Meaning and Objectives of Cash Flow Statement

While the Balance Sheet provides a snapshot of a company's financial position at a specific date and the Statement of Profit and Loss summarizes its performance over a period, these two statements, being based on the accrual principle, do not fully explain the movement of cash within a business. To fill this gap, a third crucial financial statement, the Cash Flow Statement, is prepared. It provides a detailed summary of the inflows (receipts) and outflows (payments) of cash and cash equivalents of an enterprise during a specific accounting period.

In India, the preparation of a Cash Flow Statement is a mandatory requirement for specified companies under the Companies Act, 2013 [Section 2(40)]. It must be prepared in accordance with the guidelines laid out in Accounting Standard-3 (AS-3). This statement is a powerful analytical tool for users of financial information as it helps them to understand how a company generates and uses its cash, which is critical for assessing the company's liquidity, solvency, and overall financial flexibility.

Objectives of Cash Flow Statement

The primary objective of a cash flow statement is to provide useful, transparent information about the historical changes in a company's cash and cash equivalents by classifying all cash flows into three main categories: operating, investing, and financing activities. This structured presentation helps in achieving the following specific objectives:

• To assess the ability to generate cash and cash equivalents: The statement clearly shows where the company's cash came from and how it was spent. This helps users to evaluate the company's ability to generate positive cash flows from its core business operations, which is a key indicator of its financial health and sustainability.

• To understand the need to utilise cash flows: By detailing the cash used in investing activities (like purchasing assets) and financing activities (like repaying loans or paying dividends), the statement helps users understand the company's funding requirements and its capital expenditure strategies.

• To evaluate the timing and certainty of cash generation: For investors and creditors, making economic decisions requires an evaluation of a company's ability to generate cash and the timing and certainty of that generation. The Cash Flow Statement provides historical data that serves as a basis for these crucial future-oriented assessments.

Benefits of Cash Flow Statement

The Cash Flow Statement provides several significant benefits that complement the information provided by the Balance Sheet and the Statement of Profit and Loss, offering a more complete and dynamic view of a company's financial health.

Key Benefits

• Evaluating Financial Structure, Liquidity, and Solvency: When used alongside the other financial statements, the Cash Flow Statement allows users to evaluate changes in a company's net assets, its overall financial structure, and its ability to adapt to changing circumstances by managing the amounts and timing of its cash flows. For example, it helps to answer questions like: How did the company finance its asset expansion? Was it through internal cash from operations or by taking on new debt?

• Assessing Cash Generation Ability: The statement provides a direct and clear insight into a company's ability to generate cash from its core operations. A company can be profitable on paper (as per the Statement of P&L) but still face a severe cash crunch. The cash flow from operations is a key indicator of its real financial health. This information enables users to develop models to assess and compare the present value of the future cash flows of different enterprises.

• Enhancing Comparability of Operating Performance: The Cash Flow Statement improves the comparability of operating performance reports between different companies because it eliminates the distorting effects that arise from using different accounting treatments for the same transactions (e.g., different depreciation methods or inventory valuation policies). Cash flow is a more objective measure than profit, which is susceptible to various accounting judgments and estimates.

• Aiding Financial Planning and Cash Management: The statement is a vital tool for management in checking the accuracy of past cash flow forecasts and in planning for future cash needs. It helps in balancing cash inflows and outflows, managing temporary cash surpluses or deficits effectively, and making informed decisions about investments, borrowing, and dividend payments.

Cash, Cash Equivalents, and Cash Flows

Understanding the precise definitions of the core components of a Cash Flow Statement is essential for its correct preparation and interpretation.

Cash and Cash Equivalents

As per AS-3, the statement is designed to explain the change in the total balance of 'Cash and Cash Equivalents' from the beginning to the end of a period.

• Cash: This is the most liquid asset and comprises cash on hand (physical currency and coins) and demand deposits with banks. Demand deposits are balances held in bank accounts (like current accounts) that can be withdrawn at any time without prior notice.

