1.

THE CASH FLOW STATEMENTS

Introduction
At the end of each accounting period the trading profit and loss account and the balance sheet
are prepared
Theses-two statements however may not tell us clearly the movement of cash and its
application during the accounting period. A third financial statement knows as cash flow
statements is always prepared in accordance 'with an International Accounting Standards
Seven (IAS 7).

A cash flow statement is an additional financial statement that emphasizes the liquidity
position of the organization. It depicts changes in cash position (cash and cash equivalents)
from one period to another. The cash flow statement explains the reasons for such in flows
and outflows of cash as the case- might be. Cash flow statement reports cash flows during the
period. It provides an explanation for increases and decreases in cash and cash equivalent.

Cash flow can be defined as an increase or decrease in the amount of cash and cash
equivalent resulting from any business dealing.

In this case cash means cash at hand and deposits repayable on demand with any financial
institution, which includes even deposits denominated in foreign currency.

Cash equivalent, are short term highly liquid investment that are readily convertible into
known amount of cash without notice and which are within three month of maturity when
acquired, less advances from banks repayable within months from the date of advance.

Cash flows help management in making plans for the immediate future.
A projected cash flow statement or cash budget will help the management in ascertaining
how much cash will be available to meet obligations to trade Accounts payable, to pay bank
loans and to pay dividends to the shareholders.

A proper planning of cash resources will enable management to have cash available
whenever needed and put in the some profitable or productive use in case there is surplus
cash available.
The main purpose of the cash flow statement is trying to reconcile the profitability and
liquidity stand^ of any business because the profit and loss account may reflect a high profit
figure (level) and in actual sense when it does not correspond with the cash and cash
equivalent at hand.
The cash flow statement will help to explain why a firm with increasing Profitability may
experience liquidity problems and vice versa.

In addition, the uses of accounting information may be misled by the high profitable level and
think there is enough cash at hand for example
 Shareholders might believe that if the organizations profit and loss account shows high
profit then it should be able to pay them dividends - returns on capital.
 Employees might be convinced that by the high profit revealed they can begin demanding
for high pay and they will assume that the company / organization should be pay off their
outstanding wages and salaries if any.
 The government revenue agencies such as the Uganda Revenue Authority (URA) may not
listen to pleas by the organization to extend its tax payment period basing on the high
profit reflected in the profit and loss account. The URA may not appreciate that the
company may not be able to pay because the profitability does not correspond with the
liquidity.

 Investors, public and government may think that a firm has made profits and that has the
ability to pay its debts when they fall due.
Preparation of Cash flow Statement will help to resolve the above misinterpretations.

Benefits of Cash Flow Statement / Analysis

Preparation and presentation of cash flow statement is beneficial to the organization in the
following ways;
 A cash flow statement is useful for short term planning. A business needs sufficient cash
to meet its various obligations in the near future. Such as payment to suppliers,
procurement of fixed asset, payment of debts maturing in the near future and expenses of
the business.

 Helps in efficient cash management, cash flow analysis helps in evaluating financial
policies and cash proportion. Cash is the basis for all operations and hence a projected
cash flow statement will enable management to plan to and coordinate the financial
operations properly that know the sources and application of cash.
 Helps in Internal finance management; cash analysis provides information about funds,
which will be available from operation. This will help the management in determining
policies, regarding internal financial management for example possibility of repayment of
long-term debts, dividends; policies planning, replacement of plant and machinery.
 Disclose the movement of cash:
Cash flow statement discloses the complete story of cash movement; the increase in or
decrease of cash and the reason thereof can be known. It discloses the reasons for low cash
balances in spite of heavy operating profits or for heavy cash balances in spite of low profits.

A comparison of original forecast with the actual results highlights the trend of movement of
cash which may otherwise go undetected.
 Discloses success or failure of cash planning:
The extent of success and failure of cash planning can be known by comparing the
projected cash flow statement with the actual cash flow statement and necessary remedial
measures can be taken.

Limitations of Cash Flow Analysis

 Cash flow statement cannot be equated with the income statement. An income statement
takes into account both cash as well as non cash items and therefore net cash flow does
not necessarily mean net income of the business.
 Cash flow statement cannot replace the income statement. Each of them has a separate
function to perform.
 The cash balance disclosed by the cash flow statement may not represent the real liquid
position of business since it can be easily influenced by postponing purchases and other
payments.

Presentation of Cash Flow Statement

A cash flow statement is prepared and presented in accordance with LAS 7. According to
LAS 7, Cash flows during the period should be classified and presented under three main
headings
• Cash flow from operating activities
• Cash flow from or towards investing activities
• Cash flow from or towards financing activities.

Operating Activities
This shows whether and to what extent organization can generate cash flow from its
operations. These are generally cash effect of transaction and other events relating to
operating and trading activities.

