The statement of cash flows reports cash inflows and outflows for an accounting period, classified under operating, investing, and financing activities.
Definitions
Cash
Cash on hand and demand deposits.
Cash equivalents
Short-term highly liquid investments readily convertible to known amounts of cash, subject to insignificant risk of value change.
Cash flows
Inflows and outflows of cash and cash equivalents.
Objectives
- Highlight cash inflows and outflows from different activities.
- Understand liquidity.
- Manage cash efficiently.
- Predict weaknesses.
- Compare with budgets.
- Determine the ability to pay dividends to stockholders and payments to creditors.
Activities
Operating Activities
Cash flow resulting from the entity’s day-to-day production and selling activities, excluding investing and financing activities. Includes cash received from customers and cash paid to suppliers and employees.
Investing Activities
Cash flow resulting from the entity’s asset-related activities: the acquisition and disposal of long-term assets and other investments not considered cash equivalents.
Financing Activities
Cash flow from activities that alter the equity capital and borrowing structure of the entity.
Preparation Methods
Only cash flow from operating activities differs between the 2 methods. Cash flows from investing and financing activities are calculated identically in both, and net cash inflow from operating activities is the same regardless of method.
Direct method
Converts each income statement item to a cash flow, e.g. sales converted to cash receipts from sales.
Indirect Method
Adjusts net income for non-cash items and working capital changes to arrive at operating cash flow.
- Start with net income as reported on the statement of profit or loss.
- Add back depreciation and other non-cash expenses.
- Subtract gain on disposal of fixed assets and interest income, reported under investing activities.
- Add back loss on disposal of fixed assets, reported under investing activities.
- Add back interest expense, reported under financing activities.
- Adjust for changes in current assets and current liabilities:
- An increase in current assets is deducted from net income.
- An increase in current liabilities is added to net income.
- A decrease in current assets is added to net income.
- A decrease in current liabilities is deducted from net income.
- Arrive at net cash inflow or outflow from operating activities.