F1 4.02 Cash Flows from Operating Activities

The Statement of Cash Flows comprises the following sections

Cash flows from operating activities (which is sometimes shown separately as a reconciliation of profits to cash flows from operating activities)
Cash flows from investing activities
Cash flows from financing activities
A reconciliation of cash and cash equivalents at the start and end of the financial period

In this section we shall look at the first section of the statement of cash flows; that is the cash flows from operating activities. We shall explain how this section is prepared using the Indirect Method and illustrate how it can be completed from the current period’s Statement of Profit or Loss, the current and previous periods’ Statements of Financial Position together with a small number of additional notes.

Note: This section of the Statement of Cash Flows can also be prepared using something called the Direct Method. This method records the company’s actual receipts and payments from its day-to-day activities. Although this might seem to be the most logical approach to take, in practice the Indirect Method covered below is used by the vast majority of companies when preparing a statement of cash flows.

General approach

The indirect method begins with the company’s profits and then adjusts this figure to calculate the cash flow from its operating activities. Remember that the company’s profits are calculated on the accruals basis and therefore includes non-cash items such as depreciation and as well as transactions that have occurred but where the associated cash flow take place at different times (e.g. a sale is made at the year-end but the customer pays after the year-end).

A variety of adjustments are therefore required in order to move from profit to cash flow.

1 Starting point

If the question gives you a choice, you should start with the company’s Profits from Operations for the period (i.e. the company’s profit before interest and tax).

If however, the question requires you to start with another type of profit (e.g. profit before tax) then you should add back any expenses or deduct any income in order to get back to the Profit from Operations figure.

[Note that if the company made a loss rather than a profit, you should record the loss as a negative amount in the Statement]

Question
Information taken from a company’s statement of profit or loss for a year is shown below.
Sales revenue £142,659
Cost of sales £51,079
Gross profit £91,580
Administration costs £23,910
Selling costs £42,717
Finance costs £13,260
Finance income £718
Profit before tax £12,411
Tax £4,106
Profit for the year £8,305
Calculate the company’s Profit from Operations for the year
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The company’s profit from operations are £24,953

This has been calculated by starting with the profit before tax of £12,411 then deduct the finance income of £718 and add the finance costs of £13,260.

2 Non-cash income and expenses

Any non-cash expenses that have been included in the calculation of Profit from Operations should be added back and any non-cash income should be deducted.

Common additions

Depreciation
Amortization (i.e. depreciation on intangible assets)
Losses on the disposal of non-current assets
Impairments (i.e. unexpected falls in the value of non-current assets)

Common deductions

Gains or profits on disposals of non-current assets

Question
A company has made a profit from operations of £458,100. This amount includes depreciation charges of £71,500, losses on disposals of equipment of £12,900 and profits on disposals of motor vehicles of £21,300. To what figure would the profit from operation be adjusted to, once the non-cash items were taken into account?
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The adjusted figure would be £521,200 (i.e. the profit plus the depreciation and losses on disposal less the profit on disposal)

3 Changes to the company’s working capital

When we calculate a company’s Sales Revenue, Cost of Sales and Expenses and use them to calculate its Profits we take into account how inventories, customer debts and supplier liabilities have changed over the period. As a result in order to move from profits to cash flow we have to adjust for these changes.

Changes in inventories

Where inventories have decreased over the period we will add the decrease
Where inventories have increased over the period we will deduct the increase

In order to help identify whether the change in inventories should be add or deducted in Cash Flows from Operating Activities consider the following. If inventories have risen the company has more cash tied up in its inventories, this will have a negative effect on its cash flow and should therefore be deducted. If however, inventories have fallen, the company has less cash tied up in its inventories which will have a positive effect on its cash flow and should therefore be added.

Changes in trade and other receivables

Where trade and other receivables have decreased over the period we will add the decrease
Where trade and other receivables have increased over the period we will deduct the increase

If trade and other receivables have risen it means that the company has more cash tied up in its customer debts which will have a negative effect on its cash flow and should therefore be deducted. If they have fallen it means that less cash is tied up as customer debts which has a positive effect on its cash flow and should therefore be added.

Changes in trade and other payables

Where trade and other payables have decreased over the period we will deduct the decrease
Where trade and other payables have increased over the period we will add the increase

You will note that changes in trade and other payables are added and deducted in the opposite way to changes in inventories or trade and other receivables. This is because trade and other payables are liabilities rather than assets. If trade and other payables have fallen it means that the business has paid out more cash than the expense it has incurred, which will have a positive effect on its cash flow and should therefore be deducted.