The Net cash flow from operating activities represents the Net increase / decrease in cash and
cash equivalents resulting from the operation.
Generally cash flows from operating activities will be those activities which determine the
net profit or loss of any business enterprise for example these include cash receipts from
sales, receipts from fees and commission cash payment to suppliers cash payments for and on
behalf of employees.

Methods of Presenting Cash Flow Statement

Cash flows from operating activities are presented following either the direct or indirect
method.

1. Indirect Method

Here you start with the operating profit (PBIT) as determined in the income statement, adjust
it for non-cash flow items and movements in working capital items as discussed below.
Adjustments for non-cash flow items;
• Depreciation on assets
Depreciation does not result in outflow of cash and yet is charged in the profit and loss
account as an expense hence reducing on the net profit. Therefore the depreciation on non-
current assets must be added back to the net profit in order to find out the real cash generated
from operations.
• Amortization of intangible asset
Goodwill, preliminary expenses and other intangible assets written off against profit reduces
the net profit without affecting the cash balance. The amount written off should therefore be
added back to the operating profit to find out the cash from operations.
• Loss on sale of asset
In case of a loss on disposal it does not result in any cash outflow and yet it is charged against
the profit and as expense. Such losses on disposal of asset must be added back to the net
profit. Because it had understated the profits
• Gains/profit from sale of Non-current asset:
These are taken to be profit earned as a result of sale / disposal of an asset. The profit is
always added on the profit of the year and yet does not result in an extra inflow of cash.
Therefore such profit on sale of asset must be subtracted from the operating profit because
they had overstated the profits.
• Provision for bad debts
These are just mere book keeping entry and does not involve payment out of cash. When
preparing the profit and loss account an increase in the provision for bad debts is included in
the expenses hence reducing on the operating profit. Such increase must be added back to the
profit.
On the other hand, a decrease in the provision for bad debts is taken as an income which is
added on the gross profit and hence increasing the net profit of the year yet the cash flow is
not affected. Such decrease must be deducted from the operating profit when preparing the
cash flow statement.

Adjustments for movement in Working Capital Items

The term working capital is normally used to indicate the amount of funds which a business
has at any time to enable it meet demands requiring immediate settlement. This consists of
current assets such as Accounts Receivable, Inventories, bank, prepayment of expenses these
are sometimes known as circulating capital, they are assets, which are easily converted into
cash.
Working capital also include those liabilities or obligation which the business must satisfy by
payment in cash in the very near future, they include trade Accounts Payable for goods
supplied, bank overdraft, bills payable, accrued expenses for services rendered, income tax
payable, dividends payable, incomes received in advance etc.

The following adjustments are required when preparing a cash flow statement;
Accounts Receivable
Increase in Accounts receivable implies that there is a sale of goods on credit, which has a
positive effect on the operating profit. When Accounts receivable increase it means that
receipts are being delayed, the business is giving along credit period, and this reduces the
cash in-flows and yet the profit and loss reflects a high profit figure. This increase in accounts
receivable must be subtracted from the operating profit.
A decrease in Accounts receivable implies that there are receipts from customers hence
cash inflows and therefore such reduction must be added back to the operating profit.

• Accounts Payable
An increase in Accounts payable implies that there is purchase of goods on credit and the
business is delaying payment to its suppliers. This means that business is delaying payment
hence retaining cash, indirectly its taken to be an inflow of cash. Purchase of goods being an
element of cost of sales an increase in trade accounts payable for purchases reduces the profit
for the year and yet it does not involve any cash payment. An increase in Accounts payable
must be added back to the operating profit.
The decrease in accounts payable from one period to another implies that there is. payment
to Suppliers hence a decrease of cash from operation. This reduction must be subtracted from
the operating profit.

Outstanding expenses and income received in advance

The effect of these items on cash from operation and operating profit is the same as the effect
of Accounts payable.
This means that any increase in these items will result in increase in cash from operation
while any decrease means decrease in cash from operations.
This is because the operating profit from is computed after charging all expenses 1 whether
paid or outstanding.

In ease certain expenses have not been paid this will result in decrease of operating profit
without corresponding decrease in cash from operations.
Similarly incomes received in advance is not taken into account while computing profit from
operations since it relates to next year. It means cash flow from operation will be higher than
the actual net profit as shown by profit and loss account. This must be added back on the
operating profit.

• Prepaid expenses and outstanding incomes

The effect of prepaid expenses and outstanding incomes on cash from operations is similar to
the effect of Accounts receivable.
While computing operating profit, the expenses for the accounting period are charged to the
profit and loss account,
Expenses paid in advance are not charged to the income statement. This prepayment of
expenses does not decrease the operating profit for the year but it decreases cash flow from
operations.
Similarly income are earned during the year are credited to the profit and loss account
whether it has been received or not.
Thus incomes which has not been received but which has become due/outstanding are added
to the operating profit for the year without increasing cash from operation, such must be
deducted from the operating profit.

