Introduction. What exactly is the statement of cash flows? Composing the statement

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1 Introduction The course about the statement of cash flows (also statement hereinafter to keep the text simple) is aiming to help you in preparing one of the apparently most complicated statements. Most complicated because it s shows the movement of cash whilst the accounting you do on daily basis is on accruals basis. Now all of a sudden it proves to be tricky to think cash. As always, we begin with explaining the statement itself, the meaning of it and why it s used. We then move onto the framework of it and slowly piece by piece try to help you in building it up. We focus on the most common movement types and with the use of our template you can easily alongside follow how they are to be presented. Just to add that bit of extra incentive, we also explain why the statement is of importance. The course itself is structured with the aim to have it easily follow able and understandable with examples to illustrate where possible. There will be just simple words and everything written in down to earth style for an easy and quick understanding. So let s kick off! What exactly is the statement of cash flows? Cash flow is as the name says a flow on cash during a reporting period. It cares little for accruals based accounting and focuses purely on stating whether cash moved or not. As its cash flows, referring to different types of streams, there are in fact two obvious ones inflows and outflows. First would mean money coming in and second hence resources going out from company s funds. What the statement shows is which process during the reporting period has generated cash and which has taken resources. It also shows how much money company has spent on investing into equipment and how much money it has received from others investing into the business (called financing ) etc. We ll cover all the components and most common movements with our next sections. Composing the statement The statement of cash flows is as was mentioned prepared for a reporting period and not for a date in time (as always, the prior period figures are presented just as well). For the reporting period you start with your operating activities cash flows and continue from there to investing and financing activities. We ll cover each group separately in our next section. As you ve shown your cash flows, you reach to the net cash flows for the period. It s either negative or positive and it s something that should equal to the change in cash and cash equivalents balances on the balance sheet from prior to current balance sheet date. If the balance decreased it means you ve had an outflow of cash and it should be reflected so also on the statement of cash flows. Essentially what you do on the statement is reach to the cash flow result for the period, add it to the beginning of the period balances as shown on our template way down at the bottom and reach the balances at the end of the period. Note here that if your cash and cash equivalent balances are nominated in foreign currencies, the effect of the gains and losses should also be taken into account here (again, take a look at our template for this).

2 And let s not forget, when preparing the annual report, all significant figures should be disclosed and explained more detail in referred notes. It s something that applies to this statement just as it does to others and it s equally important, but as such preparers of the annual reports still neglect to enclose further information about cash flows lines in notes. Components of the statement Statement of cash flows is divided into three groups of activities a company may be active in operating, investing and financing. Note here that the last two groups don t necessarily need to be there. If a company has not had any financing activities no loans taken or paid back, not capital payments done etc. the group is not presented. It s just as same with the investing activities more often than not it s still the tangible assets being acquired that result in flows being presented within the group, but if those are not present in the reporting period and no other investing activities just as well, there s no need for this group on the statements either. Something we ll do right now is cover all those groups to give you an idea how they work and what goes where. Operating activities Operating activities are effectively those that are directly linked to your business your sources of revenue and their cash inflows, expenses done in connection and outflows from such. Generally speaking, when the rest two groups are shown as direct cash movement, cash flows from operating activities can be shown as direct or indirect. Direct cash flows are exactly what the name says cash movement is shown in its amount for all the relevant transactions (i.e. sales, purchase of inventory, services, payroll etc.). For an example if you paid 10,000 as salaries, it s exactly what you also show on the statement. It s irrelevant what the expense was, you show the actual cash paid. Same goes for other expenses and income just as well. Don t think about receivables etc. It s what you collected as cash that s to be showed on the statement of cash flows. Indirect method for showing cash flows is only used for operating activities because the other flows cannot really be shown as indirect movements. However, the reason for choosing indirect presentation method for operating activities has its benefits. Direct method means there are quite considerate sums disclosed and at times finding the right amount due can be trickier. In essence the indirect method is easier, if you d ask me. You start from the operating profit taken from the income statement and everything else you add is an adjustment to the profit to find the real cash movement. Now remember, income statement is done on accruals basis whilst the statement of cash flows shows the real cash movement. Accruals basis accounting means that even if cash hasn t moved, if the transaction is done, it s to be recognized as in we account for receivables and payables. Just as same operating profit includes non-cash expenses or incomes that are to be adjusted as well.