Once the above profits and adjustments have been recorded we can calculate the company’s “Cash Generated from/Used by Operations“

Question
A company made a profit from operations in its last financial year of £1,407,000. This includes depreciation charges of £194,000.
At the start of the year, the value of the company’s inventory was £614,000, by the end of the year this had changed to £498,000.
At the start of the year, the value of the company’s trade and other receivables was £351,000, at the end of the year it was £382,000.
At the start of the year, the value of the company’s trade and other payables was £277,000, at the end of the year it was £226,000.
What was the cash flow from its operations in the year?
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The company’s Cash Generated from its Operations was £1,635,000
This was calculated as follows:
- Profit from operations of £1,407,000
- Add depreciation of £194,000
- Add the decrease in inventories of £116,000
- Deduct the increase in trade and other receivables of £31,000
- Deduct the decrease in trade and other payables of £51,000

4 Interest (finance costs) and tax

The interest paid and tax paid by the company in the financial period will then be deducted from the Cash Generated from / Used by Operations in order to calculate the company’s Net Cash Generated from / Used by Operations

Calculating the interest paid by the company

The interest paid might be different from the interest recorded in the Statement of Profit or Loss as Finance Costs. Watch out for any accruals relating to interest recorded in the company’s Current Liabilities. To calculate the interest paid take the interest accrual at the start of the period, add the interest charges in the Statement of Profit or Loss and then deduct the interest accrual at the end of the period. The interest paid will be recorded as a negative figure in the Statement as it represents cash leaving the company.

Question
At the start of its financial year, a company brought forward an accrued expense in respect of loan interest of £5,000. At the end of the year, this loan interest accrual was changed to £7,000. The loan interest charged to the company’s Statement of Profit or Loss was £44,000.
How much loan interest was paid in the year?
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The loan interest paid was £42,000 (i.e. the opening accrual of £5,000 plus the loan interest charged of £44,000 less the closing accrual of £7,000).

Calculating the tax paid by the company

The tax paid by the company will normally be different from the tax charge included in the Statement of Profit or Loss. It can be calculated as the tax liability at the start of the period, plus the tax charge recorded in the Statement of Profit or Loss, less the tax liabilities at the end of the period. The tax paid in the period will be recorded as a negative figure in the Statement as it represents cash leaving the company.

Question
At the start of a company’s financial year, it owed £79,000 in corporation tax. Its corporation tax charge for the year was £58,000 and at the end of the financial year, it owed £61,000 in corporation tax.
How much corporation tax did the company pay during the financial year?
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The amount paid was £76,000 (i.e. the opening liability of £79,000 plus the tax charge for the year of £58,000 less the closing liability if £61,000).

Illustration

We have been provided with the following Statement of Profit or Loss for the year ended 31/12/X9 for a company together with its Statements of Financial Position for the years ended 31/12/X8 and 31/12/X9 and some additional notes. We have been told to prepare the Statement of Cash Flows for the company and doing so, we should start from the company’s Profit Before Tax.

1 Starting point

As instructed, we will begin the Statement with “Profit Before Tax” (as taken from the Statement of Profit or Loss) and then add back the Finance costs in order to get to the company’s Profit from Operations.

2 Non-cash items

Next we will identify any non-cash items included in the calculation of Profit from Operations by reviewing the Statement of Profit or Loss and the Notes that have been provided in the question. The Statement of Profit or Loss includes a £4,000 profit from the disposal of property, plant and equipment which should be included as a deduction and the Notes mention depreciation for the year of £43,000 which should be added.

3 Changes to the company’s working capital

We will now look at how Inventories, Trade & Other Receivables and Trade and Other Payables have changed over the period.

Inventories have increased over the period by £5,000 (increases will be deducted)
Trade & Other Receivables have decreased over the period by £6,000 (decreases will be added)
Trade & Other Payables have increased over the period by £4,000 (increased will be added)

Next, we can calculate the Cash Generated from Operating Activities by starting with the profit and adding and deducting the various adjustments.

4 Interest (finance costs) and tax

There are no accruals relating to interest expenses either at the start or end of the year. As a result, we can say that the interest paid in the year is the amount of interest recorded in the Statement of Profit or Loss, that is, £3,000.

The tax paid in the year is the opening tax liability of £9,000 plus the current year’s tax charge of £6,000 less the closing tax liability of £6,000. The amount paid is therefore £9,000.

We can now deduct these payments and from the Cash Generated by Operations to calculate the Net Cash Generated from Operating Activities.

The first section of the Statement is now complete.

Alternatively, many companies will present the above separately from the Statement of Cash Flows. This will then be presented as something called a Reconciliation of Profit Before Tax to Net Cash Flow from Operating Activities as shown below. The final line from this reconciliation, that is, the Net Cash from Operating Activities, will then be recorded as the first line of the company’s Statement of Cash Flows.