Cash Flow Statement | Financial Management

Cashflow statement provides information about the cash receipts and payments of a firm for a given period. It provides important information that compliments the profit and loss account and balance sheet.

The information about the cashflows of a firm is useful in providing users or financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize these cash flows.

The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation.

The statement deals with the provision of information about the historical changes in cash equivalents of an enterprise by means of a cashflow statement which classifies cash flows during the period from operating, investing and financing activities.

AS-3 Revised-Cashflow Statements:

Scope:

(a) Cashflow statement provides information about the cash receipts and payments of an enterprises for a given period. It provides important information that supplements the profit and loss account and balance sheet.

(b) The statement of cashflows is required to be reported by Accounting Standard-3 (Revised) issued by the Institute of Chartered Accountants of India in March 1997 which replaces the ‘Changes in Financial Position’ as per AS-3.

(c) There are certain changes in the preparation of cashflow statement from the previous methods as a result of the introduction of AS-3 (Revised).

(d) AS-3 (Revised) is mandatory in nature in respect of accounting periods commencing on or after 1-4-2001 for the following:

(i) Enterprises whose equity or debt securities are listed on a recognized stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognized stock exchange in India as evidenced by the board of directors’ resolution in this regard.

(ii) All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crores.

Meaning of Certain Terms:

(a) ‘Cash’ comprises cash on hand and demand deposit with banks.

(b) ‘Cash equivalents’ are short term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of changes in value. Examples of cash equivalents are, treasury bills, commercial paper, etc.

(c) ‘Cashflows’ are inflows and outflows of cash and cash equivalents. It means the movement of cash into the organization and movement of cash out of the organization. The difference between the cash inflows and outflows is known as ‘net cashflow’ which can be either net cash inflow or net cash outflow.

Classification of Cashflows:

The cashflow statement relating to a particular period is classified into the following three main categories of cash inflows and cash outflows:

(a) Cashflows from operating activities,

(b) Cashflows from investing activities, and

(c) Cashflows from financing activities.

Cashflows from Operating Activities:

Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. Operating activities include cash effects of those transactions and events that enter into the determination of net profit or loss.

Following are examples of cash flows from operating activities:

(a) Cash receipts from the sale of goods and the rendering of services.

(b) Cash receipts from royalties, fees, commissions, and other revenue.

(c) Cash payments to suppliers for goods and services.

(d) Cash payments to and on behalf of employees.

(e) Cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits.

(f) Cash payments or refunds of income tax unless they can be specifically identified with financing and investing activities, and

(g) Cash receipts and payments relating to future contracts, forward contracts, option con­tracts, and swap contracts when the contracts are held for dealing or trading purposes.

Cashflows from Investing Activities:

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. In other words, investing activities include transactions and events that involve the purchase and sale of long-term productive assets (e.g., land, building, plant and machinery, etc.) not held for resale and other investments.

The following are examples of cashflows arising from investing activities:

(a) Cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalised research and development costs and self-constructed fixed assets.

(b) Cash receipts from disposal of fixed assets (including intangibles).

(c) Cash payments to acquire shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than payments for those instruments considered to be cash equivalents and those held for dealing or trading purposes).

(d) Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interests in joint ventures (other than receipts from those instruments considered to be cash equivalents and those held for dealing or trading purposes).

(e) Cash advances and loans made to third parties (other than advances and loans made by a financial enterprise).

(f) Cash receipts from the repayments of advances and loans made to third parties (other than advances and loans of a financial enterprise)

(g) Cash receipts and payments relating to futures contracts, forward contracts, option con­tracts, and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts and payments are classified as financing activities.

Cashflows from Financing Activities:

Financing activities are activities that result in changes in the size and composition of the owners’ capital (including preference share capital in the case of a company) and borrowings of the enterprise.

Following are the examples of cashflows arising from financing activities:

(a) Cash proceeds from issuing shares or other similar instruments.

(b) Cash proceeds from issuing debentures, loans, notes, bonds and other short term borrow­ings.

(c) Cash repayments of amounts borrowed, i.e., redemption of debentures, bonds, etc.

(d) Cash payments to redeem preference shares.

(e) Payment of dividend.

In addition to the general classification of three types of cashflows, AS-3 (Revised) provides for the treatment of the cashflows of certain special items as under:

Foreign Currency Cashflows:

(a) Cashflows arising from transactions in a foreign currency should be recorded in an enterprises reporting currency.

(b) The reporting should be done by applying the exchange rate at the date of cashflow statement.

(c) A rate approximates the actual rate may also be used. For example, weighted average exchange rate for a period may be used for recording foreign currency transactions.

(d) The effect of changes in exchange rates on cash and cash equivalents held in foreign currency should be reported as a separate part in the form of reconciliation in order to reconcile cash and cash equivalents at the beginning and end of the period.

(e) Unrealized gains and losses arising from changes in foreign exchange rates are not cashflows.

