Revise lecture 29

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•Statement of cash flows
– IAS 7

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 Statement of cash flows – IAS 7
Objective of the statement of cash flows IAS 7

• To ensure that all entities provide information

about the historical changes in cash and cash
equivalents by means of a statement of cash
flows.
• To classify cash flows (i.e. inflows and outflows of
cash and cash equivalents) during the period
between those arising from operating, investing
and financing activities.
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 Statement of cash flows – IAS 7
Usefulness of cash flow
• Users of financial statements need information on
the liquidity, viability and financial adaptability
of entities. Deriving this information involves the
user making assessments of the future cash flows
of the entity.
• Future cash flows are regarded (in financial
management theory and increasingly in practice
in large companies) as the prime determinant of
the worth of a business.

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 Statement of cash flows – IAS 7
• Although IAS 7 does not prescribe a format
for statements of cash flows, it does require
the cash flows to be classified into:

1. Operating activities
2. Investing activities
3. Financing activities

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 Statement of cash flows – IAS 7
• This classification may require a particular
transaction to be shown partly under one
heading and partly under another.
• For example, when the cash repayment of a
loan includes both interest and capital, the
interest might be shown as an operating
activity and the capital element as a financing
activity.

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 Statement of cash flows – IAS 7

• The objective of the standard headings is to

ensure that cash flows are reported in a form
that highlights the significant components of
cash flow and facilitates comparison of the
cash flow performance of different
businesses.

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 Statement of cash flows – IAS 7
• One reason why the statement of cash flow
was considered necessary is that final profit
figures are relatively easy to manipulate.
There are many items in an income statement
involving judgement:
1. Inventory valuation
2. Depreciation
3. Allowance for receivables

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 Statement of cash flows – IAS 7

• This makes it difficult to interpret a

company’s results with confidence. A
statement of cash flows showing merely
inflows and outflows of cash is easier to
understand and more difficult to manipulate.

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 Statement of cash flows – IAS 7
Definitions

• Cash: cash on hand (including overdrafts) and

on demand deposits.

• Cash equivalents: short-term, highly liquid

investments that are readily convertible into
known amounts of cash and are subject to an
insignificant risk of changes in value.
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 Adjustments to profit before tax
Depreciation

Depreciation is not a cash flow.

• Capital expenditure will be recorded under

‘investing activities’ at the time of the cash
outflow.
• Depreciation has to be added back to reported
profit in deriving cash from operating activities.

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 Adjustments to profit before tax
Profit / loss on disposal on non-current asset

When a non-current asset is disposed of:

• The cash inflow from sale is recorded under

‘investing activities’
• A loss on disposal is added to profit in deriving
cash from operating activities.
• Similarly, a profit on disposal is deducted from
profit.

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 Adjustments to profit before tax
Change in receivables

• An increase in receivables is a deduction from

profit in deriving cash from operating
activities.

• Similarly, a decrease in receivables is an

addition to profit.

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 Adjustments to profit before tax
Change in inventory

• An increase in inventory is a deduction from

profit in deriving cash from operating
activities.

• Similarly, a decrease in inventory is an

addition to profit.

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 Adjustments to profit before tax
Change in payables

• An increase in payables is an addition to

profit in deriving cash from operating
activities.

• Similarly, a decrease in payables is a

deduction from profit

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 Adjustments to profit before tax
Interest paid and income taxes paid

The final adjustments to find cash flow from

operating activities are:

• Deduct interest paid

• Deduct interest element of finance lease
payments
• Deduct income taxes paid

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 Investing activities
Investing cash flows include:

1. Cash paid for property, plant and equipment and

other non-current assets
2. Cash received on the sale of property, plant and
equipment and other non-current assets
3. Cash paid for investments in or loans to other
entities
4. Dividends received on investments.

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 Financing activities
Financing cash flows comprise receipts or
repayments of principal from or to external
providers of financing including:

• Receipts from issuing shares or other equity

instruments.
• Repayments of amounts borrowed (other
than overdrafts)

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 Financing activities

• The capital element of finance lease rental

payments.

• Receipts from issuing debentures, loans,

notes and bonds and from other long-term
and short-term borrowings (other than
overdraft, which are normally included in cash
and cash equivalents).
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 Advantages of the statement of cash
flows

• It may assist users of financial statements in

making judgements on the amount, timing
and degree of certainty of future cash flows.

• It gives an indication of the relationship

between profitability and cash generating
ability and thus of the quality of the profit
earned.
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 Advantages of the statement of cash
flows

• Analysts and other users of FS often, formally

or informally, develop models to assess and
compare the present value of the future cash
flow of entities. Historical cash flow
information could be useful to check the
accuracy of past assessments.

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 Advantages of the statement of cash
flows
• A statement of cash flows in conjunction with
a statement of financial position provides
information on liquidity, viability and
adaptability.

• Cash flows cannot be manipulated easily and

are not affected by judgement or by
accounting policies.

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 Interpretation of statements of cash
flow
• The statement of cash flows should be reviewed
after preparation. In particular, cash flows in the
following areas should be reviewed:

1. Cash generation from trading operations

2. Dividends and interest payments
3. Capital expenditure
4. Financial investment
5. Management of financing
6. Net cash flow

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 Limitations of the statement of cash
flows
• Statements of cash flows are based on
historical information and therefore do not
provide complete information for assessing
future cash flows.

• There is some scope for manipulation of cash

flows, e.g. a business may delay paying
suppliers until after the year end.

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 Limitations of the statement of cash
flows

• Cash flow is necessary for survival in the

short-term, but in order to survive in the
long-term a business must be in profitable.
A huge cash balance is not a sign of good
management if the cash could be invested
elsewhere to generate profit.

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