Unit II - Cash Flow Statement

FINANCIAL STATEMENT ANALYSIS
UNIT II
INTRODUCTION TO CASH FLOW STATEMENT
Learning Objectives
 Understanding concept of cash flow
 Accounting standard for Cash Flow Statement (AS-3)
 Preparation of Cash Flow Statement
 Importance & Limitations of Cash Flow Statement
CASH FLOW STATEMENT

In financial accounting, a cash flow statement, also known as statement of cash flows, is a
financial statement that shows how changes in balance sheet accounts and income
affect cash and cash equivalents, and breaks the analysis down to operating, investing and
financing activities.
Cash Flow Statement gives information about cash receipts (sources) and cash payments
(application). It contains opening balances & closing balances of cash for a given period and
explains how the closing balance as per last balance sheet changed by various inflows &
outflows of cash to a closing balance of cash as per the next balance sheet. As per AS-3, cash
would include cash in hand and savings, current a/c balances with banks & cash equivalents.
Cash equivalents are short term & highly liquid investments that are readily convertible into
cash. An investment would normally be called a cash equivalent only when it has a short term
maturity of say 3 months or less from the date of acquisition.
Analysis of Cash Flow Statement

The cash flow statement is distinct from the income statement and balance sheet because it does
not include the amount of future incoming and outgoing cash that has been recorded on credit.
Therefore, cash is not the same as net income, which, on the income statement and balance sheet,
includes cash sales and sales made on credit. Cash flow is determined by looking at three
components by which cash enters and leaves a company: core operations, investing and
financing,
Operations
Measuring the cash inflows and outflows caused by core business operations, the operations
component of cash flow reflects how much cash is generated from a company's products or
services. Generally, changes made in cash, accounts
receivable, depreciation, inventory and accounts payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net income by adding or subtracting
differences in revenue, expenses and credit transactions (appearing on the balance sheet and
income statement) resulting from transactions that occur from one period to the next. These
adjustments are made because non-cash items are calculated into net income (income statement)
and total assets and liabilities (balance sheet). So, because not all transactions involve actual cash
items, many items have to be re-evaluated when calculating cash flow from operations.
For example, depreciation is not really a cash expense; it is an amount that is deducted from the
total value of an asset that has previously been accounted for. That is why it is added back
into net sales for calculating cash flow. The only time income from an asset is accounted for in
CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from one accounting period to the next must
also be reflected in cash flow. If accounts receivable decreases, this implies that more cash has
entered the company from customers paying off their credit accounts - the amount by which AR
has decreased is then added to net sales. If accounts receivable increase from one accounting
period to the next, the amount of the increase must be deducted from net sales because, although
the amounts represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals that a company has spent more money to
purchase more raw materials. If the inventory was paid with cash, the increase in the value of
inventory is deducted from net sales. A decrease in inventory would be added to net sales. If
inventory was purchased on credit, an increase in accounts payable would occur on the balance
sheet, and the amount of the increase from one year to the other would be added to net sales.
The same logic holds true for taxes payable, salaries payable and prepaid insurance. If something
has been paid off, then the difference in the value owed from one year to the next has to be
subtracted from net income. If there is an amount that is still owed, then any differences will
have to be added to net earnings.
Investing
Changes in equipment, assets or investments relate to cash from investing. Usually cash changes
from investing are a "cash out" item, because cash is used to buy new equipment, buildings or
short-term assets such as marketable securities. However, when a company divests of an asset,
the transaction is considered "cash in" for calculating cash from investing.
Financing
Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash
from financing are "cash in" when capital is raised, and they're "cash out" when dividends are
paid. Thus, if a company issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders, the company is reducing its cash.
Major Cash Inflows

• Issue of new shares for cash
• Receipt of short term & long term loans from banks, financial institutions etc
• Sale of assets & investments, Dividend & Interest received,
• Cash generated from operations
Major Cash Outflows

• Redemption of preference shares, Purchase of fixed assets or investments
• Repayment of long term and short term borrowings
• Decrease in deferred payment liabilities, Loss from operations
• Payment of tax, dividend etc.
Classification of Activities
As per AS-3 the cash flow statement should report cash flows during the period classified by
• OPERATING ACTIVITIES
• INVESTING ACTIVITIES
• FINANCING ACTIVITIES
CASH FLOW FROM OPERATING ACTIVITIES