(f) The difference amount arise due to changes in exchange rate, should not be included in operating, investing and financing activities. This shall be shown separately in the reconcili­ation statement.

Extraordinary Items:

(a) Any cashflows relating to extraordinary items should as far as possible classify them into operating, investing or financing activities and those items should be separately disclosed in the cashflow statement. Some of the examples for extraordinary items is bad debts recovered, claims from insurance companies, winning of a law suit or lottery etc.

(b) The above disclosure is in addition to disclosure mentioned in AS-5, ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’.

Interest and Dividends:

a. Cashflows from interest and dividends received and paid should each be disclosed sepa­rately.

b. The treatment of interest and dividends, received and paid, depends upon the nature of the enterprise i.e., financial enterprises and other enterprises.

c. In case of financial enterprises, cashflows arising from interest paid and interest & dividends received, should be classified as cashflows from operating activities.

d. In case of other enterprises:

(i) Cash outflows arising from interest paid on term loans and debentures should be classified as cash outflow from financing activities.

(ii) Cash outflows arising from interest paid on working capital loan should be classified as cash outflow from operating activities.

(iii) Interest and dividends received should be classified as cash inflow from investing activities.

(iv) Dividend paid on equity and preference share capital should be classified as cash outflow from financing activities.

Taxes on Income:

(a) Cashflows arising from taxes on income should be separately disclosed.

(b) It should be classified as cashflows from operating activities unless they can be specifically identified with financing and investing activities.

(c) When tax cashflows are allocated over more than one class of activity, the total amount of taxes paid is disclosed.

Investments in Subsidiaries, Associates and Joint Ventures:

(a) Any such investments should be reported in the cashflow statement as investing activity.

(b) Any dividends received should also be reported as cashflow from investing activity.

Acquisition and Disposal of Subsidiaries and Other Business Units:

The aggregate cashflows arising from acquisitions and from disposals of subsidiaries or other business units should be presented separately and classified as investing activities.

Non-cash Transactions:

Investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from a cashflow statement. Such transactions should be disclosed elsewhere in the financial statements in a way that provides all the relevant information about these investing and financing activities.

The exclusion of noncash transactions from the cashflow statement is consistent with the objective of a cashflow statement as these do not involve cashflows in the current period.

Examples of noncash transactions:

(i) The acquisition of assets by assuming directly related liabilities.

(ii) The acquisition of an enterprise by means of issue of shares.

(iii) Conversion of debt into equity.

Data Required In Preparation of a Cashflow Statement:

The following basic information are required for the preparation of a cashflow statement:

i. Balance Sheets:

Balance sheets at the beginning and at the end of the accounting period indicate the changes that have taken place in assets, liabilities and capital.

ii. Profit and Loss Account:

The profit and loss account of the current period enables to determine the amount of cash provided by or used in operations during the accounting period after making adjustments from noncash, current assets and current liabilities.

iii. Additional Data:

In addition to the above statements, additional data are collected to determine how cash has been provided or used e.g., sale or purchase of assets for cash.

Procedure in Preparation of Cashflow Statement:

The procedure used for the preparation of a cashflow statement is as follows:

(a) Net increase or decrease in cash and cash equivalents accounts:

The difference between cash and cash equivalents for the period may be computed by comparing these accounts given in the comparative balance sheets. The results will be cash receipts and payments during the period responsible for the increase or decrease in cash and cash equivalent items.

(b) Calculation of the net cash provided or used by operating activities:

It is by the analysis of profit and loss account, comparative balance sheet and selected additional information.

(c) Calculation of the net cash provided or used by investing and financing activities:

All other changes in the Balance sheet items must be analyzed taking into account the additional information and effect on cash may be grouped under the investing and financing activities.

(d) Preparation of a cashflow statement:

It may be prepared by classifying all cash inflows and outflows in terms of operating, investing and financing activities. The net cashflow provided or used in each of these three activities may be highlighted.

(e) Ensure that the aggregate of net cashflows from operating, investing and financing activities is equal to net increase or decrease in cash and cash equivalents.

(f) Report any significant investing, financing transactions that did not involve cash or cash equivalents in a separate schedule to the cashflow statement.

Reporting of Cashflows from Operating Activities:

The purpose for determining the net cash from operating activities is to understand why net profit/loss as reported in the profit and loss account must be converted. The financial statements are generally prepared on accrual basis of accounting under which the net income will not indicate the net cash provided by or net loss will not indicate the net cash used in operating activities.

In order to calculate the net cashflows in operating activities, it is necessary to replace revenues and expenses with actual receipts and payments in cash. This is done by eliminating the noncash revenues and/noncash expenses from the given earned revenues and incurred expenses.

There are two methods of converting net profit into net cashflows from operating activities:

(a) Direct method, and

(b) Indirect method.

