Chapter 6

CASH FLOW ANALYSIS

Nature and Purpose

The statement of cash flow required by PAS 7 provides information about cash inflows and
outflows during an accounting period as well as the next change in cash from the operating, investing
and financing activities in a manner that reconcile the beginning and ending cash balances.

The primary purpose of a cash flow statement is to provide relevant information about a
company's cash receipts and cash payments during an accounting period that is useful in evaluating
the preceding items. In the regard, the PAS 7 states that the information in a statement of cash
flows, if used with the information in the other financial statements, should help users to assess and
evaluate:

a) A company's ability to generate positive future net cash flows.

b) A company's ability to meet its obligations and pay dividends.
c) A company's need for external financing.
d) The reason for differences between a company's net income and associated cash
receipts and payments
e) Both the cash and noncash aspects of a company's financing and investing transactions
during the accounting period.

The following information may also be obtained from the cash flow statement:

1) The changes in net assets of an enterprise and its ability to affect the amounts and
timing of cash flows in order to adopt to changing circumstances and opportunities
2) The ability of the enterprise to generate cash and cash equivalents and enables the users
to develop models to assess and compare the present value of the future cash flows of
different enterprises , and
3) It enhance the comparability of the reporting of operating performance by different
enterprises because it eliminates the effects of using different accounting treatments for
the same transactions and events.

The Basic Approach to a Cash Flow Statement

Cash – In preparing a statement of cash flows, the term cashy is broadly defined to include bot cash
and cash equivalent.

Cash equivalent – consist of short term, highly liquid investments such as treasury bills, SEC registered
commercial paper and money market funds.

Classification of Cash Flow Activities

 The amount of cash flows arising from operating activities is a key indicator of the extent to
which the operations of the enterprise have generated sufficient cash flows to repay loans, maintain
the operating capability of the enterprise, pay dividends and make new investments without resource
to external sources of financing. Information about the specific components of historical operating
cash flows is useful, in conjunction with other information, in forecasting future operating cash flows.

Operating activities include delivering or producing goods for sale and providing services: and the
cash effects of transactions and other events that enter into the determination of income. Examples
are :

INFLOWS

Sales of goods

Revenue from services

Return on interest earnings assets (interest)

Return on equity securities (dividends)

Receipts from contracts help for dealing and trading purposes

Tax refunds unless identified with financing and investing activities

OUTFLOWS

Payments for purchase of inventories

Payments for operating expenses (salaries, rent, insurance, etc.)

Payments for purchases from supplies other than inventory

Payments for lenders interest)

Payments for taxes unless identified with financial and investing activities

Investing Activities

The separate disclosure of cash flows arising from investing activities is important because the
cash flows represent the extent to which expenditures have been made for resources intended to
generate future income and cash flows.

Investing activities include acquiring and selling or otherwise disposing of (a) securities that are
not cash equivalent (b) productive assets that are expected to benefit the firm for long periods of
times; and lending money collecting on loans. Examples are:

INFLOWS

Sales of long-lived assets such as property, plant and equipment, intangibles and other long-lived
assets

Sales of debt or equity securities of other entities

 Collection of loans (principal) to others (other than advances and loans made by a financial
institution)

OUTFLOWS

Acquisition of long-lived assets such as property, plant and equipment, intangibles and other
long-lived assets

Purchase of debt or equity securities of other entities

Loans (principal) to others (other than advances and loans made by a financial institution)

Financing Activities

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 capital to enterprise.

Financing activities include borrowing from creditors and repaying the principal; and obtaining
resources from owners and providing them with a return on the investment. Examples are;

INFLOWS

Proceeds from borrowing (short-term and long term)

Proceeds from issuing the firm's own equity securities

OUTFLOWS

Repayment of debt principal

Repurchase of firm's own shares

Payment of dividends

Acquisition of the enterprise's own shares

Content and Form of the Statement of Cash flows

A statement of cash flows (SCF) for a period shall report the following:

A. Net Cash

1. Provide or used by operating activities

2. Provide or used by investing activities

3. Provide or used by financing activities

B. Net effect of those flows on cash and cash equivalents during the period in a manner that
reconciles the beginning and ending cash and cash equivalents.

Reporting Requirements

1.An entity shall report cash flows from operating activities using either :

(a)Direct method- whereby major classes of gross cash receipts and gross cash payments are
disclosed.

(b)Indirect method-whereby profit or loss is adjusted for the affects of transactions of a non-cash
nature .

Under the direct method ,information about major classes of gross cash receipts and gross cash
payments may be obtained either.

(a) from the accounting records of the entity.

(b) By adjusting sales, cost of sales and other items in the income statement.

1.changes during the period in inventories and operating receivables and payables.

2.other non-cash items.

