Table of Content
Information about the cash flows of an enterprise is useful in providing users of 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 utilise those 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 Standard deals with the provision of information about the historical changes in cash and cash equivalents of an enterprise by means of a cash flow statement which classifies cash flows during the period from operating, investing and financing activities.
This statement provides relevant information in assessing a company’s liquidity, quality of earnings and solvency.
- Cash flow statement provides information about the changes in cash and cash equivalents of an enterprise.
- Identifies cash generated from trading operations.
- The operating cash surplus which can be applied for investment in fixed assets.
- Portion of cash from operations is used to pay dividend and tax and the other portion is ploughed back.
- Very useful tool of planning.
Cash flow statements are prepared to explain the cash movements between two points of time.
Sources of Cash:
- Issue of shares and debentures and raising long-term loan.
- Sale of investments and other fixed assets.
- Cash from operations (Net Operating Profit).
Applications of Cash
- Redemption of preference shares and debentures and repayment of long- term loan.
- Purchase of investments and other fixed assets.
- Payment of tax.
- Payment of dividend.
- Loss on Operation (Net Operating Loss)
Note – Cash includes Bank Account also. Increase in cash or decrease in cash is put in the applications and the sources respectively just to balance the cash flow statement. At this juncture, you may note that changes in all balance sheet items are to be taken into consideration separately in cash flow statement for explaining movement of cash.
2. ELEMENTS OF CASH
As per AS 3, issued by the Council of the ICAI,
- Cash in hand,
- Demand deposits with banks, and
Cash equivalents include:
- 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
- Securities with short maturity period of, say, three months or less from the date of acquisition
- Deploy, for a short period, idle cash required to meet short-term cash- commitments.
- Acquisition of preference shares, shortly before their specified redemption date, bank deposits with short maturity period, etc.
Conclusion: Thus, cash flow statement deals with flow of cash funds but does not consider the movements among cash, bank balance payable on demand and investment of excess cash in cash equivalents. Examples are cash withdrawn from current account, cash deposited in bank for 60 days, etc.
3. CLASSIFICATION OF CASH FLOW ACTIVITIES
AS 3 provides explanation for changes in cash position of the business entity. As per Accounting Standard 3, cash flows during the period are classified as Operating; Investing and Financing activities.
1. Definition: These are the principal revenue generating activities of the enterprise.
2. Net Impact: Net impact of operating activities on flow of cash is reported as ‘Cash flows from operating activities’ or ‘cash from operations’.
3. Key Indicator: The amount of cash flows from operating activities is a key indicator of the extent to which the operations of the enterprises have generated sufficient cash flows to:
- Maintain the operating capability of the enterprise;
- Pay dividends, repay loans; and
- Make new investments without recourse to external sources of financing.
4. Information Provided: It provides useful information about financing through working capital.
5. Benefits: Information about the specific components of historical operating cash flows is useful, in conjunction with other information, in forecasting future operating cash flows.
Cash flows arising from operating activities
Key indicator of the extent to which the operations of the entity have generated sufficient cash flows to
- repay loans
- maintain the operating capability of the entity
- pay dividends
- make new investments without recourse to external sources of financing
Primarily derived from the principal revenue-producing activities of the entity
Generally, result from the transactions and other events that have role in the determination of net profit or loss
- Cash receipts from the sale of goods and the rendering of services
- Cash receipts from royalties, fees, commissions, and other revenue
- Cash payments to suppliers for goods and services
- Cash payments to and on behalf of employees
- Cash receipts and cash payments of an insurance entity for premiums and claims, annuities, and other policy benefits
- Cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities
- cash receipts and payments relating to futures contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.
- Cash flows arising from the purchase and sale of dealing or trading securities
- Cash advances and loans made by financial institutions since they relate to their main revenue-producing activity
1. Definition: These are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
2. Separate Disclosure: Separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which the expenditures have been made for resources intended to generate future incomes and cash flows.
