Dr.

Sarika Mahajan

CASH FLOW STATEMENT

In the previous lesson, you have learnt various types of analysis of financial
statements and its tools such as comparative statements, common size
statement and trend analysis, etc. You have also learnt various kinds of
accounting ratios such as liquidity, activity, profitability, solvency, etc. You
have learnt that accounts are mainly maintained on accrual basis but cash also
plays significant role. Cash is mainly generated for operating activities which
is buying assets and discharging liabilities. Cash is also raised from the issue
of shares and debentures or loans but adequate cash should be available for
use in time and no cash should remain idle. For this another tool of analysis is
used which is cash flow statement. In this lesson, you will learn about cash
flow statement and its methods of preparation.
Meaning and Objectives

Cash plays a very important role in the economic life of a business. A firm
needs cash to make payment to its suppliers, to incur day-to-day expenses and
to pay salaries, wages, interest and dividends etc. In fact, what blood is to a
human body, cash is to a business enterprise. Thus, it is very essential for a
business to maintain an adequate balance of cash. For example, a concern
operates profitably but it does not have sufficient cash balance to pay dividends,
what message does it convey to the shareholders and public in general. Thus,
management of cash is very essential. There should befocus on movement of
cash and its equivalents. Cash means, cash in handand demand deposits with the
bank. Cash equivalent consists of bankoverdraft, cash credit, short term deposits
and marketable securities.
Cash Flow Statement deals with flow of cash which includes cash equivalents
as well as cash. This statement is an additional information tothe users of

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Financial Statements. The statement shows the incoming and outgoing of cash.
The statement assesses the capability of the enterprise togenerate cash and
utilize it. Thus a Cash-Flow statement may be definedas a summary of receipts
and disbursements of cash for a particular periodof time. It also explains
reasons for the changes in cash position of the firm.Cash flows are cash inflows
and outflows. Transactions which increase thecash position of the entity are
called as inflows of cash and those whichdecrease the cash position as outflows
of cash. Cash flow Statement tracesthe various sources which bring in cash such
as cash from operatingactivities, sale of current and fixed assets, issue of share
capital anddebentures etc. and applications which cause outflow of cash such as
loss from operations, purchase of current and fixed assets, redemption
ofdebentures, preference shares and other long-term debt for cash. In short, a
cash flow statement shows the cash receipts and disbursements during acertain
period. The statement of cash flow serves a number of objectiveswhich are as
follows :

 Cash flow statement aims at highlighting the cash generated from

operating activities.
 Cash flow statement helps in planning the repayment of loan schedule
and replacement of fixed assets, etc.
 Cash is the centre of all financial decisions. It is used as the basis for the
projection of future investing and financing plans of the enterprise.
 Cash flow statement helps to ascertain the liquid position of the firm in a
better manner. Banks and financial institutions mostly prefer cash flow
statement to analyse liquidity of the borrowing firm.
 Cash flow Statement helps in efficient and effective management of cash.
 The management generally looks into cash flow statements to understand
the internally generated cash which is best utilised for payment of
dividends.
 Cash Flow Statement based on AS-3 (revised) presents separately cash
generated and used in operating, investing and financing activities.
 It is very useful in the evaluation of cash position of a firm.

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Cash and relevant terms as per AS-3 (revised)

As per AS-3 (revised) issued by the Accounting Standards Board

1. (a) Cash fund :

Cash Fund includes (i) Cash in hand

(ii) Demand deposits with banks, and

(iii) cash equivalents.

(b) Cash equivalents are short-term, highly liquid investments, readily

convertible into cash and which are subject to insignificant risk of changes in
values.

2. Cash Flows are inflows and outflows of cash and cash equivalents. The
statement of cash flow shows three main categories of cash inflows and cash
outflows, namely : operating, investing and financing activities.

(a) Operating activities are the principal revenue generating activities of the
enterprise.

(b) Investing activities include the acquisition and disposal of long term assets
and other investments not included in cash equivalents.