3.other items for which the cash effects are investing of financing cash flows.

Under the indirect method , the net cash flow from operating activities is determined by adjusting net
profit or loss for the effects of:

(a) changes during the period in inventories and operating receivables and payables.

(b) Non-cash items such as depreciation, provisions, deferred taxes , unrealized foreign currency
gains and losses , undistributed profits of associates, monitory interest.

(c) All other items for which the cash effects are investing or financing cash flows.

The net cash flow from operating activities may be represented under the indirect method by
showing the revenues and expenses disclosed in the income statement and the changes during the
period in inventories and operating receivables and payables.

2.An entity shall report separately major classes of gross cash receipts and gross cash payments
arising from investing and financing activities.

3. Cash flows arising from the following operating , investing or financing activities may be reported
on the net basis.
(a)cash receipts and payments on behalf on the customers.
(b)cash receipts and payments for the items in which the turnover is quick.

4.Cash flows arising from each of the following activities of a financial institution may be reported on
a net basis .
 (a)cash receipts and payments for the acceptance.

(b)the placement of deposits with.

(c) cash advances and loans made to customers.

5.Cash flows arising from transactions in a foreign currency should be recorded in an entity’s .

6.Cash flows from interest and dividends received and paid should each be disclosed separately.

7. Cash flows arising from taxes on income shall be separately disclosed.

Calculating Cash Flow from Operating Expenses

Direct method

In reporting the cash flows from operating activities enterprises are encouraged in report major
classes of gross cash receipts and gross cash payments and the net cash flow from operating activities.
At minimum, the following classes of operating cash receipts payments should be separately
reported.

1) Cash collected from customers, including lessees, licensees and the like

2) Interest, fees, royalties and dividends received

3) Other operating cash receipts, if any

4) Cash paid to employees and other supplies of good and services

5) Interest paid

6) Income taxes paid

7) Other operating expenses, if any

8) Contracts held for dealing or trading purposes

Indirect Method

Enterprises that choose not to provide the major classes of operating cash receipts and payments by
the direct method shall determine and report the same amount of net cash flow from operating
activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities.
Income Statement -decrease in
Accounts inventory
+decreases in
accounts payable or +decrease in
accounts payable
-accounts receivable
-Increase in accounts
+decrease in payable
deferred revenue or

-decrease in deferred
Sales revenue revenue

-Depreciation,
Cost of good sold
depletion and
+decrease in interest amortization
receivable or expense
-Increase in interest +Decrease in accrued
receivable expenses or

+Amortization on -Increase n accrued

premium investment expenses or
on bonds or
+Decrease in prepaid
-Amortization on expenses
premium investment
on bonds
Interest Revenue and
dividend revenue
Selling and
+Increase in
administrator
unearned revenue or
expenses Cash Flows from
-decrease in
unearned revenue Operating Activities

+Gains on disposals
of assets and
liabilities
Collections
-Investment income
from customers

Other revenues

+Increase in
Adjustments inventory or
 Cash Inflows From
Operating
Interest and

= dividends Payments
collected = of
Operating
expenses

Other operating

= receipts

Net Operating cash

flow

Payments of

= Suppliers

Cash Outflows For

Operating Activities
 -Losses on disposal
of assets and
liabilities

Interest Expenses -investment loss

(equity method)

Decrease in income
taxes payable or

-Increase in income
taxes payable

+Decrease in = Payment
deferred income of interest
taxes payable or

-Increase in deferred
income taxes payable

Other expenses

+Decrease in interest
payable or = Other operating

-increase in interest Expenses

payable

+Amortization of
premium on bonds
Income tax expenses
payable or

-amortization of
discount on bonds
payable

= Payments
of income taxes
Cash Outflows For
Operating Activities
 Net Income After Taxes

Net Income After Taxes

Plus

Decrease in current assets (except cash, marketable securities and non-trade accounts)

Increase in current liabilities (except financing or non-operating accounts. e.g., bank, loan,
current maturities of long-term debt)

Depreciation, depletion and amortization expense

Amortization of discount on bonds payable

Amortization premium on investment in bonds

Increase in deferred income taxes

Loss (net) on disposal of assets or liabilities

Minus
Subsidiary loss under the equity method

Interest expenses*

Income taxes*

Increase in current assets (except cash, marketable securities and non-trade

accounts)

Decrease in current liabilities (except financing or non-operating accounts, e.g.,

bank loan, current maturities of long-termEquals
debt)

Amortization of premium on bonds payable

Net Cash
Amortization of discount on investment Flow Operations
in bonds
Interest paid Income taxes paid
Decrease in deferred income taxesCash from Operating Activities
Net

Gain (net) on disposal of assets or liabilities

Subsidiary gain under the equity method

Steps in Preparing the Statement of Cash Flows

These are the two most commonly used method of analysis to prepare the statement of cash flows (1)
the visual inspection method and (2) the worksheet method.

