F1 4.01 The Statement of Cash Flows

Statement of Cash Flows

The Statement of Cash Flows describes a company’s cash flows, that is, its inflows or receipts of cash and its outflows or payments of cash.

It must be given equal prominence in the financial statements to the other main statements (i.e. the Statement of Profit or Loss, the Statement of Financial Position and the Statement of Changes in Equity).

Unlike the other three main statements, the Statement of Cash Flows is not prepared using the accruals basis. Instead it is prepared on a CASH BASIS.

Benefits provided by a statement of cash flows

International Accounting Standard 7 “Statement of Cash Flows” tells us that the statement helps users evaluate and assess:

• A company’s ability to generate cash from its day-to-day operations
• A company’s liquidity and solvency (i.e. its ability to pay its liabilities as they fall due and the likelihood that it will run out of cash)
• The accuracy of past assessments (or forecasts) of cash
• The relationship between profitability and net cash flow (i.e. if the company makes profits is its cash position likely to improve or might it worsen)

Cash and Cash Equivalents

Whilst we have just mentioned cash so far in this session, the Statement of Cash Flows actually provides information as to how a company’s Cash and Cash Equivalents have changed over a financial period. These terms are defined below:

Cash

The term cash refers to cash on hand (e.g. cash in a company’s safe and in its tills) as well as its demand deposits with banks and building societies. Demand deposits means that the money can be accessed immediately and so would include balances in a company’s current bank accounts as well as savings accounts whose balances can be accessed quickly.

Cash equivalents

The term cash equivalents refers to short-term investments (i.e. up to 3 months) that are highly liquid (i.e. can be easily converted into cash). In addition, the risk of the money invested in a cash equivalent must be insignificant so the company will know exactly how much they will receive at the end of the investment. An example of a cash equivalent would be a short-term money-market bond.

For example, let’s say that a company has some spare money and instructs its bank to invest £100,000 in a 2 month money-market bond. The £100,000 therefore leaves the company’s bank account and will be returned to the company in 2 months’ time together with a small amount of interest, let’s say £100. There is virtually no risk to this type of investment and as a result the £100,000 would be classed as a Cash Equivalent of the company.

Structure of the Statement of Cash Flows

The statement splits cash flows between operating, investing and financing activities

1 Cash flows from operating activities

Operating activities refer to the main revenue-producing activities of the entity as well as any other activities that are not included in the other types of cash flows.

This section will therefore include cash inflows from sales receipts as well as other receipts from royalties, commissions and other revenue. It will also include cash outflows such as payments to suppliers of goods and services and amounts paid to and on behalf of employees. We will also include payments of corporation tax (unless the tax can specifically be identified with financing or investing activities).

Direct and indirect methods

There are two methods that can be used to prepare this section of the Statement. The first is known as the Direct Method and this records major classes of cash receipts and gross payments.

The alternative is known as the Indirect Method and starts with the company’s profit for the period and then makes adjustments in respect of non-cash items and the effects of changes in working capital in order to move to the cash generated or used from operating activities.

Although it might appear that the Direct Method would be the simplest method to use, the Indirect Method is by far more common and is the method we will cover in this course.

Example of the Net Cash Flows from Operating Activities section (using the Indirect Method)

2 Cash flows from investing activities

Investing activities refer to acquisitions and disposals of long-term assets and investments other than cash equivalents.

This section will therefore include cash flows from

• Payments for the acquisition of property, plant and equipment and other long-term assets such as shares or debentures in other companies
• Receipts from the sale of property, plant and equipment and other long-term assets such as shares or debentures in other companies
• Interest received from savings or from debentures
• Dividends received from shareholdings in other companies

[Note that company’s should not net off these payments and receipts against each other]

Example of the Net Cash Flows from Investing Activities section

3 Cash flows from investing activities

Financing activities refer to changes in the size and composition of the company’s shares and its debt/borrowings

This section will include cash flows from:

• Issues of shares
• Buy-backs or redemptions of shares
• Issues of debentures and new loans
• Repayments of debentures and loans
• Payments of dividends to shareholders

[Note that company’s should not net off these payments and receipts against each other]

Example of the Net Cash Flows from Financing Activities section

Reconciliation of Cash Flows

In addition to the above sections on types of cash flows, the Statement will also include a reconciliation of the company’s cash and cash equivalents at the start and the end of the financial period.

The reconciliation shall demonstrate that the difference between the opening and closing cash and cash equivalents is explained by the net cash flows from operating, investing and financial activities.

Example of the Reconciliation section

Presentation of the Statement of Cash Flows

The Statement of Cash Flows are usually presented in one of two ways. The first is shown below and simply lists the different sections in order.

The second way of presenting the information splits the statement into two parts; the first records a Reconciliation of Profit to Cash Flows from Operating Activities (i.e. the first section of the Statement of Cash Flows) and the second part starts with the Net Cash Flows from Operating Activities and then records the other sections. This second way of presenting the information is popular as there is often insufficient space on a single page to record the Statement in a single part.

The above example is shown as two separate parts below.

Note on Cash and Cash Equivalents

The Notes to the Financial Statements should include information about the company’s cash and cash equivalents and how the balances at the start and end of the financial period are calculated.

An example of the type of note that would be included is shown below.

Illustration

“Cash and cash equivalents consist of cash on hand, balances with banks and investments in money market bonds. Cash and cash equivalents included in the Statement of Cash Flows comprise the following amounts in the Statement of Financial Position”