The statement of cashflow is prepared as an important management tool by all businesses. Businesses need to have clear and realistic cash planning as it helps managers to survive through most difficult periods.
Virtually all transactions are represented by cash or near cash, including credit cards, sales of goods and services. Cash is an asset as any other asset.
Cash is the unit of measurement, a medium of exchange and a store of value.
Business may fail if it is unable to pay its creditors or pay other claims on the business.
The statement of cashflow addresses the shortfall of information in the income statement and balance sheet. It answer the question of how much capital expenditure has the company made and how it was funded, what was the extend of the borrowing and how much debt was paid, how much the company need to fund new working capital requirement and finally, how much company's financing was met by funds generated from its trading activities and how much met by new external funding.
The statement of cashflows provides information in the changes in the level of cash between the start and the end of reporting period, how much cash has been generated and for what purpose the cash has been used. It allows us to see how the company financed its growth and investment and the extend to which company was funded by loans and equity.
Statement of cash flow format
Statement of cash flows categorises the business activities into: operating activities, investing activities and financing activities.
The cash from operating activities are the main revenue producing activities and include cash received from customers and cash paid to suppliers or employees. There are two methods of calculating the operating activities: direct method and indirect method.
Cashflows from investing activities are the acquisition and disposal of long term assets and other investments that are not considered cash equivalent.
Cashflow from financing activities include changes to the equity capital and borrowing structure.
Interests and dividends may be classified as either operating, investing or financing activities and they must be used consistently from period to period. Taxes from income are generally classified as operating activities.
Aggregate cashflows relating to acquisitions and disposals of subsidaries and other business units should be presented separately and classified as investing activities.
Direct and indirect cashflow
As mentioned above cashflow from operating activities can be presented via direct or indirect method. The indirect method is easier to use and it is used by most companies. The movement of cash is presented in the income statement to derive operating profit. Each method (direct or indirect) involves individual identification of the cash during the period included in the income statement.
Direct method - provides for analysis of all transactions for relevant reporting period to identify all receipts and payments relating to operating activities for that period. This includes cash received from customers, cash paid to suppliers, cash payments for employees and on behalf of employees etc. It would appear something like this:
Operating activities
Cash receipts from customers
Cash paid to suppliers
Cash paid to employees
Cash paid for other operating expenses
Cash generated from operations
Interest paid
Income tax paid
Net cash from operating activities
Generally, because of the amount of time required to analyse the relevant cash information, the direct method has not been popular among many companies. It does, however, provides very useful information.
Indirect method - is the method most adopted in the UK. The operating revenues and costs are generally associated with cash receipts and cash payments so the profit earned will approximate the generated cashflow during that period. The cash may be determined by adjusting the profit before tax in the income statement for depreciation and/or amortisation. It also gives the working capital of inventories, trade receivables and trade payables. It would appear something like this:
Operating activities
Profit before tax
Added back depreciation and amortisation
Adjust net finance income/cost
Increase/decrease in trade receivables
Increase/decrease in inventories
Increase/decrease in trade payables
Cash generated from operations
Interest paid
Income tax paid
Net cash generated from operating activities
Structure of statement of cashflow
The statement of cashflows requires categorising of activities into operating activities, financing activities and investment activities.
Operating activities
Within the operating activities we derive:
Cash generated from operations - is the cash effect from operating transactions using direct or indirect method.
Interest paid - payments of cash of providers of finance, for example interest paid or bank overdrafts as well as long-term and short term loans.
Income tax paid - include all items in relation to taxes on revenue and capital profits i.e corporation tax, overpayments etc. VAT is not included within this heading.
Investing activities
These include:
Acquisitions and disposals of subsidiaries - is the acquisition and sale of investments in subsidiary undertakings and it does not include any income derived from those investments which is included within the dividends provided.
Purchases and sales of tangible and intangible assets and investments - relate to acquisition and disposal of long-term assets and other investments not included in the cash equivalent.
Loans to and from associate companies - it includes cash advances and loans made to associate companies and cash received from repayment of such loans.
Loans to and from subsidiary companies - includes cash advances and loans made to subsidiary companies and cash receipts from repayments made from subsidiary companies.
Interest received - includes interest received on long term and short term loans.
Dividends received - receipts of cash that results from investments.
Financing activities
These include:
Proceeds of issue from ordinary shares - cash proceeds from issue of ordinary shares and the cash payments to shareholders to acquire or redeem ordinary shares.
Proceeds from repayments of borrowings - cash receipts from issuing debentures, loans, notes, bonds, mortgages and other short term or long term borrowings and cash repayments on amounts borrowed.
Dividends paid to ordinary shareholders - all dividends paid in cash to ordinary shareholders.
Dividends paid to minority interests - dividends paid to other ordinary shareholders.
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