6.2 Benefits of Cash Flow Statement

• A cash flow statement, when used with other financial statements, helps users evaluate changes in net assets, financial structure, liquidity, and solvency of an enterprise.
• Cash flow information is useful in assessing an enterprise’s ability to generate cash and cash equivalents, and in developing models to assess future cash flows.
• Cash flow reporting enhances comparability of operating performance between different enterprises by eliminating the effects of varying accounting treatments.
• It helps in balancing cash inflows and outflows, adapting to changing conditions, and checking the accuracy of past cash flow assessments.
• The statement is helpful in examining the relationship between profitability, net cash flow, and the impact of changing prices.

6.3 Cash and Cash Equivalents

• Cash flow statement displays cash and cash equivalents inflows/outflows from enterprise activities within a specific period.
• AS-3 defines ‘Cash’ as cash in hand and demand deposits with banks, ‘Cash equivalents’ as short-term, highly liquid investments convertible into known cash amounts with insignificant risk of value change.
• Investments qualify as cash equivalents when maturity is three months or less from acquisition date.
• Investments in shares are excluded from cash equivalents, with an exception for preference shares of a company acquired shortly before their specific redemption date, assuming only insignificant risk of failure to repay.
• Short-term marketable securities convertible into cash immediately without considerable value change are treated as cash equivalents.

6.4 Cash Flows

• Cash Flows represent the movement of cash in and out due to non-cash items.
• Cash inflow is the receipt of cash from non-cash items, while cash outflow is the payment in respect of such items.
• Examples of cash flows include collection of cash from trade receivables, payment to trade payables, payment to employees, receipt of dividend, and interest payments.
• Cash management involves investing excess cash in cash equivalents, but purchases of marketable securities or short-term investments are not considered in preparing cash flow statements.
• Cash equivalents include marketable securities or short-term investments, which are not considered in cash flow statements to avoid double-counting.

6.5 Classification of Activities for the Preparation of Cash Flow

• The preparation of a cash flow statement involves classifying activities into three categories.
• These categories are operating activities, investing activities, and financing activities.
• This classification is important to separate the cash flows generated or used by each type of activity.
• It helps users of the cash flow statement to assess the impact of these activities on the financial position and cash and cash equivalents of an enterprise.
• The classification is in accordance with AS-3 (Accounting Standard 3).

6.5.1 Cash from Operating Activities

• Operating activities are the primary or main activities of an enterprise, such as procurement of raw materials, incurrence of manufacturing expenses, and sale of goods.
• Cash from operating activities is derived from the main activities of the enterprise and indicates the internal solvency level of the company.
• Cash inflows from operating activities include cash receipts from sale of goods and rendering of services, as well as cash receipts from royalties, fees, commissions, and other revenues.
• Cash outflows from operating activities include cash payments to suppliers for goods and services, cash payments to and on behalf of employees, and cash payments for income taxes.
• Cash flows arising from the purchase and sale of dealing or trading securities, as well as cash advances and loans made by financial enterprises, are classified as operating activities.

6.5.2 Cash from Investing Activities

• Investing activities involve acquisition and disposal of long-term assets and other investments not in cash equivalents.
• This includes purchase and sale of fixed assets like machinery, furniture, land, etc.
• Transactions related to long-term investments are also part of investing activities.
• Cash outflows from investing activities include payments for fixed assets, investments, loans to third parties.
• Cash inflows from investing activities include receipts from disposal of fixed assets, repayment of loans, dividends from investments.

6.5.3 Cash from Financing Activities

• Financing activities involve long-term funds or capital of an enterprise.
• Examples of cash inflows from financing activities include cash proceeds from issuing shares (equity or/and preference) and debentures, loans, bonds, and other short/long-term borrowings.
• Examples of cash outflows from financing activities include cash repayments of amounts borrowed, interest paid on debentures and long-term loans and advances, and dividends paid on equity and preference capital.
• Cash flows from financing activities are important for predicting claims on future cash flows by providers of funds to the enterprise.
• The classification of cash flows from financing activities can vary depending on the transaction and the enterprise.

6.5.4 Treatment of Some Peculiar Items

• Extraordinary items are non-recurring events, such as loss due to theft or natural disasters, and should be classified and disclosed separately in cash flow statements under operating, investing, or financing activities.
• Interest and dividends are classified as operating activities for financial enterprises, and as financing activities for non-financial enterprises. Taxes on income and gains should be classified as operating activities unless they can be specifically identified with financing and investing activities.
• Non-cash transactions, such as acquisition of machinery by issuing equity shares, should be excluded from a cash flow statement but disclosed elsewhere in the financial statements.
• Cash flows from operating activities, investing activities, and financing activities are the main heads in a cash flow statement.

