Accounting | Statement of cash flows

💰 Statement of Cash Flows: Following the Money Trail

Hello future accountants! Welcome to one of the most practical and crucial chapters in Corporate Accounting: the Statement of Cash Flows (SCF).

You've already mastered the Income Statement (Profit) and the Statement of Financial Position (Assets and Liabilities). But remember, a business can look profitable on paper yet still run out of money! This happens because profit includes non-cash items (like depreciation).

The SCF cuts through the complexity. It tells the real story of where a company’s actual cash came from and where it went during a specific period. Think of it as the company's bank statement summary.

🎯 Learning Objectives for this Chapter

• Understand the purpose and importance of the Statement of Cash Flows.
• Identify the three main sections of cash flow activities.
• Master the two methods (Direct and Indirect) for calculating cash flow from operating activities.
• Be able to prepare and interpret a Statement of Cash Flows.

1. Why Cash is King: Accrual vs. Cash

To understand the SCF, we need to briefly revisit the difference between accrual accounting and cash accounting.

Accrual Accounting (Used in Income Statement)

When do we record revenue and expenses? When they are earned or incurred, regardless of when the cash actually moves.

• Example: You sold goods on credit today. Your Income Statement records the sale today, even though the customer won't pay for 30 days.

Cash Accounting (Used in SCF)

When do we record transactions? Only when the cash is physically received or paid out.

• Example: That customer pays you 30 days later. That is when the cash flow is recorded in the SCF.

The Big Idea: A profitable company (high accrual profit) can fail if it doesn't manage its cash flow (low actual cash). The SCF is the financial report that tracks this vital cash health.

2. The Three Pillars of Cash Flow Activities

Every cash transaction a business makes can be categorised into one of three major activities. This structure is fundamental to preparing the SCF.

A. Cash Flow from Operating Activities (CFO)

These are the cash flows generated or used by the principal revenue-producing activities of the entity.
Analogy: This is the money flowing in and out just from doing your main job.

• Inflows: Cash receipts from the sale of goods/services.
• Outflows: Cash payments to suppliers, employees (wages), operating expenses, and often interest paid and tax paid.

Key Takeaway: A healthy business should ideally generate a positive cash flow from its operations (CFO) consistently. If it’s negative, the business is probably funding its operations by borrowing or selling assets!

B. Cash Flow from Investing Activities (CFI)

These are cash flows related to the acquisition and disposal of long-term assets (non-current assets) and other non-operating investments.

• Inflows: Proceeds from selling Property, Plant, & Equipment (PPE); proceeds from selling investments.
• Outflows: Payments to purchase new PPE (e.g., land, machinery, vehicles); payments to acquire other businesses or financial investments.

Did you know? Companies that are growing rapidly often show large negative CFI because they are investing heavily in new equipment and facilities.

C. Cash Flow from Financing Activities (CFF)

These are cash flows related to changes in the size and composition of the entity’s contributed equity and borrowings.
Analogy: This is money coming from or going back to the owners (shareholders) and long-term lenders (banks).

• Inflows: Proceeds from issuing new shares; proceeds from taking out long-term loans.
• Outflows: Repayment of long-term loans; payment of dividends to shareholders; redemption of shares.

3. Calculating Cash Flow from Operations (CFO)

Calculating CFO is often the hardest part because we have to translate accrual profit (from the Income Statement) back into pure cash flow. There are two accepted methods:

Method 1: The Direct Method (Focuses on Cash In/Out)

This method is straightforward and easier to understand, but requires detailed records that many companies don't publicly disclose. It calculates the actual cash received and paid.

Cash received from customers
Less: Cash paid to suppliers
Less: Cash paid for expenses
Less: Cash paid for income tax
= Net Cash Flow from Operating Activities

Don’t worry if this seems tricky at first—it’s mostly addition and subtraction of true cash movements!

Method 2: The Indirect Method (Focuses on Reconciliation)

The Indirect Method is preferred by most large companies because it uses data readily available from the Income Statement and the Statement of Financial Position (SFP). It starts with profit and adjusts it for non-cash items and changes in working capital.

Step-by-Step: The Indirect Method Walkthrough

Step 1: Start with Profit Before Tax

We start here because we are trying to find the cash flow before the financing and tax impact.

Step 2: Adjust for Non-Cash Items (Add Back)

These are expenses that reduced the profit but did not require an actual cash payment. Since they reduced profit, we must ADD them back to find the real cash flow.

• The biggest item: Depreciation and Amortisation. This is an accounting estimate, not a cash payment.
• Non-cash losses: e.g., Loss on sale of fixed assets. (This loss will be accounted for fully later in CFI).

Step 3: Adjust for Movements in Working Capital

Working Capital (Current Assets and Current Liabilities) changes show the timing difference between when an expense/revenue is recorded and when cash is exchanged.

Step 4: Subtract Interest Paid and Tax Paid

These are cash expenses that must be deducted to find the final CFO.

4. Final Presentation and Interpretation

Once you calculate the net cash flow from all three sections (CFO, CFI, CFF), you combine them to find the overall cash movement.

A. Reconciling the Cash Flow Statement

The mathematical structure of the final section looks like this:

\( \text{Net Cash Flow from Operating Activities} \)
\( \mathbf{+} \text{ Net Cash Flow from Investing Activities} \)
\( \mathbf{+} \text{ Net Cash Flow from Financing Activities} \)
\( \mathbf{= \text{ Net Increase (or Decrease) in Cash and Cash Equivalents}} \)

Next, we verify this movement against the balance sheet:

\( \text{Net Increase (or Decrease) in Cash} \)
\( \mathbf{+} \text{ Cash and Cash Equivalents at the Beginning of the Period} \)
\( \mathbf{= \text{ Cash and Cash Equivalents at the End of the Period}} \)

B. Interpreting the Results

The real power of the SCF is interpretation. What does the pattern of cash flow tell us?

Key Takeaway: The SCF provides essential insight into the liquidity and financial flexibility of a business, telling analysts exactly how the company is funding its operations and growth. A strong CFO is always the best sign of business health.

🌟 Revision Checklist and Encouragement

Well done! The Statement of Cash Flows is often viewed as difficult, but if you remember the three activities and the steps for the Indirect Method (especially the working capital rules), you are set!

• Can you list the three sections of the SCF? (Operating, Investing, Financing)
• Which non-cash expense must be added back in the Indirect Method? (Depreciation)
• Where do you record the payment of a dividend? (CFF - Financing)
• Where do you record the purchase of a new factory? (CFI - Investing)

Keep practising those working capital adjustments—they are the key to mastering this statement!