• Cash Equivalents: These are defined as short-term, highly liquid investments that meet two specific criteria:

  1. They must be readily convertible into a known amount of cash.
  2. They must be subject to an insignificant risk of changes in their value.
  An investment typically qualifies as a cash equivalent only if it has a very short maturity, generally three months or less from the date of acquisition. Common examples include treasury bills, commercial papers, money market funds, and short-term bank deposits. Investments in equity shares are usually excluded because their values can fluctuate significantly.

Cash Flows

'Cash Flows' refers to the actual movement of cash and cash equivalents into (inflow) and out of (outflow) the enterprise. The statement is concerned only with transactions that result in a change in the total balance of cash and cash equivalents.

• Cash Inflow: Any transaction that leads to an increase in the total balance of cash and cash equivalents (e.g., cash received from the sale of goods or from the issue of shares).

• Cash Outflow: Any transaction that leads to a decrease in the total balance of cash and cash equivalents (e.g., cash paid to purchase machinery or to pay salaries).

It is important to distinguish cash flows from non-cash transactions and from movements that are part of cash management. Transactions between items that are themselves part of cash and cash equivalents are not considered cash flows. For example, depositing ₹ 10,000 cash from hand into the company's bank account, or withdrawing cash from the bank for office use, does not change the total balance of cash and cash equivalents. Similarly, investing surplus cash into a highly liquid marketable security (a cash equivalent) is simply a part of managing the cash portfolio and does not represent an operating, investing, or financing activity. These internal movements are therefore excluded from the Cash Flow Statement.

Classification of Activities in the Cash Flow Statement

As per Accounting Standard-3 (AS-3), to provide a clear and structured view of a company's cash movements, all cash inflows and outflows during a period must be classified into one of three distinct categories. This classification is crucial as it helps users to assess the impact of these different types of activities on the company's financial position and its overall cash balance. The three categories are Operating, Investing, and Financing Activities.

1. Cash from Operating Activities

Operating activities are the principal revenue-producing activities of the enterprise. Essentially, they are the cash flows generated from the main, day-to-day activities related to the company's core business operations that are not investing or financing activities. The amount of cash flow from operations is a key indicator of a company's internal financial strength, showing the extent to which it can generate sufficient cash from its primary business to maintain operating capability, repay loans, pay dividends, and make new investments without relying on external financing.

• Common Cash Inflows from Operating Activities:

  • Cash receipts from the sale of goods and rendering of services to customers.
  • Cash receipts from royalties, fees, commissions, and other forms of revenue that are central to the business.

• Common Cash Outflows from Operating Activities:

  • Cash payments to suppliers for goods and services (e.g., raw materials, inventory).
  • Cash payments to and on behalf of employees (e.g., salaries, wages).
  • Cash payments for other operating expenses (e.g., rent, utilities, insurance premiums).
  • Cash payments of income taxes (unless they can be specifically identified with financing and investing activities).

Note: For a financial enterprise like a bank, activities such as making loans and accepting deposits, as well as receiving and paying interest, are considered operating activities because they are its main business.

2. Cash from Investing Activities

Investing activities are those related to the acquisition and disposal of long-term assets and other investments that are not included in cash equivalents. These activities reflect the company's strategy for long-term growth and represent the extent to which expenditures have been made for resources that are intended to generate future income and cash flows.

• Common Cash Inflows from Investing Activities:

  • Cash receipts from the sale of fixed assets (tangible and intangible), such as machinery, buildings, or patents.
  • Cash receipts from the sale of shares, warrants, or debt instruments of other companies (when held as long-term investments).
  • Cash received from the repayment of loans and advances previously made to third parties.
  • Interest and dividends received on investments held in other companies.

• Common Cash Outflows from Investing Activities:

  • Cash payments to acquire fixed assets (tangible and intangible).
  • Cash payments to acquire shares, warrants, or debt instruments of other companies as investments.
  • Cash advances and loans made to third parties.