• Opening and Closing Inventory

The amount of opening Inventory is charged to the debit side of the income statement. It thus
reduces the operating profit without reducing the cash from operations.

Similarly, the amount of closing Inventory is credited to the income statement it thus
increases the amount of operating profit without increasing the cash from operation. Put the
other way around an increase in Inventory implies that cash must have gone out for
acquisition or purchase of tradable inventory (goods).

While a decrease means, there is a sale of Inventory hence an inflow of cash on assumption
that there is cash sale of Inventory.
Generally, any non-cash flow items and changes in working capital item that will have
increased the operating profit must be subtracted and. any item that will have decreased the
operating profit must be added back so as to determine the net cash flows from operations.

Direct Method
If cash flow statement is presented following the direct method, Cash flows are categorized
and presented under their major classes. The classes may include;
o Cash receipt from sales
o Collections from customers/ Accounts receivable
o Payments to trade suppliers
o Payments to other suppliers
o Payments to and on behalf of the employees

Although IAS 7 recommends organizations to use direct method as the most preferred
method, the indirect method is more popular.
The direct method is preferred because the cash flows can be traced to the activities of the
organization unlike indirect method where cash flows from operations are determined using
the income statement and the balance sheet.
However, implementation of the method will require management of both accrual and cash
accounting system which may be expensive for the organization.
The indirect method uses information from the income statement and balance sheet prepared
following the accrual system hence only one system is required.

Investing Activities
This relates to changes in non-current assets which will generate future profit and cash flows.
Examples include;
o Sale of property, plant and equipment
 o Investment in debentures and other loan instruments of other organizations.
o Purchase of plant, property and equipment.
o Disposal of equity and debenture interests in another company
Note that in case there is a sale of an asset then you expect the cost of the asset to reduce as
compared to the previous year.
But if there is a sale of an asset and the cost of the asset is seen increasing then it would mean
that there was a double transaction of sale and purchase of an asset during the period.
It's therefore necessary to prepare that particular asset account and determine the value of the
purchase asset.

Financing Activities
This relates to cash flows from or towards the providers of finance. Examples include: -
o Issue of new shares, in case shares have been issued and cash is received that is after
deducting expenses on issue of shares or discount on issued shares will he taken as
source of cash. This will also include the share premium.
o Raising of long term loans and debentures
o Long-term loans such as issue of debenture from Financial Institutions are sources of
cash, however the interest paid in these loans is regarded as cash out flows.
o Payment of long-term loans.
o The payment of long term loans, such as term loan and debentures result into cash out
flow.
o Decrease in unsecured loan deposits
o The decrease in these liabilities denotes that they have been paid off
o Payment of Dividends
o These are returns on capital invested by the shareholder. This decreases the cash
available for business hence its an out flow of cash.
o Short term borrowing
o Cash receipts from banks, short-term borrowing increase cash in-flows.

PROFORMA CASH FLOW STATEMENT (indirect Method)-IAS 7

Cash flows from operating activities
Operating Profit/profit/(loss) before interest and tax xx
Depreciation charge for the year xx
Amortization (intangible and fictitious assets) xx
Increase / (decrease) in accounts payable xx / (xx)
(Increase )/decrease in accounts receivable (xx)/ xx
(Increase) / decrease in inventory (xx)/ xx
Loss/(gain) on disposal xx / (xx)
Increase/(Decrease) in provision for bad debts xx / (xx)
Cash generated from operations xx
Interest paid (xx)
Taxes paid (xx)
Net cash flows from operating activities xx
Cash flows from investment activities
Acquisition (or purchase) of non-currents assets (xx)
Disposal of non-currents assets xx
Net cash flows from investing activities xx
Cash flows from financing activities
Issue of shares (including share premium) xx
Issue of debentures xx
Acquisition of Long-term loan xx
Dividends Paid (xx)
Redemption of debentures (xx)
Repayment of loan (xx)
Net cash flow from financing activities xx
Increase / (Decrease) in cash and cash equivalents xx/(xx)
Add: Cash and cash equivalents at b/d (Note) xx
Cash and cash equivalents at c/d (Note) xx

Note:
1. Analysis of cash and cash equivalents
1.1.20-2 3 I.Dec 20-3 Change
(Balance b/d) (Balance c/d)
Cash in hand xxx xxx
Cash at hank xxx xxx
Cash equivalents xxx xxx