3 Effectively the order you d reach to cash generated from operations is as follows: 1) Take operating profit for the period from the income statement. 2) Add back depreciation expense as it s a non-cash (i.e. if the operating profit was 20,000 and the depreciation expense 1,000, adding it back would result in 21,000 on the statement of cash flows as an adjusted operating profit). 3) Take off all non-cash incomes and add back non-cash expenses should there be some on the income statement within the operating profit. If the cash hasn t moved, it s not shown on the statement of cash flows. 4) Adjust the reached result with changes in receivables and payables. For receivables and prepayments what you ought to do is subtract from prior period balance this year s balance and add the sum as a change in receivables and prepayments onto the statement. For an example if prior period balance was 200 and this year s balance is 100, your receivables decreased, but if you think about it, it means you collected this 100 as cash. It s the opposite with payables you subtract from current period s balance prior period s balance. Again, for an example using the same numbers, this year s payable balance is 100 and prior year s balance was 200. Subtracting a 100 from 200 results in Effectively if you think about it, your payables decreased which means you apparently paid some money to suppliers. Only makes sense if it s an outflow on the statement, doesn t it? Just stick to subtracting right balances from each other and you ll get the ins and outs correct in no time! 5) Find the change in inventory as it s on the asset side of the balance sheet, just as receivables and prepayments, the method for finding the right sign (either a negative or a positive amount) is the same from prior period s balance subtract this year s balance and you have your number. And this is it! Those should be all your operations related cash flows. Interest and income tax paid under operating activities are again something that s shown as direct cash flow and as such it s easy to find the right amounts. One possible trick for you here, to find the actual cash movement just take the prior period balance (either payable or receivable), add this periods expense / income (whichever the case is) and subtract this period s balance (either payable or receivable) and you reach to the actual cash movement. In case of payable it s the amount we had to pay during the period that arose already from prior period added to the amounts we were charged this year less any unpaid balance still. If you think it through, it s going to help you in finding those cash movements a lot easier. Investing activities Investing activities are those that are not directly business related but are of more supporting nature or not business related at all fixed assets used in processes, loans given out etc. It s where your company invests into something that s of a longer use. Don t forget that everything connected to those investments is part of this group selling, repayments etc. Note here that cash flows from investing activities are always direct cash flows meaning you disclose the actual cash paid or received.

4 Something to also note if you have unpaid balances for fixed assets at year end, they are to be excluded from the balances you used in operating activities when finding the changes in payables. Buying assets isn t an expense and as such it s not to be shown there. Financing activities Cash flows you show financing activities are those that are related to keeping your business going. It s not operation related cash flows, but completely the opposite. They are cash flows related to support and finance the operations if the operations themselves are not able to fully cover for everything. Keep in mind that it s not only operations being financed, but also any asset acquisitions etc. If the company receives any external financing in the form of capital payments, loans taken etc., it s being financed. As with investing activities, if it s connected to financing activities, it s always shown within the same group. Note here that cash flows from financing activities are always direct cash flows meaning you disclose the actual cash paid or received. Importance of the statement What s the most important thing for a company? Yes, to earn profits, but to also make those profits realize in cash! Without cash there isn t much to build upon you d have no funds to buy services needed for business, to buy goods or to pay to employees. Money makes the wheels turn and it s similar in every type of business. It s vital for your company to earn money. Now this is something the statement comes into the equation and I m not joking around, it s also a tool for you. The statement is a tool to understand where your company spends the most money and if it s getting it back or not. Since it s divided into activities it shows very clearly where the focus on the company during the reporting period was and for an example if it s investing significantly or if it required additional financing from owners, banks etc. This all should be viewed in the light of operating activities however. In a situation where the operating cash flows are negative and the company has also acquired additional capital it s probable the company is not doing all that well. Strictly speaking a company should be able to manage its needs with the cash flows generated from its operations and nothing more. It s something called as being a viable business and a going concern. There are of course situations where the result is actually expected to be negative outflow of cash and it s due to investing considerably into spreading business and acquiring new assets etc. It s the time where a company needs a lot of money to be paid for suppliers for assets that don t necessarily generate income from day one. On the statement of cash flows they re outflow and nothing more in the beginning. So it s really looking at all those three activity groups before deciding on how a company is doing, but in my view it says an awful lot about the health of a business. Presentation Statement of cash flows is something that s presented for a full period and not for a certain date in time. Just as balance sheet and income statement it too can include references to notes and as such, please keep in mind that all significant flows need to be explained and given detailed information about in the referred notes. When the balance sheet and income statement have variations when it comes to

5 presentation opportunities, the statement of cash flows has but one the way you disclose the cash flows from operating activities. Essentially you can group cash flows generated from operations under one line named just the same (as shown also in our template) or show them separately under various lines like: Changes in receivables and prepayments Changes in payables and prepayments Changes inventory Depreciation and revaluation, etc. Or, not as changes (i.e. indirect cash flows), but direct flows: Cash flows from sales revenue Cash flows from buying goods Cash flows from payroll, etc. Please note that should you choose to show them separately, you start off from operating profit from the income statement and disclose operations related cash flows separately to follow. Should you disclose direct cash flows though, keep in mind that in such a case you do not start from operating profit, but as mentioned above you show all operations related cash flows on separate lines starting from the very revenue itself. Hopefully this course gave you an idea of what the statement of cash flows is and how it works. What we did was a short introduction to the activity groups the cash flows can be divided into and what sort of flows are there within those groups. Please note however that this statement isn t a statement on its own but a composition of different resources, including the balance sheet and the income statement. As such, we strongly recommend you also take a look at our balance sheet and income statement course.