12.

2 – Cash flows from operating

activities
The first section of the Statement of Cash Flows shows Cash Flows from Operating Activities.
These are all the normal revenue-generating activities carried out by a firm in conducting its day-
to-day business, such as manufacturing goods or supplying services
This is the most important part of the Statement of Cash Flows. If the firm is not able to generate
cash from its operations, it cannot survive.
Examples of operating activities include:

 Cash received from customers

 Cash paid to suppliers
 Cash paid to employees
 Cash paid for other expenses
 Interest paid
 Income tax paid

See the video at right for an overview of the Cash Flows from Operating Activities section,
as well as an overview of the other two sections.
The total of this section is described as Net Cash Provided by (used in) Operating Activities. The
reason for the term in brackets is that if the total is a positive number, the net result of the
operating activities is that more cash has come in than gone out – cash has been provided by
operating activities – but the total is a negative number, the net result of the operating activities is
that more cash has gone out than come in – cash has been used in operating activities.

Treatment of Interest Received

Interest received would be classified as a cash flow from operating activities for a financial
institution, because it is in the business of paying and receiving interest, but there is some debate
as to whether interest received is a cash flow for operating activities or investing activities. The
Accounting Standards do not specify which it should be, and allows firms to make the choice
depending on its circumstances. For consistency, in your Business Simulation, you should treat
interest received as a cash flow from investing activities, which are discussed in the next section.

12.3 – Cash flows from investing

activities
The second section of the Statement of Cash Flows shows Cash Flows from Investing Activities.
This sections shows cash flows from the purchase or sale of non-current assets. Examples could
include the buying or selling of:

 Land and buildings

  Plant and equipment
 Motor vehicles
 Shares in other companies
 Loans made by the business

The latter item does not involve literally buying or selling anything, but rather lending money, or
being paid that money. A loan made by the company to another party is still shown as a non-
current asset on the Balance Sheet and acquiring or disposing of this asset is still a cash flow
from investing activities.
This section will also show:

 Dividends received
 Interest Received (as discussed in the previous section)

The total of this section is described as Net Cash Provided by (used in) Investing Activities

12.4 – Cash flows from financing

activities
The third section of the Statement of Cash Flows shows Cash Flows from Financing Activities. It
shows cash flows associated with the financing of the business, such as taking out loans or
issuing shares. The exception to this is short-term credit such as trade credit (i.e. Accounts
Payable). Even though it could be said that firm is using trade credit as a source of finance,
financing activities, for the purpose of the Statement of Cash Flows, is defined to mean using
long-term sources of finance.
Remember also, from Lesson 7, that leasing is considered to be source of financing. Examples
of financing activities include:

 Proceeds from the issue of shares

 Proceeds from long-term borrowing
 Repayment of long-term borrowing
 Payment of finance lease liabilities
 Dividends paid

The total of this section is described as Net Cash Provided by (used in) Financing Activities.
13.1 – Deducing cash flows from
operating activities
It would be possible to construct the Balance Sheet and Profit and Loss Statement, and then separately keep tra
transactions to construct the Statement of Cash Flows, but it would be much simpler to construct the Statement
Flows from the other two statements. Typically this involves a few simple calculations to deduce the required inf
information in those other two statements.
For this and the following two sections, we can illustration the process of constructing the Statement of Cash Flo
Sheet and Profit and Loss Statement using the sample statements to the right.
The typical components of this section of the Statement of Cash Flows are:

 Cash Receipts from Customers

 Cash Paid to Suppliers
 Cash Paid to Employees
 Cash Paid for Other Expenses
 Interest Paid
 Income Tax Paid

Outlined below are the calculations needed to deduce these values from the other two financial statements.
Click on the headings below to expand and collapse the content
Deducing Cash Receipts from Customers
This can be done as follows:

Opening balance of Accounts Receivable 15

plus Sales for the period 100

= Amount we might expect to receive 115

less Closing balance of Accounts Receivable (20)

= Cash received from customers 95

Deducing Cash Paid to Suppliers

There are two steps to this. First we have to deduce the amount paid for purchases, which is not
shown in the Profit and Loss Statement.

