Cash Flow Statement — Notes

A cash flow statement reports the inflows and outflows of cash and cash equivalents of an enterprise during a period, classified into operating, investing and financing activities, and reconciles the opening and closing balances. It is prepared under AS 3 (revised), Cash Flow Statements, and forms part of a company’s financial statements under the Companies Act, 2013.

Why profit and cash differ: profit is measured on the accrual basis (credit sales, outstanding expenses, depreciation, provisions), while cash changes only on receipt or payment; buying assets, repaying loans and paying dividends use cash without touching profit.

Importance:

• explains the movement in cash, activity by activity, and the gap between profit and cash;
• shows whether operations generate enough cash to pay suppliers, staff, tax, interest and dividends;
• helps plan capital spending, repayments and dividend policy;
• shows how new assets were financed (shares, debentures, loans or operations);
• allows comparison across years and firms with little effect of accounting policies.

• Cash: cash on hand and demand deposits with banks.
• Cash equivalents: short-term, highly liquid investments, readily convertible into known amounts of cash and subject to an insignificant risk of change in value. An investment qualifies normally only when it has a maturity of three months or less from the date of acquisition (treasury bills, commercial paper, short deposits, overnight funds). Equity shares are excluded. A bond bought years ago is not a cash equivalent merely because it now matures within three months.
• Cash flows: inflows and outflows of cash and cash equivalents.

Not cash flows:

• movements between components of cash and cash equivalents (a 45-day deposit made from the current account);
• non-cash investing and financing transactions: assets acquired for shares or debentures, bonus shares, conversion of debentures into shares (excluded and disclosed elsewhere);
• book transfers to reserves (general reserve, capital redemption reserve);
• the dividend proposed for the current year, a contingent liability not provided for.

Operating activities — the principal revenue-producing activities and other activities that are not investing or financing: receipts from customers, royalties, fees and commission; payments to suppliers and employees; income tax paid (unless specifically identified with investing or financing).

Investing activities — acquisition and disposal of long-term assets and of investments not included in cash equivalents: purchase and sale of land, buildings, machinery, patents; purchase and sale of shares and debentures of other enterprises; loans and advances made to others and their recovery; interest and dividend received (non-financial enterprise).

Financing activities — activities that change the size and composition of owners’ capital and borrowings: issue of equity and preference shares (with premium); issue of debentures and raising of loans; redemption of preference shares and debentures (with any premium); repayment of loans; share issue expenses; interest and dividends paid.

Interest and dividends: for a non-financial enterprise, interest and dividend received are investing and interest and dividend paid are financing; for a financial enterprise, interest paid, interest received and dividend received are operating, and dividend paid is financing.

The statement is prepared by the indirect method: the operating section starts from net profit before tax and adjusts it; investing and financing sections list gross receipts and payments.

Step 1 — net profit before tax (working note). The balance sheet shows only the retained part of profit, so rebuild it:

Net profit before tax = (closing − opening balance in the Statement of Profit and Loss) + transfers to reserves (general reserve, capital redemption reserve) + dividends paid during the year (previous year’s proposed dividend and this year’s interim dividend) + provision for tax made during the year.

The dividend proposed for the current year is not added: it is a contingent liability, not an appropriation of this year’s surplus.

Not in the ISC 2027 syllabus: extraordinary items and refund of tax, transactions relating to capital reserve, the adjusted Profit and Loss Account method and the direct method of operating cash flow.

Step 2 — non-cash and non-operating items.

• Add: depreciation; amortisation (goodwill, patents, trademarks written off); loss on sale of fixed assets or investments; increase in provision for doubtful debts (when receivables are taken gross); interest on debentures and loans (finance costs).
• Deduct: profit on sale of fixed assets or investments; interest and dividend received (non-financial enterprise); decrease in provision for doubtful debts.
• Result: operating profit before working capital changes.

Step 3 — working capital. For each current asset (inventories, trade receivables, prepaid expenses): increase → deduct, decrease → add. For each current liability (trade payables, outstanding expenses): increase → add, decrease → deduct. Result: cash generated from operations. Cash and cash equivalents, provision for tax and borrowings are not part of this step.

Step 4 — tax. Deduct income tax paid (from the provision for tax account): net cash from operating activities.

Working accounts reveal the figures the balance sheets hide:

• Asset at cost (with an accumulated depreciation account): the asset sold leaves at cost against its accumulated depreciation, the sale price and the profit or loss; purchases are the balancing figure.
• Accumulated depreciation: opening + depreciation for the year − depreciation on the asset sold = closing; the depreciation for the year is usually the balancing figure.
• Asset at written-down value: opening + purchases + profit on sale = sale price + loss on sale + depreciation + closing.
• Investments: opening + purchases + profit on sale = sale price + loss on sale + closing.

Investing section: purchases (outflows) and full sale prices (inflows) of fixed assets, intangibles and investments; loans given (outflow) and recovered (inflow); interest and dividend received. The profit or loss on sale is adjusted only in the operating section.

• Equity shares: increase in share capital − shares issued to vendors − bonus shares, plus the premium received (from the securities premium account, which may also be debited with issue expenses and redemption premiums).
• Share issue expenses paid: financing outflow, whatever they are written off against.
• Preference shares and debentures redeemed: outflow of the face value plus any premium paid. A capital redemption reserve created out of profit is a transfer, not a cash flow; add it back in the profit working.
• Debentures issued and loans raised: inflows; repayments: outflows. Short-term borrowings are financing too.
• Interest paid on debentures and loans: work it for the period each balance was outstanding; it is added back in operating and paid under financing.
• Dividends paid: previous year’s proposed dividend and this year’s interim dividend (and preference dividend paid) are outflows; this year’s proposed dividend has no effect.

Non-cash issues (shares or debentures to vendors, bonus shares, conversion) are kept out.

The cash check: net increase or decrease (A + B + C) + opening cash and cash equivalents = closing cash and cash equivalents. Every balance sheet line must be explained exactly once.