(a) Direct Method:

Under direct method, cash receipts from operating revenues and cash payments for operating expenses are arranged and presented in the cashflow statement. The difference between cash receipts and cash payments is the net cashflow from operating activities. It is in effect a cash basis Profit and Loss account. In this case, each cash transaction is analyzed separately and the total cash receipts and payments for the period are determined.

The summarized data for revenue and expenses can be obtained from the financial statements and additional information. We may convert accrual basis of revenue and expenses to equivalent cash receipts and payments. Make sure that a uniform procedure is adopted for converting accrual base items to cash base items.

Under direct method, items like depreciation, amortisation of intangible assets, preliminary expenses, debenture discount, etc. are ignored from cashflow statement since the direct method includes only cash transactions and noncash items are omitted. Likewise, no adjustment is made for loss or gain on the sale of fixed assets and investments.

(b) Indirect Method:

In this method the net profit (loss) is used as the base and converts it to net cash provided or used in operating activities. The indirect method adjusts net profit for items that affected net profit but did not affect cash. Non-cash and non-operating charges in the profit and loss account are added back to the net profit while non-cash and non-operating credits are deducted to calculate operating profit before working capital changes.

It is a partial conversion of accrual basis profit to cash basis profit. Necessary adjustments are made for increase or decrease in current assets and current liabilities to obtain net cash from operating activities.

Other Aspect:

Other Disclosure Requirements:

(a) If any significant cash and cash equivalent balances held by the enterprise are not available for use by it, it should be disclosed in the cashflow statement. For example, cash held by the overseas branch which is not available for use by the enterprise due to exchange control regulations or due to other legal restrictions.

(b) Any additional information to understand the financial position and liquidity position of an enterprise should be disclosed.

(c) A reconciliation of cash and cash equivalents given in its cashflow statement with equivalent items reported in the Balance sheet.

(d) An enterprise should disclose the policy which it adopts in determining the composition of cash and cash equivalents.

(e) The effect of any change in the policy for determining components of cash and cash equivalents should be reported in accordance with AS-5, ‘Net Profit or Loss for the Period, Prior Period Items, and Changes in Accounting Policies’.

Uses and Limitations of Cashflow Statement:

Uses:

The presentation of financial information in cashflow statement will be useful in the following ways:

(a) Helps in efficient cash management:

One of the most important functions of the management is to manage company’s cash resources in such a way that adequate cash is available to meet the liabilities. A projected cashflow statement enables the management to plan and coordi­nate the financial operations of the business efficiently.

(b) Helps in internal financial management:

The cashflow analysis helps in exploring the possibility of repayment of long-term debts which depends upon the availability of cash.

(c) Discloses the movement of cash:

The cashflow statement discloses the increase or decrease in cash and the reasons therefore. It helps the Finance Manager in explaining how the company is short of cash despite higher profits and vice versa.

(d) Discloses success or failure of cash planning:

Comparison of actual and budgeted cashflow statement will disclose the failure or success of the management in managing cash resources and necessary remedial measures can be taken in case of deviations.

(e) Helps to determine the likely cashflow:

Projected cashflow statements help the management to determine the likely inflow or outflow of cash from operations and the amount of cash required to be raised from other sources to meet the future needs of the business.

(f) Supplemental to funds flow statement:

Cashflow analysis supplements the analysis provided by funds flow statement as cash is a part of the working capital.

(g) Better tool of analysis:

For payment of liabilities which are likely to be matured in the .near future, cash is more important than the working capital. As such, cashflow statement is certainly a better tool of analysis than funds flow statement for short-term analysis.

Limitations:

The cashflow analysis is criticized for the following reasons:

(a) Misleading Inter-industry comparison:

Cashflow statement does not measure the economic efficiency of one company in relation to another. Usually a company with heavy capital investment will have more cash inflow. Therefore, inter-industry comparison of cashflow statement may be misleading.

(b) Misleading Inter-firm comparison:

The terms of purchases and sales will differ from firm to firm. Moreover, cash inflow does not always mean profit. Therefore, inter-firm comparison of cash flows may also be misleading.

(c) Misleading comparison over a period of time:

Just because the company’s cashflow has increased in the current year, a company may not be better off than the previous year. Thus, the comparison over a period of time can be misleading.

(d) Influenced by changes in management policies:

The cash balance as disclosed by the cashflow statement may not represent the real liquid position of the business. The cash can be easily influenced by purchases and sales policies, by making certain advance payments or by postponing certain payments.

(e) Cannot be equated with Income statement:

Cashflow statement cannot be equated with the income statement. An Income statement takes into account both cash as well as non-cash items. Hence, net cashflow does not necessarily mean net income of the business.

(f) Not a replacement of other statements:

Cashflow statement is only a supplement of funds flow statement and cannot replace the Income statement or the Funds flow statement as each one has its own function or purpose of preparation.

Despite the above limitations, cashflow statement is a very useful tool of financial analysis. It discloses the volume and speed at which cashflows in various segments of the business and the amount of capital tied-up in a particular segment.