Opening Inventory 22
 plus Purchases X

= Amount available for sale 22 + X

Less Closing Inventory (the amount unsold) (30)

= Cost of Sales (the cost of the amount sold) 60

22 + X – 30 = 60, and therefore X = 60 + 30 – 22 = 68.

The final step is as follows:

Opening balance of Accounts Payable 10

plus Purchases for the period 68

= Amount we might expect to pay 78

less Closing balance of Accounts Payable (15)

= Cash paid to suppliers 63

Deducing Cash Paid for Tax

We would expect that taxes incurred in one year are paid in the next. The $4m in tax on the
Balance Sheet at the end of 2015 would be paid in 2016, and the $5m in tax shown on the Profit
and Loss Statement for 2016 appears as tax payable at the end of 2016. So cash paid for tax
would be $4m.

Final Cash Flows from Operating Activities

Since there are no prepayments or accruals on the Balance Sheet, we can assume that all other
expenses, including payments to employees and interest, were paid in cash during the
period. We can therefore construct the Cash Flows from Operating Activities as shown below.

Cash Receipts from Customers 95

Cash Paid to Suppliers (63)

Cash Paid for Other Expenses (including (17)

Employees)

Interest Paid (3)

 Income Tax Paid (4)

Net Cash provided by Operating Activities 8

13.2 – Deducing cash flows from

financing activities
It would be possible construct the Balance Sheet and Profit and Loss Statement, and then separately keep track
to construct the Statement of Cash Flows, but it would be much simpler to construct the Statement of Cash Flow
statements. Typically this involves a few simple calculations to deduce the required information from the informa
two statements.
For this and the following two sections, we can illustration the process of constructing the Statement of Cash Flo
Sheet and Profit and Loss Statement using the sample statements to the right.
The typical components of this section of the Statement of Cash Flows are:

 Cash Receipts from Customers

 Cash Paid to Suppliers
 Cash Paid to Employees
 Cash Paid for Other Expenses
 Interest Paid
 Income Tax Paid

Outlined below are the calculations needed to deduce these values from the other two financial statements.
Click on the headings below to expand and collapse the content
Deducing Cash Receipts from Investing Activities
The Cash Flows from Investing Activities section of the Statement of Cash Flows might include items such as:

 Land and buildings

 Plant and equipment
 Motor vehicles
 Shares in other companies
 Loans made by the business

In all of these cases (as long as the value of fixed assets is shown at cost, separately from depreciation) the cas
will simply be the change in the value of these assets. Depreciation is ignored because it is not a cash flow.

Final Cash Flows from Investing Activities

Based on the financial statements at right, we can therefore construct the Cash Flows from
Investing Activities as shown below.

Purchase of land and buildings 10

 Purchase of Plant and Equipment 10

Net Cash used in Investing Activities 20

Deducing Cash Flows from Dividends

Some detective work is required to deduce cash paid as dividends. The net profit for the year
was $10m, but retained earnings did not go up by $10m – it went DOWN by
$10m. Therefore $20m must have been declared as a dividend, and this can be seen as
Dividends Payable on the Balance Sheet at the end of 2016. This is because dividends declared
at the end of the year are not paid out in cash until the following year – after all, it takes time after
the end of the year to work out how much profit has been made and decide on dividends.
Since the value of Dividends Payable shown on the Balance Sheet at the end of 2016 is equal to
the total dividend which must have been declared to be paid the following year, as discussed
above, the Dividend Payable at the end of 2015 ($15m) must have been paid out in cash during
2016

Final Cash Flows from Financial Activities

Based on the financial statements at right and the discussion above, we can therefore construct
the Cash Flows from Financing Activities as shown below.