3. Cash from Financing Activities

Financing activities are activities that result in changes in the size and composition of the owners’ capital and borrowings of the enterprise. These activities show how the company raises funds from owners and lenders to finance its operations and investments, and how it returns funds to them.

• Common Cash Inflows from Financing Activities:

  • Cash proceeds from the issue of shares (equity or preference) to owners.
  • Cash proceeds from the issue of debentures, bonds, notes, and other long-term or short-term borrowings.

• Common Cash Outflows from Financing Activities:

  • Cash repayments of amounts borrowed (e.g., redemption of debentures, repayment of loans).
  • Buy-back of equity shares from the open market.
  • Interest paid on borrowings (as it is the cost of obtaining finance).
  • Dividends paid to shareholders (as it is the return on owners' capital).

A separate disclosure of financing activities is important because it is useful for predicting future claims on the company's cash flows by its providers of funds (both owners and lenders).

Treatment of Some Peculiar Items

While preparing a Cash Flow Statement, certain items require special attention because their classification is not always straightforward or their nature is unique. AS-3 provides specific guidance on how to treat these peculiar items to ensure consistency and clarity in reporting.

1. Extraordinary Items

Extraordinary items are transactions and events that are clearly distinct from the ordinary activities of the business and are not expected to recur frequently or regularly. Examples include losses from natural disasters like earthquakes or floods, or proceeds from an insurance claim related to such an event.

• Treatment: Cash flows associated with extraordinary items should be classified and disclosed separately under the appropriate activity heading—operating, investing, or financing.

• Rationale: This separate disclosure is crucial as it enables users to understand the nature and effect of these non-recurring events on the company's cash flows and to distinguish them from the normal, recurring cash flows.

2. Interest and Dividend

The classification of interest and dividends depends on the nature of the enterprise.

For a Financial Enterprise (e.g., a Bank or an NBFC)

For a financial enterprise, whose main business is lending, borrowing, and investing, these items are part of their core operations.

• Interest Paid: Classified as an Operating Activity outflow.

• Interest Received: Classified as an Operating Activity inflow.

• Dividend Received: Classified as an Operating Activity inflow.

• Dividend Paid: Classified as a Financing Activity outflow (as it is a return to providers of capital).

For a Non-Financial Enterprise (e.g., a Manufacturing or Trading Company)

For these companies, interest and dividends are related to their financing and investment decisions, not their main operations.

• Interest Paid: Classified as a Financing Activity outflow (as it is the cost of raising debt).

• Dividend Paid: Classified as a Financing Activity outflow (as it is a return to owners).

• Interest Received: Classified as an Investing Activity inflow (as it is a return on investments like loans given or debentures held).

• Dividend Received: Classified as an Investing Activity inflow (as it is a return on investments in the shares of other companies).

3. Taxes on Income and Gains

AS-3 requires that cash flows arising from taxes on income should be separately disclosed.

• General Rule: Tax payments are typically classified as cash flows from Operating Activities because they arise from the profits of the main business operations.

• Exception: If a tax payment can be specifically and practicably identified with a financing or an investing activity, it should be classified under that respective category. For example:

  • Dividend Distribution Tax paid on dividends is a financing activity and should be shown as an outflow under Financing Activities.
  • Capital Gains Tax paid on the profit from the sale of a fixed asset should be classified as an outflow under Investing Activities.

• Tax Refunds: A refund of income tax is treated as a cash inflow from Operating Activities.

4. Non-cash Transactions

The Cash Flow Statement is concerned only with transactions that involve the inflow or outflow of cash and cash equivalents. Therefore, as per AS-3, significant investing and financing transactions that do not require the use of cash or cash equivalents should be excluded from the Cash Flow Statement.

However, because these transactions are important and affect the capital and asset structure of the company, they must be disclosed elsewhere in the financial statements (usually in the Notes to Accounts) to provide all relevant information.

Common examples of non-cash transactions include:

• Acquisition of assets by issuing shares or debentures (e.g., purchasing machinery in exchange for company shares).