(c) Financing activities are activities that result in change in the size and
composition of the owner’s capital (including Preference share capital in the
case of a company) and borrowings of the enterprise.

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Classification of Cash inflows and Cash Outflows Activities

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METHOD OF PREPARING CASH FLOW STATEMENT

There are two methods of preparing the Cash Flow Statement. Both methods
give the same results in respect of the final total as well as sub-totals of the three
sections – operating, investing and the financing. They differ only in the manner
the information regarding cash flow from operating activities is presented.

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Some facts about cash flow statement :

(i) Only listed companies are required to prepare and present Cash flow
statement.

(ii) The Accounting period for the Cash Flow Statement is the same for which
Profit and Loss Account and Balance Sheet are prepared.

(iii) Cash flow items are as (a) Cash flow from operating activities: (b) Cash
flow from investing activities (c) Cash flow from financing activities.

(iv)Operating activities include revenue producing activities which are not

investing and financing activities.

(v) There are two methods of calculating cash flow from operating activities
namely Direct method and Indirect method. SEBI (Securities Exchange Board
of India) Guidelines recommend for only direct method.

(vi)Extra ordinary Item: The Cash flow associated with extraordinary items
should be classified as arising from operating, investing financing activities. For
example, the amount received from Insurance Company on account of Loss of
Stock or loss from earthquake should be reported as cash flow from operating
activities.

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Treatment of Some Peculiar Items

 Extraordinary items
Extraordinary items are not the regular phenomenon, e.g., loss due to theft or
earthquake or flood. Extraordinary items are non-recurring in nature and hence
cash flows associated with extraordinary items should be classified and
disclosed separately as arising from operating, investing or financing activities.
This is done to enable users to understand their nature and effect on the present
and future cash flows of an enterprise.

 Interest and Dividend

In case of a financial enterprise (whose main business is lending and
borrowing), interest paid, interest received and dividend received are classified
as operating activities while dividend paid is a financing activity. In case of a
non-financial enterprise, as per AS-3, it is considered more appropriate that
payment of interest and dividends are classified as financing activities whereas
receipt of interest and dividends are classified as investing activities.

 Taxes on Income and Gains

Taxes may be income tax (tax on normal profit), capital gains tax (tax on capital
profits), dividend tax (tax on the amount distributed as dividend to
shareholders).AS-3 requires that cash flows arising from taxes on income
should be separately disclosed and should be classified as cash flows from
operating activities unless they can be specifically identified with financing and
investing activities. This clearly implies that:

 tax on operating profit should be classified as operating cash flows.

 dividend tax, i.e., tax paid on dividend should be classified as financing
activity along with dividend paid.
 Capital gains tax paid on sale of fixed assets should be classified under
investing activities.
 Non-cash Transactions
As per AS-3, investing and financing transactions that do not require the use of
cash or cash equivalents should be excluded from a cash flow statement.
Examples of such transactions are – acquisition of machinery by issue of equity
shares or redemption of debentures by issue of equity shares. Such transactions

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should be disclosed elsewhere in the financial statements in a way that provide
all the relevant information about these investing and financing activities.
Hence, assets acquired by issue of shares are not disclosed in cash flow
statement due to non-cash nature of the transaction.

I: Direct Method

As the name suggests, under direct method, major heads of cash inflows and
outflows (such as cash received from trade receivables, employee benefits
expenses paid, etc.) are considered. It is important to note here that items are
recorded on accrual basis instatement of profit and loss. Hence, certain
adjustments are made to convert them into cash basis such as the following :

1. Cash receipts from customers = Revenue from operations + Trade

receivables in the beginning – Trade receivables in the end.

2. Cash payments to suppliers = Purchases + Trade Payables in the

beginning – Trade Payables in the end.

3. Purchases = Cost of Revenue from Operations – Opening Inventory

+Closing Inventory.

4. Cash expenses = Expenses on accrual basis + Prepaid expenses in the

beginning and Outstanding expenses in the end – Prepaid expenses in the
end and Outstanding expenses in the beginning.

