Learning objective

By the end of this chapter, you should be able to:

• Differentiate between profit and cash flow
• Describe the need for management to control cash flow
• Classify the effect of transactions on cash flows

Profit versus cash flow

Profit is the excess (surplus) of revenues over expenses for an accounting period, calculated using the accrual basis of accounting. Cash flow is the actual movement of cash into and out of the business during the same period.

These two measures often differ because accrual accounting records income and expenses based on when they are earned or incurred, not when cash changes hands.

Why profit ≠ cash flow

• Timing differences: Revenue is recognized when earned, not necessarily when cash is received. Expenses are recognized when incurred, not when cash is paid.
• Non-cash items: Depreciation, amortization, and provisions reduce profit without affecting cash.
• Capital transactions: Purchasing fixed assets uses cash but doesn’t immediately affect profit (the cost is expensed later through depreciation).
• Working capital changes: Increases in inventory or receivables use cash but don’t reduce profit.

Example

Consider a company that makes a $100,000 credit sale in December, purchases inventory for $60,000 and pays cash, and records $10,000 depreciation. Profit calculation:

	$
Revenue	100,000
Cost of sales	60,000
Depreciation	10,000
Profit	30,000

Cash flow impact:

	$	Explanation
Cash received	0	Sale was credit
Cash paid	(60,000)	Purchases were paid for
Depreciation	0	Non-cash item
Net cashflow	(60,000)

This analysis shows the key point: even though the company reports a $30,000 profit, it hasn’t received any cash from the sale and has paid out $60,000 in cash. If cash flows aren’t managed carefully, a business can face a cash crisis despite appearing profitable.

Reasons for cash flow management

Management must actively control cash flow for the following reasons.

• Liquidity requirements: Companies need cash to meet immediate obligations such as payroll, supplier payments, and loan repayments. A profitable company can still fail if it runs out of cash.
• Investment opportunities: Adequate cash flow allows a business to seize opportunities, invest in growth, and respond to market changes without relying only on external financing.
• Creditor confidence: Strong cash flow signals financial health to lenders, suppliers, and investors, which can improve credit terms and borrowing capacity.
• Dividend payments: Dividends require cash, not just profits. Shareholders’ returns can only be paid from available cash resources.
• Economic downturns: Cash reserves provide a buffer during difficult trading periods, helping a business survive temporary setbacks.

Cash flow management techniques

Management can control cash flow through:

• Accelerating cash collections from customers (credit control)
• Negotiating favorable payment terms with suppliers
• Managing inventory levels efficiently
• Timing capital expenditure appropriately
• Arranging appropriate financing facilities
• Forecasting cash flows to anticipate shortfalls

These have been covered in the last module under liquidity ratios.

Statement of cash flow

Cash flows are inflows (receipts) and outflows (payments) of cash and cash equivalents. Inflows are denoted as positive while outflows are denoted as negative on the statement of cash flow.

The statement of profit or loss reports financial performance (profitability). The statement of cash flows shows liquidity and solvency by explaining how cash and cash equivalents changed during the period.

Definitions

Regulatory framework

IAS 7: Statement of Cash Flows governs the preparation and presentation of cash flow statements. The standard applies to all entities preparing financial statements under IFRS.

Objective of IAS 7

The primary objective of IAS 7 is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a statement of cash flows. This statement classifies cash flows during the period according to operating, investing, and financing activities.

Scope

IAS 7 applies to all entities preparing financial statements in accordance with IFRS. The standard requires entities to present a statement of cash flows as an integral part of their primary financial statements, giving it equal prominence with the statement of financial position, statement of profit or loss and other comprehensive income, and statement of changes in equity.

Cash and cash equivalents

To prepare or interpret a statement of cash flows, you first need to be clear about what counts as “cash and cash equivalents” under IAS 7.

Definitions

Cash

It comprises cash on hand and demand deposits.

Cash equivalents

They are short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value.

Characteristics of cash equivalents

According to IAS 7, an investment normally qualifies as a cash equivalent only when it has a short maturity of three months or less from the date of acquisition. Key characteristics include:

1. Short maturity: Generally three months or less from the acquisition date
2. Readily convertible: Can be quickly converted to cash without significant transaction costs
3. Known amounts: The amount to be received is determinable with reasonable certainty
4. Insignificant risk: Minimal risk of changes in value due to interest rate or market fluctuations

Examples of cash and cash equivalents

Items that typically qualify:

• Cash in hand (petty cash, till floats)
• Cash at bank (current accounts, checking accounts)
• Short-term bank deposits (with a maturity of three months or less)
• Treasury bills (if purchased within three months of maturity)
• Commercial paper (short-term, highly liquid)
• Money market funds (with immediate access) Items that do NOT qualify:
• Bank overdrafts (unless repayable on demand and form an integral part of cash management)
• Equity investments (subject to price volatility)
• Long-term deposits (maturity exceeding three months)
• Preference shares (unless very close to the redemption date with a specified redemption amount)

Classification of cash flow statement

IAS 7 requires cash flows to be classified into three categories:

• Operating activities
• Investing activities
• Financing activities

Operating activities

Cash flows from the principal revenue-generating activities of the entity and other activities that are not investing or financing activities. Examples include:

• Cash receipts from customers for goods and services
• Cash payments to suppliers for goods and services
• Cash payments to employees (wages and salaries)
• Cash payments for operating expenses (rent, utilities, insurance)
• Cash receipts from royalties, fees, commissions
• Cash payments for income taxes (unless specifically identified with financing or investing activities)

Investing activities

Cash flows from the acquisition and disposal of long-term assets and investments not classified as cash equivalents. These items typically appear in the statement of financial position as non-current assets. Examples include:

• Cash payments to acquire property, plant, and equipment
• Cash receipts from disposal of property, plant, and equipment
• Cash payments to acquire equity or debt instruments of other entities
• Cash receipts from the disposal of equity or debt instruments of other entities
• Cash advances and loans made to other parties
• Cash receipts from repayment of advances and loans

Financing activities

Cash flows that result in changes in the size and composition of the contributed equity and borrowings (i.e., non-current liabilities) of the entity. Examples include:

• Cash receipts from issuing shares
• Cash payments to repurchase shares (treasury shares)
• Cash receipts from issuing debentures, loans, and bonds
• Cash repayments of amounts borrowed (loan principal, not interest)
• Cash payments of lease liabilities (principal portion)
• Cash payments of dividends