Proceeds from Issue of Share Capital 15

Proceeds from Long-term Borrowing 5

Dividends Paid (15)

Net Cash provided by Financing Activities 5

13.3 - Reconciling Net Profit with

Cash Flows from Operating Activities
Accounting Standards require that financial statements show a reconciliation between Net Profit and Cash Flows
Activities. This is a process that starts with Net Profit, makes appropriate adjustments to eliminate elements of p
flows, adjusts for changes in the Balance Sheet that result from cash flows from operating activities that do not g
and Loss Statement, and eliminates elements of profit that relate to investing activities (such as profit or loss on
The details of each type of adjustment are as follows:
Click on the headings below to expand and collapse the content
 Depreciation
Any non-cash expenses that have been used in calculating profit need to be reversed. The main example of thi
has been used as an expense to reduce profit, but since it’s not a cash flow, it needs to be added back to profit i
portray cash flow.

Current Assets

 Any increase in Current Assets represents a use of cash – for example, to buy
inventory. Similarly, an increase in Accounts Receivable is a reduction in the amount of
cash available, but it represents sales that have NOT been received in cash but are
instead owed by customers.
 Hence, a decrease in a Current Asset represents a receipt of cash.

Current Liabilities

 Any increase in Current Liabilities represents a positive cash flow – cash coming into the
firm. For example, an increase in short-term debt means that cash has been
borrowed. An increase in Accounts Payable means that cash that would have been
payable to suppliers has not been paid and is still owed.
 Hence, a decrease in Current Liabilities represents a use of cash; e.g. to pay down debt
or pay cash to suppliers.

Profit or loss on the sale of assets

These are included in the calculation of Net Profit but are not operating cash flows. They are
associated with investing activities. Any such profits are deducted from Net Profit, and any such
losses are added to Net Profit, in reconciling Net Profit with Cash Flows from Operating
Activities.
Reconciliation of Net Profit with Cash Flow from Operating Activities
This can be illustrated using the financial statements at right. We begin with Net Profit of $10m.

Net Profit 10

plus Depreciation 5

less Increase in Inventory* (8)

less Increase in Accounts Receivable* (5)

plus Increase in Accounts Payable** 5

plus Increase in Tax Payable** 1

Net Cash provided by Operating Activities 8

Notes:
* Inventory and Accounts Receivable have increased, which are uses of cash and negative
cash flows.
** Accounts Payable and Tax Payable have increased, representing sources of cash and
positive cash flows.

13.4 - Interpreting the Statement of

Cash Flows
We have seen that the Profit and Loss Statement is designed to measure the change in wealth
over a specified period of time, and this is usually best achieved through accrual accounting.
However, accrual accounting hides the movement of cash, and we saw in Topic 1 that cash is
the ultimate determinant of value and success over the entire lifespan of a firm. That’s where the
Statement of Cash Flows comes, so that in addition to the information contained in the Profit and
Loss Statement, we can see how and when the firm is generating and using cash. As has been
stated, a profitable firm that runs out of cash will go bankrupt if it can’t pay its debts.
In Lessons 14 to 15 we will look at the detailed analysis of the financial statements, but we can
make the following general points about interpreting the Statement of Cash Flows.

Decreases in cash
If a firm’s cash position is deteriorating, that is clearly a cause for concern that should be
addressed.

 If it’s because the firm is investing in non-current assets, that’s probably a good think in
terms of future profitability and success, as long as there is still enough cash to operate.
 If the deterioration is because of cash used in operating activities, that’s much more
concerning, because it means the firm is losing money.

Increases in cash
If a firm’s cash position is improving, that is not necessarily a good thing. It depends on the
reason(s). The question has to be asked – is this increase sustainable?

 If it’s because the firm is generating cash from operating activities, that’s clearly a healthy
situation.
 If a firm is losing cash through operating activities, but improving its cash position by
borrowing money or issuing new shares, that is clearly unsustained and should be a
cause for major concern. Over the years, many firms heading for bankruptcy had cash
flow statements just like this.