• Conversion of debentures into equity shares.

• Acquisition of an enterprise by means of an issue of shares.

Ascertaining Cash Flow from Operating Activities (Indirect Method)

As per AS-3, cash flow from operating activities can be ascertained by either the direct method or the indirect method. The indirect method is the most widely used approach in practice. It does not report the gross cash receipts and payments. Instead, it starts with the Net Profit before Tax and Extraordinary Items as per the Statement of Profit and Loss and adjusts this figure for the effects of non-cash transactions and changes in working capital to arrive at the net cash flow from operating activities.

Logic and Steps of the Indirect Method

The logic behind the indirect method is to reconcile the accrual-based net profit with the cash-based flow from operations. The Statement of P&L includes many items that do not involve an actual inflow or outflow of cash in the current period. The indirect method systematically reverses the impact of these items. The process involves three main steps:

Step 1: Start with Net Profit before Tax and Extraordinary Items

The starting point is the net profit figure before tax is deducted. This is because income tax paid is a separate cash outflow that is adjusted at the end of the operating activities section. The transfer to reserves is an appropriation of profit and must be added back to the net profit after tax to arrive at the profit before appropriations, which is then adjusted for tax.

Derivation: Net Profit After Tax + Transfer to Reserves + Provision for Tax made during the year = Net Profit Before Tax.

Step 2: Adjust for Non-Cash and Non-Operating Items

The net profit figure is adjusted for items that were included in its calculation but either did not affect cash, or that rightfully belong to investing or financing activities.

• Add back Non-Cash Expenses: These are expenses that were debited to the Statement of P&L (reducing the profit) but did not involve an actual outflow of cash. To reverse their effect, they are added back. Examples include:

  • Depreciation and Amortisation (e.g., goodwill, patents written off).
  • Provisions (like provision for doubtful debts).

• Add back Non-Operating Expenses: These are expenses related to investing or financing activities that were debited to the Statement of P&L. They are added back here because their actual cash impact will be shown under the investing or financing activities section. Examples include:

  • Interest paid on debentures and loans (a financing activity).
  • Loss on the sale of fixed assets/investments (an investing activity).

• Subtract Non-Operating Incomes: These are incomes that were credited to the Statement of P&L (increasing the profit) but relate to investing or financing activities. They are subtracted to remove their effect from the operating profit. Examples include:

  • Interest received on loans given or investments held (an investing activity).
  • Dividend received on shares held as investments (an investing activity).
  • Profit on the sale of fixed assets/investments (an investing activity).

After these adjustments, the resulting figure is the Operating Profit before Working Capital Changes.

Step 3: Adjust for Changes in Working Capital Items

The final step is to adjust for changes in current assets and current liabilities (excluding cash, cash equivalents, and bank overdrafts) between the beginning and end of the period. This step converts the accrual-based operating profit to a cash basis.

After these adjustments, we get Cash Generated from Operations. From this, Income Tax Paid (net of any refund received) is deducted to arrive at the final Net Cash from (or used in) Operating Activities.

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Ascertainment of Cash Flow from Investing and Financing Activities

Unlike operating activities, for which there are two distinct methods (direct and indirect), the ascertainment of cash flows from investing and financing activities is more straightforward. The net cash flow from these activities is determined by identifying and aggregating the individual gross cash receipts (inflows) and gross cash payments (outflows) for each category.

The primary sources of information for these calculations are the company's comparative Balance Sheets, the Statement of Profit and Loss, and any additional information provided (e.g., in the notes to accounts or adjustments).

Ascertaining Cash Flow from Investing Activities

Investing activities relate to the acquisition and disposal of long-term assets and other investments. To find the cash flow, we need to analyze the changes in non-current assets like Property, Plant and Equipment (Tangible Assets), Intangible Assets, and Non-current Investments.

Methodology: Using Ledger Accounts

Simply looking at the net change in an asset's value between two balance sheet dates is often insufficient, especially when there has been a purchase, sale, and depreciation during the year. The most reliable method is to prepare a ledger account for the specific asset (e.g., Machinery Account) and its related Accumulated Depreciation Account, if any.

