The Statement of Cash Flows

The difference between profit and cash

Whilst a business might be profitable this does not mean they will be able to survive. To achieve this they need cash to be able to pay their debts. If they could not pay their debts they would be put into administration or liquidated.

The main reason for this problem is that profit is not the same as cashflow. Profits (from the income statement) are calculated on the accruals basis. Most goods and services are sold on credit so at the point of sale revenue is recognised but no cash is received. The same can be said of credit purchases. There are also a number of expenses that are recognised that have no cash impact; depreciation is a good example of this. So a business can at the same time be profitable but have no cash left to pay its suppliers.

For this reason it is important that users of the financial statements can assess the cash position of a business at the end of the year but also how cash has been used and generated by the business during the accounting period.

Cash flow management

As mentioned above, cash flow is vital to the survival of a company both in the long and the short term. To reflect this, one of the key measures of the health of a business is solvency or liquidity.

In summary management have various liquid assets at their disposal that they can use to settle their debts in the short term. These include inventory, receivables and cash (i.e. current assets). They are used to pay off overdrafts, trade payables, loan interest and tax balances (i.e. current liabilities).

Management should maintain sufficient current assets to be able to pay their current liabilities as they fall due. If they do not, they will default their payments, lose supplier goodwill or suffer fines and sanctions. In the worst case scenario a supplier, lender or tax authority may even have a company put into administration or liquidation in an attempt to recover amounts due to them.

To ensure an effective balance management must consider inventory production and storage cycles and have an effective system of credit control to ensure cash is received into the business as soon as possible. On the flip side they must also manage the level of debt they expose the business to.

IAS 7 Statement of Cash Flows

The objectives of IAS 7 are to ensure that companies:

• report their cash generation and cash absorption for a period by highlighting the significant components of cash flow in a way that facilitates comparison of the cash flow performance of different businesses.
• provide information that assists in the assessment of their liquidity, solvency and financial adaptability.

Format of a statement of cash flows

IAS 7 Statement of Cash Flows requires companies to prepare a statement of cash flows as part of their annual financial statements. The cash flow must be presented using standard headings. Note: there are two methods of reconciling cash from operating activities, the direct and indirect method.

Cash generated from operations

There are two methods of calculating cash from operations – the direct or indirect method. The method used will depend upon the information provided within the question.

Direct method

This method uses information contained in the ledger accounts of the company to calculate the cash from operations figure as follows:

Indirect method

This method reconciles between profit before tax (as reported in the income statement) and cash generated from operations as follows:

This working begins with the profit before tax as shown in the income statement. The remaining figures are the adjustments necessary to convert the profit figure to the cash flow for the period.

 Adjustments to profit before tax:

• Depreciation – Added back to profit because it is a non-cash expense
• Interest expense – Added back because it is not part of cash generated from operations (the interest actually paid is deducted later)
• Increase in trade receivables – Deducted because this is part of the profit not yet realised into cash but tied up in receivables
• Decrease in inventories – Added on because the decrease in inventories liberates extra cash
• Decrease in trade payables – Deducted because the reduction in payables must reduce cash

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags:	statement of cash flows;direct method;indirect method;financial statement;financial statements;annual accounts;example of financial statement;sample of financial statement;IAS7;IAS 7