Introduction to cashflow statement
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 recognised when earned, not necessarily when cash is received. Expenses are recognised when incurred, not when cash is paid.
- Non-cash items: Depreciation, amortisation, and provisions reduce profit without affecting cash.
- Capital transactions: Purchasing non-current assets uses cash but doesn’t immediately affect profit (the cost is expensed later through depreciation).
- Working capital changes: Buying more inventory uses cash without reducing profit. An increase in receivables means revenue is in profit before the cash is received.
Example: Profit versus cash flow
Consider a company that makes a $100,000 credit sale in December, buys inventory for $60,000 in cash and sells all of it during the period, 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 cash flow (60,000) Answer: 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.
Statement of cash flows
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.
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.
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:
- Short maturity: Generally three months or less from the acquisition date
- Readily convertible: Can be quickly converted to cash without significant transaction costs
- Known amounts: The amount to be received is determinable with reasonable certainty
- Insignificant risk: Minimal risk of changes in value due to interest rate or market fluctuations
Examples of cash and cash equivalents
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
- Interest received
- Dividends received
Financing activities
Cash flows that result in changes in the size and composition of the contributed equity and borrowings (short-term and long-term loans, bonds and debentures, but not bank overdrafts that count as cash equivalents) 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 interest
- Cash payments of dividends
The next chapter, Operating cashflows, builds on these classifications to show how operating cash flow is calculated using the direct and indirect methods.