However, the following items are not to be considered:

1. Non-cash items such as depreciation, discount on shares, etc., be written off.

2. Items which are classified as investing or financing activities such as interest

received, dividend paid, etc.

As per AS-3, under the direct method, information about major classes of gross
cash receipts and cash payments may be obtained either–

 from the accounting records of the enterprise, or

 by adjusting revenue from operation, cost of revenue from operations and
other items in the statement of profit or loss for the following:
 changes during the period in inventories and trade receivables and
payables;
 other non-cash items;

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  and other items for which cash effects are investing or financing cash
flows.
Proforma
Cash Flows from Operating Activities (Direct Method)
Cash flows from operating activities:
Cash receipts from customers xxx
(–) Cash paid to suppliers and employees (xxx)
= Cash generated from operations xxx
(–) Income tax paid (xxx)
= Cash flow before extraordinary items xxx
+/– Extraordinary items xxx
= Net cash from operating activities xxxx

Illustration 1
From the following information, calculate cash flow from operating activities
using direct method.

Statement of Profit and Loss for the year

ended on March 31, 2015

Particulars Note Figures for Current

reporting period
i) Revenue from operations 2,20,000
ii) Other Income
iii)Total revenue (i+ii) 2,20,000
iv) Expenses
Cost of materials consumed 1,20,000
Employees benefits expenses 30,000
Depreciation 20,000
Other expenses
Insurance Premium 8,000
Total expenses 1,78,000
v) Profit before tax (iii-iv) 42,000
Less Income tax (10,000)
vi) Profit after tax 32,000

Additional information:
Particulars April 01, 2014 March 31, 2015
Rs Rs
Trade receivables 33,000 36,000
Trade payables 17,000 15,000
Inventory 22,000 27,000
Outstanding employees benefits 2,000 3,000
expenses
Prepaid insurance 5,000 5,500
Income tax outstanding 3,000 2,000

Indirect method

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Indirect method of ascertaining cash flow from operating activities begins with
the amount of net profit/loss. This is so because statement of profit and loss
incorporates the effects of all operating activities of an enterprise. However,
Statement of Profit and Loss is prepared on accrual basis (and not on cash
basis). Moreover, it also includes certain non-operating items such as interest
paid, profit/loss on sale of fixed assets, etc.) and non-cash items (such as
depreciation, goodwill to be written-off, etc.. Therefore, it becomes necessary to
adjust the amount of net profit/loss as shown by Statement of Profit and Loss
for arriving at cash flows from operating activities. Let us look at the example :

Statement of Profit and Loss Account

for the year ended March 31, 2015

Particulars Note Figures in

Rs
i) Revenue from Operations 1,00,000
ii) Other Income 1 2,000
iii) Total Revenues (i+ii) 1,02,000
iv) Expenses
Cost of Materials Consumed 30,000
Purchases of stock-in-trade 10,000
Employees Benefits Expenses 10,000
Finance Costs 5,000
Depreciation 5,000
Other Expenses 12,000
72,000
v) Profit before Tax (iii-iv) 30,000
Note: Other income includes profit on sale of land.

The above Statement of Profit and Loss shows the amount of net profit
of Rs 30,000. This has to be adjusted for arriving cash flows from
operating activities. Let us take various items one by one.
1. Depreciation is a non-cash item and hence, Rs 5,000 charged as
depreciation does not result in any cash flow. Therefore, this amount
must be added back to the net profit.
2. Finance costs of Rs 5,000 is a cash outflow on account of
financing activity. Therefore, this amount must also be added back to
net profit while calculating cash flows from operating activities. This
amount of finance cost will be shown as an outflow under the head of
financing activities.
3. Other income includes profit on sale of land: It is cash inflow
from investing activity. Hence, this amount must be deducted from
the amount of net profit while calculating cash flows from
operating activities.