By posting the opening and closing balances and the information given in adjustments (like sale, profit/loss, depreciation), the missing figure—usually the 'Purchase of Asset' (a cash outflow) or the 'Sale Proceeds' (a cash inflow)—can be found as the balancing figure.

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Ascertaining Cash Flow from Financing Activities

Financing activities relate to changes in owners' capital and borrowings. To find the cash flow, we need to analyze the changes in items like Share Capital, Long-term Borrowings (Debentures, Loans), and also consider related payments like interest and dividends.

Methodology: Using Ledger Accounts

Similar to investing activities, preparing a ledger account for the specific liability or equity item (e.g., Long-term Loan Account, Share Capital Account) is the best way to determine the cash inflows and outflows. By posting the opening and closing balances and incorporating any additional information, the balancing figure will reveal the cash transaction during the year (e.g., 'Proceeds from new loan' or 'Repayment of loan').

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Preparation of Cash Flow Statement

The preparation of a Cash Flow Statement is a systematic process that involves analyzing the comparative Balance Sheets, the current year's Statement of Profit and Loss, and any additional information provided. The goal is to identify all transactions that resulted in an inflow or outflow of cash and cash equivalents and to classify them correctly into operating, investing, and financing activities.

The final statement must reconcile the opening and closing balances of Cash and Cash Equivalents as shown in the Balance Sheets. While the direct method can be used for operating activities, the indirect method is more common in practice and will be the focus here.

Systematic Steps for Preparation

A reliable method for preparing the Cash Flow Statement involves the following steps:

Step 1: Calculate Net Profit Before Tax and Extraordinary Items.
This is the starting point for the operating activities section (indirect method). It is found by adjusting the change in the 'Surplus' (Balance in Statement of Profit and Loss) for items like Provision for Tax, Dividends, and Transfer to Reserves.

Step 2: Prepare Ledger Accounts for Non-Current Items.
To find the hidden cash flows related to investing and financing activities, it is highly recommended to prepare ledger accounts for all non-current assets and non-current liabilities (and share capital). Key accounts include:

• Fixed Asset Account (e.g., Machinery A/c)
• Accumulated Depreciation Account
• Non-current Investment Account
• Share Capital Account
• Long-term Borrowings Account (e.g., Debentures A/c, Bank Loan A/c)
• Provision for Tax Account

By posting opening and closing balances and incorporating additional information, the balancing figures will reveal cash transactions like 'Purchase of Asset', 'Sale of Asset', 'Issue of Shares', 'Redemption of Debentures', and 'Tax Paid'.

Step 3: Calculate Net Cash Flow from Operating Activities.
Follow the indirect method: Start with the Net Profit calculated in Step 1, adjust for all non-cash and non-operating items (like depreciation, profit/loss on sale, interest expense), and then adjust for changes in working capital (current assets and current liabilities).

Step 4: Calculate Net Cash Flow from Investing Activities.
List all cash inflows and outflows identified from the analysis of non-current asset accounts. This includes the purchase and sale of tangible and intangible assets, and the purchase and sale of non-current investments. Also include interest and dividends received.

Step 5: Calculate Net Cash Flow from Financing Activities.
List all cash inflows and outflows identified from the analysis of shareholders' funds and non-current liability accounts. This includes the issue and redemption of shares and debentures, raising and repaying loans, and the payment of interest and dividends.

Step 6: Consolidate and Reconcile.
Sum the net cash flows from the three activities (Operating + Investing + Financing) to get the 'Net Increase/Decrease in Cash and Cash Equivalents'. Add the 'Opening Balance of Cash and Cash Equivalents' to this amount. The result must equal the 'Closing Balance of Cash and Cash Equivalents' as shown in the Balance Sheet. This final reconciliation confirms the accuracy of the statement.

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Test your Understanding – I

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Test your Understanding – II

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Do it yourself (Page No. 260)

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