.

Interpreting cash flow statement becomes an easy task, if interpreted in comparison with the income statement and the balance sheet, this is the reason why cash flow statement is not a substitute but a complementary support with the income statement and the balance sheet, and provides additional information to the investors.

QUICK REVISION

▪ Interim dividend paid is treated as cash outflow and added back to the profits.

▪ Proposed dividend being a non operating item is added back to current year profit.

▪ Balances of fixed asset in two balance sheet dates, reveals whether it has been purchased or sold.

▪ Cash from acquisition/disposal from subsidiaries is shown separately & included under the investing activities.

▪ More cash inflows means increase in the ability of the firm to pay out its dividends, reduce debt and repurchase its bands/shares.

Let us now study a hypothetical cash flow statement in order to deepen the understanding of how to interpret it:

Statement of cash flows for the year ended Dec 31, 2014 (Direct Method)

An analysis of the cash flow statement reveals that the company is profitable. Cash received from customers lead to an inflow of cash, means that there is a decrease in debtors, which arose due to credit sales. Therefore, indicating better collection efforts by the company. Increase in creditors is a sign that suppliers are confident in the company and willing to give interest free financing.

The analysis of investing activities reveals that company is involved in purchasing more land and building. Though it is showing a negative balance still it means that company is utilising its money to invest in land and building and trying to overcome the obsolete machinery and trying to expand the business.

Cash balance from financing activity reveals that the cash flow from operating activities is used in paying the cash dividend to its shareholders. And that money is also being raised by issuing bonds in the market.

Overall, there is a decrease in the cash balance by Rs 8500. But this should not raise the alarm because of company’s profitability and the fact that cash was used for its expansion by purchasing land, building and was utilised for paying out cash dividends.

LIMITATIONS OF CASH FLOW STATEMENT

Though cash flow statement serves as a guide to many investors and reveals many hidden facts about companies it is suffering from many limitations-

1) Cash flow statement is prepared under the cash basis of accounting, therefore it ignores the basic accounting concept of accrual basis.

2) It is not suitable for judging profitability of any concern as it does not take into consideration the non cash charges.

SUMMARY

Cash is the fuel which helps the engine of business to run for a longer period of time. Cash is essential for the smooth functioning of the business, without adequate cash no firm will be able to function for long. For adequate maintenance of cash, proper record of the incoming and outgoing of cash is kept, this is done in the form of cash flow statement.

Cash flow statement means a guide map which guides the organisation about the changes in cash balances over a specified period of time. It summarises the cash moment into three categories of operating, investing and financing activities. As per Companies Act 2013 it is a mandatory procedure to present cash flow along with its financial accounts. Though no prescribed format is set for the same, the listed companies as per AS 3 are bound to follow the indirect method for cash statement preparation, whereas non listed companies are given an option to follow either direct or indirect method for preparation.

The only difference between these two methods is the calculation of cash flows from operating activities. In direct method the items are simply classified between cash receipts and cash payments, and calculations are made to get the cash flows. Whereas in indirect method, adjustments for depreciation, provision for taxation, loss/profit on sale of patents etc are also made.

The need for preparing cash flow statement is realised in order to judge the liquidity position of the firm, to find how frequently cash is changing, to find the incoming sources of cash and find where it is being utilised. It also reveals if the firm is running out of cash or not.

Despite of its importance, it is not considered adequate for judging the profitability as it ignore the accrual basis of accounting and ignores the non cash charges while calculating cash flow from operating activities.

you can view video on Cash Flow Statement: Meaning, Needs, Preparation and Interpretation

SUGGESTED READINGS

S.H.Penman, “Financial Statement Analysis and Security Valuation”, McGraw Hill (India),2014
T.Ittelson, “Financial Statements”, Career Press, 2008

Points to Ponder

1) Cash is the fuel which helps the engine of business to run for a longer period of time.

2) Cash is essential for the smooth functioning of the business, without adequate cash no firm will be able to function for long.

3) For adequate maintenance of cash, proper record of the incoming and outgoing of cash is kept, this is done in the form of cash flow statement.

4) Cash flow statement means a guide map which guides the organisation about the changes in cash balances over a specified period of time.

5) It summarises the cash moment into three categories of operating, investing and financing activities.

6) As per Companies Act 2013 it is a mandatory procedure to present cash flow along with its financial accounts.

7) The listed companies as per AS 3 are bound to follow the indirect method for cash statement preparation, whereas non listed companies are given an option to follow either direct or indirect method for preparation.

8) The need for preparing cash flow statement is realised in order to judge the liquidity position of the firm, to find how frequently cash is changing.

9) It is prepared to find the incoming sources of cash and find where it is being utilised. It also reveals if the firm is running out of cash or not.

10) It ignores the accrual basis of accounting and ignores the non cash charges while calculating cash flow from operating activities, hence not considered adequate to judge the profitability.