Classification of activities:

• Purchase of machinery: Investing activity
• Proceeds from issue of equity share capital: Financing activity
• Cash revenue from operations: Operating activity
• Proceeds from long-term borrowings: Financing activity
• Proceeds from sale of old machinery: Investing activity
• Cash receipt from trade receivables: Operating activity
• Trading commission received: Operating activity
• Redemption of preference shares: Financing activity
• Cash purchases: Operating activity
• Proceeds from sale of non-current investment: Investing activity
• Purchase of goodwill: Investing activity
• Cash paid to supplier: Operating activity
• Interim dividend paid on equity shares: Financing activity
• Employee benefits expenses paid: Operating activity
• Proceeds from sale of patents: Investing activity
• Interest received on debentures held as investments: Operating activity
• Interest paid on long-term borrowings: Financing activity
• Office and administrative expenses paid: Operating activity
• Manufacturing overheads paid: Operating activity
• Dividend received on shares held as investment: Operating activity
• Rent received on property held as investment: Operating activity
• Selling and distribution expenses paid: Operating activity
• Income tax paid: Operating activity
• Dividend paid on preference shares: Financing activity
• Under-writing commission paid: Operating activity
• Rent paid: Operating activity
• Bank overdraft: Operating activity
• Cash: Cash equivalent
• Marketable securities: Cash equivalent
• Refund of income-tax received: Operating activity.

6.6 Ascertaining Cash Flow from Operating Activities

• Cash flows from operating activities can be ascertained using either the Direct or Indirect method.
• The Direct method provides useful information for estimating future cash flows, but it’s less commonly used in practice.
• The Indirect method adjusts net profit or loss for non-cash transactions, deferrals/accruals, and operating cash receipts/expenses.
• Under the Indirect method, the starting point is net profit/loss before taxation and extraordinary items.
• Proposed dividends, considered contingent liabilities, are shown in Notes to Accounts and accounted for as dividend payable after shareholder approval. In the cash flow statement, previous year’s proposed dividends are added to operating profits and shown under financial activities.

6.6.1 Indirect Method

• The text provides information about various accounts related to operating activities, including trade receivables, trade payables, expenses payable, prepaid administrative expenses, outstanding trading expenses, advance trading expenses, provision for taxation, and cash from operations.
• The cash from operating activities is calculated by adjusting net profits for changes in various accounts. For example, an increase in debtors or trade receivables would increase cash from operations, while an increase in bills payable or trade payables would decrease it.
• Expenses paid in advance at the end of the year are deducted from net profits, while an increase in accrued income during the year is added to net profits. Goodwill amortized and provision for doubtful debts are also deducted from net profits.
• When computing cash from operating activities, increases in creditors, prepaid expenses, income received in advance, inventory, and accrued income are added to net profits, while decreases in these accounts are subtracted from net profits.
• If the amount of net profit is not specified, it can be worked out by comparing the balances of the Statement of Profit and Loss given in the comparative balance sheets for two years. The difference is treated as the net profit for the year, and then adjusted with the amount of provision for tax made during the year to ascertain the amount of ‘Net Profit before tax’.

6.7 Ascertainment of Cash Flow from Investing and Financing Activities

• Cash flows from investing activities are calculated by considering the gross cash receipts and gross cash payments from investing activities. In Illustration 5, the sale of machinery results in a cash inflow of 13,000 Rs., and the purchase of machinery leads to a cash outflow of 35,000 Rs., making the net cash used in investing activities equal to (22,000) Rs.
• In Illustration 6, cash flows from financing activities are calculated based on the long-term loans. The company had long-term loans of 2,00,000 Rs. on April 1, 2016, which increased to 2,50,000 Rs. on March 31, 2017. During the year, the company repaid a loan of 1,00,000 Rs., resulting in net cash inflow from financing activities of 50,000 Rs.
• To calculate cash flows from investing activities in the first do-it-yourself exercise, consider the purchases and sales of plant, investments, goodwill, patents, and the land. The cash outflow for purchasing plant is 4,40,000 Rs., and the cash inflow from selling investments, goodwill, and patents is 1,00,000 Rs., 2,00,000 Rs., and 1,00,000 Rs., respectively. The land purchased for investment purposes and let out for commercial use results in a cash inflow of 30,000 Rs. from rent. The interest and dividend received on debentures and shares held as investments add up to 70,000 Rs. (60,000 + 10,000). Therefore, the net cash outflow from investing activities is (1,50,000) Rs.
• The second do-it-yourself exercise requires calculating cash flows from investing and financing activities. In 2017, a machine costing 2,00,000 Rs. was sold at a profit of 1,50,000 Rs. Since the depreciation charged on the machine during 2015 was 2,50,000 Rs., the book value of the machine would be 0. Therefore, the cash inflow from selling the machine is equal to its selling price of 2,00,000 Rs. However, the problem does not provide information on any other investing or financing activities. Hence, it’s not possible to calculate the net cash flows from investing and financing activities without additional information.

6.8 Preparation of Cash Flow Statement

• Cash Flow Statement provides information about change in the position of Cash and Cash Equivalents of an enterprise over an accounting period.
• Activities contributing to this change are classified into operating, investing and financing.
• While preparing a cash flow statement, fulldetails of inflows and outflows are given under these heads including the net cash flow (or use).
• The aggregate of the net ‘cash flows (or use) is worked out and is shown as ‘Net Increase/Decrease in cash and Cash Equivalents’.
• The method of working out the net cashflow (or use) from all the three activities for an accounting period is explained in the text.