Cash flows arising from investing activities
Represent the extent to which expenditures have been made for resources intended to generate future income and cash flows
- cash payments to acquire fixed assets (including intangibles). These payments include those relating to capitalised research and development costs and self- constructed fixed assets;
- cash receipts from sales of property, plant and equipment, intangibles and other long-term assets;
- cash payments to acquire equity or debt instruments of other entities and interests in joint ventures (other than payments for those instruments considered to be cash equivalents or those held for dealing or trading purposes);
- cash receipts from sales of equity or debt instruments of other entities and interests in joint ventures (other than receipts for those instruments considered to be cash equivalents and those held for dealing or trading purposes);
- cash advances and loans made to other parties (other than advances and loans made by a financial institution);
- cash receipts from the repayment of advances and loans made to other parties (other than advances and loans of a financial institution);
- cash payments for futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities; and
- cash receipts from futures contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the receipts are classified as financing activities.
1. Definition: These are the activities that result in changes in the size and composition of the owner’s capital (including preference share capital) and borrowings of the enterprise.
2. Separate Disclosure:
The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.
Cash flows arising from financing activities
useful in predicting claims on future cash flows by providers of capital to the entity
- cash proceeds from issuing shares or other equity instruments;
- cash payments to owners to acquire or redeem the entity’s shares;
- cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short-term or long-term borrowings;
- cash repayments of amounts borrowed;
- cash payments by a lessee for the reduction of the outstanding liability relating to a finance lease.
4. CALCULATION OF CASH FLOWS FROM OPERATING ACTIVITIES
1. Components: Cash flows from operating activities result from the transactions and other events that enter into the determination of net profit or loss.
2. Methods: An enterprise can determine cash flows from operating activities using either:
- Direct Method: The direct method, whereby major classes of gross cash receipts and gross cash payments are considered; or
- Indirect Method: The indirect method, whereby net profit or loss is adjusted for the effects of transactions of a non-cash nature, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing activities.
1. Information Required
(a) Gross receipts and gross cash payments may be obtained from the accounting records to ascertain cash flows from operating activities.
(b) For example,
- information about cash received from trade receivables,
- payment to trade payables, cash expenses etc., which may be obtained by an analysis of cash book.
(c) In actual practice, the relevant information is obtained by adjusting sales, cost of sales and other items in the profit and loss accounts for:
- Changes during the period in inventories and operating receivables and payables;
- Other non-cash items such as depreciation on fixed assets, goodwill written off, preliminary expenses written off, loss or gain on sale of fixed assets etc.; and
- Other items for which the cash effects are investing or financing cash flows. Examples are interest received and paid, dividend received and paid etc., which are related to financing or investing activities and are shown separately in the cash flow statement.
2. The direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method.
3. However, indirect method of determining the cash from operating activities is more popular in actual practice.
Under the indirect method, the net cash from operating activities is determined by adjusting net profit or loss instead of individual items appearing in the profit and loss account. Net profit or loss is also adjusted for the effect of:
- changes during the period in inventories and operating receivables and payables;
- non-cash items such as depreciation; and
- all other items for which the cash effects are financing or investing cash flows.
- It is worth noting that both direct and indirect methods adjust current assets and current liabilities related to operating activities to determine cash from operating activities.
- But direct method adjust individual items of profit and loss account and indirect method adjusts overall net profit (or loss) to determine cash from operation.
- Therefore, indirect method fails to provide break-up of cash from operations.
Proforma of ‘Cash Flow from Operating Activities’ by indirect method
|Net Profit for the year
|Add: Non-Cash and Non-Operating Expenses:
|Loss on Sale of Assets
|Provision for taxation, etc.
Less: Non-Cash and Non-Operating Incomes:
Profit on Sale of Assets
|Net Profit after Adjustment for Non-Cash Items
Cash from operation = Net Profit (after adjustment for Non-cash Items) - Increase in Current Assets + Decrease in Current Assets + Increase in Current Liabilities - Decrease in Current Liabilities
5. CALCULATION OF CASH FLOWS FROM INVESTING ACTIVITIES
- These activities are related to the acquisition and disposal of long-term assets, non-operating current assets and investments which results in outflow of cash.
- Disposal of the aforesaid assets results in inflow of cash.
- Thus, inflows and outflows related to acquisition and disposal of assets, other than those related to operating activities, are shown under this category.
6. CALCULATION OF CASH FLOWS FROM FINANCING ACTIVITIES
These activities are basically related to the changes in capital and borrowing of the enterprise which affect flow of cash.
Redemption of shares and repayment of borrowings results in outflow of cash.
Thus inflows and outflows related to the amount of capital and borrowings of the enterprise are shown under this head.