IAS 7 Statement of Cashflow
Why do we need to prepare a cashflow statement? The fundamental purpose of being in business is to generate a profit. However, profitability is arguably a long-term objective. In the short-term, business viability is determined by its ability to generate cash. Even very profitable companies will collapse if they do not have access to sufficient cash resources when it becomes necessary to settle a bill. Information about cashflows is therefore needed in order to allow users form an opinion about the liquidity of the business. The purpose of IAS 7 is to provide such information.
Aim of Statement of Cash flow is to show the movement in Cash and Cash Equivalents from one yr to next. Cash includes;- Cash on hand Demand deposits Bank overdrafts Cash Equivalents include;- Short-term highly liquid investments that are convertible to known amounts of cash and are subject to insignificant risk of changes in value (usually having a maturity date of 3 mths or less)
Profit and Cash are not the same. A very profitable business does not necessarily translate into a business with cash. There are three reasons why Profit and Cash are NOT the same;- (1) Treatment of Capital Items (2) Treatment of Non Cash Items (3) The Accruals Concept
The format of the Statement of Cash Flow is very important see page
In the Statement of Cash Flow, all cash flows are classified under one of three headings;- Cash flow from Operating Activities Cash flow from Investing Activities and Cash flow from Financing Activities
Cash Flow from Operating Activities Key part of Cash flow statement. Shows whether business is generating cash from its main business eg Brown Thomas cash flows earned from selling clothes and cosmetics. There are two methods for calculating the Cash flow from Operating Activities;- (1) Direct Method and (2) Indirect Method We will focus on Indirect Method.
Cash Flow from Operating Activities Indirect Method Starting point is Profit before tax (from SOCI) Next, adjust this profit figure by removing any non-cash items such as depreciation, profit/loss on sale of assets Next, we must adjust the Profit figure for Movements in Working Capital (Inventories, Trade Receivables, Trade Payables). This is done by comparing the balances for these items in the Statement of Financial Position for this year versus last year and adding or subtracting the difference to the profit figure Finally, we must adjust for interest paid and tax paid. Result = Cash Flow from Operating Activities.
The aim of the above is to adjust the Profit/Loss before interest and tax (from SOCI) for the effects of the items that results in profit and cash being different. The result of all the adjustments is Cash flow from Operating Activities which shows how much cash was generated by the business from its main business.
Cash flows from Operating Activities (Indirect Method) Profit before tax X Adjustments for Non-Cash items Profits/Losses on sale of assets X Amortisation Interest Expense X Depreciation X Operating profit before working capital changes X Increases/Decreases in Receivables Increases/Decreases in inventory Increases/Decreases in Payables Cash generated from operations Interest paid Tax paid Net cash flows from operating activities X X X (X) (X) X
Cash Flow from Investing Activities Includes;- Cash payments to acquire non current assets (requires a T- Account or working) VERY IMPORTANT Cash receipts from the sale of non current assets Interest and Dividends Received Grants received towards purchase of non-current assets
Financing Activities Includes;- Cash proceeds from the issue of shares or receipt of loan Cash inflow Repayment of a loan cash outflow Payment of dividends cash outflow Calculating the cash inflow/outflows on these items is straightforward involves comparing the opening balance and closing balance on these accounts to determine the movement.
Importance of a Cash Flow Statement Very useful when assessing the performance of a business gives detailed information as to where a company is generating cash from and where cash is being spent Can highlight liquidity problems of the company in conjunction with ratio analysis Interpreting a Cash Flow Statement When interpreting a cash flow statement of a company, a number of important points need to be borne in mind
Approaching a Statement of Cash Flow Question;- (1) Read the requirements of the question (2) Read the question itself carefully (3) Set out Opening and Closing Cash & Cash Equivalents and Increase/decrease in Cash & Cash Equivalents (4) Commence Cashflows from Operating Activities (5) Commence Cashflows from Investing Activities (6) Commence Cashflows from Financing Activites (7) Do the sum of the 3 sections above equal the Increase/Decrease in Cash and Cash Equivalents as derived in Step 3??
Miscellanous Points For the Purposes of Working Capital Movements Trade Receivables includes prepayments (but excludes prepayments relating to interest and taxation) Trade Payables include Accruals (only to the extent of accruals which are not dealt with separately in another part of Statement of Cashflow) e.g. Accrued Interest and Taxation).
Miscellanous Points Cash Generated From Operations Figure When reviewing a Statement of Cashflow, this is a key figure to examine Can the entity finance its Interest Charge and Taxation Charge from it s Cashflows from Operating Activities?
Miscellanous Points Cash and Cash Equivalents At Beginning/End of Period In the exam, transcribe these figures direct from the question i.e. Bank/Bank Overdraft Figures and any Cash Equivalents like Deposit Accounts. Do not depend on your Worked Solution to get the figure for Cash and Cash Equivalents at end of Period.
Miscellanous Points Identifying Ordinary Dividends Paid - 1) When there is no Accrual for Ordinary Dividends: Reconcile Opening & Closing retained Earnings to identify if an ordinary dividend paid. - 2) When there is an Accrual for Ordinary Dividends : Reconcile Opening & Closing Balance on Accrual for Ordinary Dividends to identify if an Ordinary Dividend was accrued for. In situation 2, amounts debited to retained earnings represent accrued ordinary dividends. Ordinary dividends paid will be identified by reconciling opening & closing Accrual for Ordinary Dividends