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 The above example gives you an idea as to how various
adjustments are made in the amount of net profit/loss. Other
important adjustments relate to changes in working capital which are
necessary (i.e., items of current assets and current liabilities) to convert
net profit/loss which is based on accrual basis into cash flows from
operating activities. Therefore, the increase in current assets and
decrease in current liabilities are deducted from the operating profit,
and the decrease in current assets and increase in current liabilities are
added to the operating profit so as to arrive at the exact amount of net
cash flow from operating activities.

As per AS-3, under indirect method, net cash flow from operating
activities is determined by adjusting net profit or loss for the effect of
:
• Non-cash items such as depreciation, goodwill writteoff,
provisions, deferred taxes, etc., which are to be added back.
• All other items for which the cash effects are investing or
financing cash flows. The treatment of such items depends upon their
nature. All investing and financing incomes are to be deducted from
the amount of net profits while all such expenses are to be added back.
For example, finance cost which is a financing cash outflow is to be
added back while other income such as interest received which is
investing cash inflow is to be deducted from the amount of net
profit.
• Changes in current assets and liabilities during the period.
Increase in current assets and decrease in current liabilities are to be
deducted while increase in current liabilities and decrease in current
assets are to be added up.

Exhibit below shows the proforma of calculating cash flows from

operating activities as per indirect method.
The direct method provides information which is useful in
estimating future cash flows. But such information is not available
under the indirect method. However, in practice, indirect method is
mostly used by the companies for arriving at the net cash flow from
operating activities.

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 Cash Flows from Operating Activities
(Indirect Method)
Net Profit/Loss before Tax and Extraordinary Items
+ Deductions already made in Statement of Profit and Loss on account of xxx
Non-cash items such as Depreciation, Goodwill to be Written-off.
+ Deductions already made in Statement of Profit and Loss on Account of xxx
Non-operating items such as Interest.
– Additions (incomes) made in Statement of Profit and Loss on xxx
Account of Non-operating items such as Dividend received,
Profit on sale of Fixed Assets.
Operating Profit before Working Capital changes xxx
+ Increase in Current liabilities xxx
+ Decrease in Current assets xxx
– Increase in Current assets xxx
– Decrease in Current Liabilities xxx
Cash Flows from Operating Activities before Tax and Extraordinary Items xxx
– Income Tax Paid xxx
+/– Effects of Extraordinary Items xxx
Net Cash from Operating Activities xxx

As stated earlier, while working out the cash flow from operating
activities, the starting point is the ‘Net profit before tax and
extraordinary items’ and not the ‘Net profit as per Statement of Profit
and Loss’. Income tax paid is deducted as the last item to arrive at the
net cash flow from operating activities.

Illustration 2
Using the data given in Illustration 1, calculate cash flows from
operating activities using indirect method.

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 Illustration 3
Calculate cash flows from operating activities from the following information.
Statement of Profit and Loss for the year ended March 31, 2015
Particulars Note Amount
No. Rs
i) Revenue from Operations 50,000
ii) Other Income 1 5,000
iii) Total Revenue (i+ii) 55,000
iv) Expenses 2
Cost of Materials Consumed 15,000
Employees Benefits Expenses 3 10,000
Depreciation and Amortisation 7,000
Expenses
Other Expenses 21,000
53,000
v) Profit before Tax (iii-iv) 2,000

Working Notes:
1. Other Income = Profit on Sale of Machinery (Rs 2,000 ) +
Income Tax Refund (Rs 3,000)
= Rs 5,000
2. Depreciation and Amortisation = Depreciation (Rs 5,000) + Goodwill
Expenses Amortised (Rs 2,000)
= Rs 7,000
3. Other Expenses = Rent (Rs 10,000) + Loss on Sale of
Equipment (Rs 3,000) + Provision for
Taxation (Rs 8,000)
= Rs 21,000

Additional Information:

April 01, 2014 March 31, 2015

Rs Rs

Provision for Taxation 10,000 13,000

Rent Payable 2,000 2,500
Trade Payables 21,000 25,000
Trade Receivables 15,000 21,000
Inventories 25,000 22,000

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