• The cash flows generated from major revenue producing activities of the entities are
covered under this head.
• Cash flow from operating activities is the indicator of the extent to which the operations
of the enterprise have generated sufficient cash to maintain the operating capability to
pay dividend, repay loans & make new investments. Main Examples are
• Cash receipts from sale of goods & services
• Cash receipts from royalties, fees, commission etc
• Cash payments to employees
• Cash payments or refunds (receipt) of income tax
• Cash receipts & payments relating to future contracts, forward contract etc
• Cash receipts and payments arising from purchase and sale of trading securities
CASH FROM INVESTING ACTIVITIES

• These are the acquisition and disposal of long term assets and other investments not
included in cash equivalents. This represents the extent to which the expenditures have
been made for resources intended to generate future incomes & cash flows, Examples are
• Cash payments for purchase of fixed assets
• Cash receipts from sale of fixed assets
• Cash payments for purchase of shares/debentures etc. in other entities
• Loans and advances given to third parties
• Repayments of loans given
CASH FROM FINANCING ACTIVITIES

• Financing activities are the activities that result in changes in the size and composition of
the owner’s capital and borrowings of the enterprise.
• Separate disclosure is important because it is useful in predicting claims on future cash
flows by providers of funds
• Examples
• Cash receipts from issue of share capital , debentures & short term & long term loans
• Cash Repayments of loans borrowed
• Cash payment to redeem preference shares
BENEFITS/IMPORTANCE OF CASH FLOW ANALYSIS
• Efficient Cash Management – manage the cash resources in such a way that adequate
cash is available for meeting the expenses
• Internal Financial Management – useful for internal financial management as it
provides clear picture of cash flows from operations
• Knowledge of change in Cash Position – It enables the management to know about the
causes of changes in cash position
• Success or Failure of Cash Planning – Comparison of actual & budgeted cash flow
helps the management to know the success or failure in cash management
• It is a supplement to fund flow statement as cash is a part of fund
• Cash Flow Statement is a better tool of analysis for short term decisions
LIMITATIONS OF CASH FLOW ANALYSIS

• Misleading Inter Industry Comparison - Cash flow does not measure the economic
efficiency of one company in relation to another company
• Misleading Inter Firm Comparison - The terms & conditions of purchases & sales of
different firms may not be the same. Hence inter firm comparison becomes misleading
• Influence of Management Policies – Management policies influence the cash easily by
making certain payments in advance or by postponing certain payments
• Cannot be equated with Income Statement – Cash flow statement cannot be equated
with income statement. Hence net cash flow does not mean income of the business
• CFS cannot substitute the B/S & Funds Flow.
Accounting Standard – AS3 on Cash Flow Statement

Objective of AS-3 is to provide desired information about historical changes in cash & cash
equivalents of an enterprise classified in to Operating, Investing and Financing activities.
• An enterprise should disclose the components of cash and cash equivalents and should
present a reconciliation of the amount in the cash statement with the equivalent items
reported in the balance sheet
• An enterprise should disclose the amount of cash & cash equivalent balance held by the
enterprises that are not available for use by it with explanation of Management
DISTINCTION BETWEEN CASH FLOW V/S FUNDS FLOW
Practical Sums
Key Terms:
Cash – It includes cash and demand deposits with Banks
Cash Equivalents – These are short term and highly liquid investments
Cash Flows – It is movement of cash
Non Cash Expenses – These are the expenses which do not involve any cash payment
Revenue Activities - These are the activities which are revenue producing
Investing Activities – These are related to acquisition and disposal of long term assets
Financing Activities – These are the activities relating to changes in capital & borrowings
Theory Questions:
1. Explain the technique of cash flow statement?
2. What is utility of cash flow statement to financial management?
3. Explain the concept of “Flow of Cash” & enumerate the sources of cash?
4. What data would you require to prepare a cash flow statement?
Suggested Readings for Fund Flow & Cash Flow Statements

Management Accounting – Bhattacharya Debarshi
Introduction to Management Accounting – Dr.Varsha Ainapure (Manan Prakashan)
Principles of Financial Management – Satish Inamdar (Everest Publishing House)
Management Accounting – Chopde (Sheth Publishers)
Practical Sums:

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FINANCIAL STATEMENT ANALYSIS

CASH FLOW STATEMENT

Analysis of Cash Flow Statement

Major Cash Inflows

Major Cash Outflows

CASH FLOW FROM OPERATING ACTIVITIES

CASH FROM INVESTING ACTIVITIES

CASH FROM FINANCING ACTIVITIES

LIMITATIONS OF CASH FLOW ANALYSIS

Accounting Standard – AS3 on Cash Flow Statement

DISTINCTION BETWEEN CASH FLOW V/S FUNDS FLOW

Suggested Readings for Fund Flow & Cash Flow Statements

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