Cash Flow Statement

Profit is not the same as cash — a firm can be profitable yet short of cash (e.g. profits locked in debtors or stock). A Cash Flow Statement shows the inflows and outflows of cash and cash equivalents during a period, explaining why the cash balance changed. It is prepared as per AS-3 (Revised) and is mandatory for most companies.

Cash means cash in hand and demand deposits; cash equivalents are short-term, highly liquid investments readily convertible into known amounts of cash (e.g. treasury bills, very short-term deposits).

Its objectives are to: show the sources and uses of cash, assess the firm's ability to generate cash and pay its obligations, explain the difference between profit and cash, and help in short-term financial planning.

The statement classifies all cash flows into three activities:

A useful rule for classifying: ask which part of the business the cash relates to. Cash from selling goods is operating; cash spent buying machinery is investing; cash raised by issuing shares is financing. (For a finance company, interest and dividends may be operating, but for a normal firm interest paid and dividends paid are financing.) Correct classification is the heart of this chapter.

Operating activities are the firm's main revenue-producing activities. Cash flow from operations is usually found by the indirect method, which starts from net profit and adjusts it back to cash — because net profit is computed on the accrual basis and includes non-cash and non-operating items.

The steps of the indirect method:

1. Start with Net Profit before Tax and Extraordinary items (work it up from the change in the P&L balance + provision for tax + proposed dividend + transfer to reserves).
2. Add back non-cash and non-operating expenses — depreciation, goodwill/patents written off, interest paid, loss on sale of assets.
3. Subtract non-operating incomes — interest/dividend received, profit on sale of assets.
4. This gives Operating Profit before Working Capital Changes.
5. Adjust working capital changes: add a decrease in current assets and an increase in current liabilities; subtract an increase in current assets and a decrease in current liabilities.
6. Subtract tax paid to get Cash Flow from Operating Activities.

The logic of step 5 is intuitive: if debtors rise, sales have not yet been collected in cash, so cash is lower than profit (subtract); if creditors rise, the firm has held on to cash it owes, so cash is higher (add).

For example, net profit before tax Rs 2,00,000; add depreciation Rs 40,000 and interest Rs 10,000; less profit on sale of asset Rs 5,000 → operating profit before working capital changes Rs 2,45,000. If debtors rose Rs 30,000 (subtract) and creditors rose Rs 20,000 (add), and tax paid was Rs 35,000, then operating cash flow = 2,45,000 − 30,000 + 20,000 − 35,000 = Rs 2,00,000. This reconciliation of profit to cash is the most important computation of the chapter.

After operating activities, the other two sections are more direct.

Investing activities — cash flows from buying and selling fixed assets and non-current (non-trade) investments:

• Outflows (subtract): purchase of fixed assets, purchase of investments.
• Inflows (add): sale of fixed assets, sale of investments, interest and dividend received.

Financing activities — cash flows from changes in the firm's capital and borrowings:

• Inflows (add): issue of shares, issue of debentures, raising loans (and securities premium received).
• Outflows (subtract): redemption of debentures/preference shares, repayment of loans, interest paid, dividend paid.

Finally, the three sections are combined:

Net Increase/Decrease in Cash = Operating + Investing + Financing flows

This net figure is then added to the opening cash & cash equivalents to arrive at the closing cash & cash equivalents — which must agree with the cash and bank balances in the balance sheet. That agreement is the proof that the statement is correct.

For example, if operating cash flow is +Rs 2,00,000, investing is −Rs 1,20,000 (bought machinery) and financing is +Rs 50,000 (issued shares less dividend paid), the net increase in cash = Rs 1,30,000; added to opening cash of Rs 40,000, closing cash = Rs 1,70,000. With this, you can explain exactly how a company's cash position moved over the year — the capstone of Class 12 Accountancy, and a skill prized in CUET, B.Com and CA Foundation alike.