A. Visual Inspection Method

Step 1: Prepare the heading for the SCF and list the three major sections:

Net cash flow from operating activities

b. Cash flow from investing activities
c. Cash flow from financing activities
STEP 2: Determine the net change in cash that occurred during the accounting period.
STEP 3: Determine the company’s net income and list this amount as the first item in the net
cash flow from operating activities section.
STEP 4: determine whether the increase or decrease in each statement of financial position account
caused an inflow or outflow of cash and if so whether to an operating investing or financial activities.
STEP 5: If no cash glow occurred, determine whether the increase or decrease in cash balance
account (except cash) was the result of a non cash income statement item or as simultaneous
investing and financing transactions.
STEP 6: complete the various sections of the SCF (based on the analysis in step 4 and 5). Check the
subtotals of the sections sum to the net change (increase or decrease) in cash (step 2) and that the
sum of the net change and cash and the beginning cash balance equal to the ending reported on the
statement of financial position.

Worksheet method of analysis

This method is commonly used in practice because analysis of even the most complex set of
financial statements maybe documented in a relatively concise working paper. Before the statement
of Cash Flows is prepared, a worksheet is prepared and the cash flow effects of operating, investing
and financing activities during the accounting period are first analyzed. The steps used in the
worksheet method are as follows:

Step 1: Enter the accounts from the statements of financial position together with their beginning and
ending account balance and the net change in the account balance.

Step 2: Directly add the Net Cash flow from Operating Activities, Cash Flow from Investing Activities,
Cash Flow from Financing Activities and Investing and Financing Activities Not Affecting Cash.

Step 3: Reconstruct the journal entries that caused the changes in the noncash accounts directly on
the worksheet making certain modifications show the cash inflows and outflows related to operating,
investing and financing activities.

General rules for reconstructing journal entries :

1. Start with the net income. Debit to the caption Net Income under the heading Net Cash Flow from
Operating Activities and a credit to Retained earnings.
2. Next is Account for all the changes in the current asset and current lability accounts (except cash
and non-trade accounts).

3. Account for the changes in the noncurrent accounts. Identify whether the transactions involves an
operating, investing, or financing activity and make the entry on the worksheet.

EXAMPLES

• If bonds payable were issued for cash at face value.

• To adjust net income for depreciation (Noncash expense)

• If ordinary share was exchanged for land

Step 4: Make a final worksheet entry to record the net change in cash. The difference between the
total cash inflows and outflows must be equal to the change in the cash account.

Step 5: Prepare the Statement of Cash Flows and accompanying schedule.

Steps in Preparing the Statement of Cash Flows

These are the two most commonly used method of analysis to prepare the statement of cash flows (1)
the visual inspection method and (2) the worksheet method.

B. Visual Inspection Method

Step 1: Prepare the heading for the SCF and list the three major sections:

a. Net cash flow from operating activities

b. Cash flow from investing activities
c. Cash flow from financing activities
STEP 2: Determine the net change in cash that occurred during the accounting period.
STEP 3: Determine the company’s net income and list this amount as the first item in the net
cash flow from operating activities section.
STEP 4: determine whether the increase or decrease in each statement of financial position
account caused an inflow or outflow of cash and if so whether to an operating investing or
financial activities.
STEP 5: If no cash glow occurred, determine whether the increase or decrease in cash balance
account (except cash) was the result of a non cash income statement item or as simultaneous
investing and financing transactions.
STEP 6: complete the various sections of the SCF (based on the analysis in step 4 and 5). Check
the subtotals of the sections sum to the net change (increase or decrease) in cash (step 2) and
that the sum of the net change and cash and the beginning cash balance equal to the ending
reported on the statement of financial position.
 Net Income After Taxes

Net Income After Taxes

Plus

Decrease in current assets (except cash, marketable securities and non-trade

accounts)

Increase in current liabilities (except financing or non-operating accounts. e.g., bank,

loan, current maturities of long-term debt)

Depreciation, depletion and amortization expense

Amortization of discount on bonds payable

Amortization premium on investment in bonds

Increase in deferred income taxes

Loss (net) on disposal of assets or liabilities

Subsidiary loss under the equity method

Interest expenses*

Income taxes*

Minus

Increase in current assets (except cash, marketable securities and non-trade accounts)

Decrease in current liabilities (except financing or non-operating accounts, e.g., bank

loan, current maturities of long-term debt)

Amortization of premium on bonds payable

Interestpaid Income taxes paid

Amortization of discount on investment in bonds

Decrease in deferred income taxes

Net Cash
Gain (net) on disposal of assets from Operating Activities
or liabilities

Subsidiary gain under equity method