2. When preparing the statement from comparative balance sheets you will usually have
to calculate such items as depreciation, loss on sales of asset and profit for the year.
3. Work out the profit if not already given using opening and closing balance, interest
expenses, tax charge, and dividends.
Shs.000
 Closing balances (P&L a/c)/Retained earning xxx
Add: Dividends (proposed and paid) xxx
Provision for taxation xxx
Interest expenses xxx
Less: Opening balance (P&L A/c)/Retained Earnings (xxx)
Profit for the year (PBIT) xxx

Retained Earnings Account

Balance B/d xxx

Interest expenses xxx Operating profit for the year xxx

(PBIT) (Balancing figure)
Taxation xxx
Dividends XXX
Balance B/d xxx
xxx Xxx

PROFORMA CASH FLOW STATEMENT-Direct Method

Cash flows from operating activities
Receipts from sales xx
Collections from customers xx
Payment to suppliers (xx)
Payments to and on behalf of staff (xx)
Cash flows from operations xxx
Taxation (xxx)
Interest paid (xxx)
Net cash flows from operating activities xxx
Cash flows from investing activities
Acquisition of non-current assets (xx)
Proceeds from disposal of investment xx
Proceeds from disposal non-current assets xx
Net cash flows from investing activities xx
Cash flows from financing activities
Proceeds from issue of shares xx
Dividend paid (xx)
Loan repayments (xx)
Net cash flows from financing activities xx
Increase/decrease in cash and cash equivalents xx
Add: Cash and cash equivalents at b/d xx
Cash and cash equivalents at c/d xx

ILLUSTRATION
ABC Company reported the following for its most recent fiscal year:
Net income 200,000
Depreciation expense 50,000
Increase in accounts receivable 10,000
Decrease in merchandise inventory 2,000
Increase in prepaid expenses 1,000
Decrease in accounts payable 9,000
Increase in wages payable 3,000
Loss on sale of equipment, 1,000

The operating activities would report the following, using the indirect method:

Cash flows from operating activities

Net income                                                                      200,000
Adjustments to reconcile net
income to net cash provided by
operating activities
Increase in accounts receivable                            (10,000)
Decrease in merchandise inventory                               2,000
Increase in prepaid expenses                                             (1,000)
Decrease in accounts payable                                            (9,000)
Increase in wages payable                                              3,000
Depreciation expense                                                           50,000
Loss on sale of equipment                                                1,000
Net cash provided by operating activities                                    236,000

CASH FLOWS FROM INVESTING ACTIVITIES

Investing activities include cash inflows from:

·       Sale of long-term assets
·       Sale of investments (except trading securities)
·       Collections of notes receivable

Investing activities include cash outflows from:

·       Purchase of long-term assets
·       Purchase of investments (except trading securities)
·       Loaning cash to others

Obtaining the data for the investing activities section involves three steps:
1.    Calculate the increase or decrease in the long-term asset accounts
2.    Reconstruct the changes in the accounts
3.    Report their effects in the investing activities
For example, if the balance of Equipment for ABC Company was 100,000 at the beginning of
the year, and 120,000 at the end of the year, we can say Equipment increased by 20,000
during the year.

However, a detailed reconstruction of Equipment revealed the following:

Equipment, beginning of year                            100,000

Purchases of equipment                               30,000
Sales of equipment                                            (10,000)
Equipment, end of year                            120,000

The equipment sold had an original cost of 10,000 and accumulated depreciation of 4,000, so
its book value was 6,000. Assuming the equipment was sold for 5,000, a loss of 1,000 on sale
of equipment was incurred.

The investing activities section for ABC Company would report the following:

Cash flows from investing activities

Cash received from sale of equipment              5,000
Cash paid for purchase of equipment           (30,000)
Net cash used in investing activities                                         (25,000)

The loss on sale of equipment of 1,000 would be added to net income in operating activities.

CASH FLOWS FROM FINANCING ACTIVITIES

Financing activities include cash inflows from:

·       Issuing stock
·       Issuing debt

Financing activities include cash outflows from:

·       Purchasing treasury stock
·       Retiring stock by purchase
·       Debt payments
·       Dividend payments

For example, if a company issued stock for $50,000 but repaid debt of $20,000, the financing
activities section would report the following.

Cash flows from financing activities

Cash received from issuing stock                           50,000
Cash paid to retire debt                                        (20,000)
Net cash provided by financing activities      30,000
PROVING CASH BALANCES

After preparing the operating, investing and financing activities of the statement of cash
flows, one final step remains. We must report the beginning and ending balances of cash and
cash equivalents, and prove that the net change in cash is explained by summing the
operating, investing, and financing activities.

Assume the beginning of year cash balance for Michelle Company was 100,000, and the end
of year cash balance was $341,000. The net increase in cash would be 241,000. Michelle
Company’s statement of cash flow, once completed, would appear as follows.

Cash flows from operating activities

Net income                                                                   200,000
Adjustments to reconcile net Income to net cash provided
by operating activities
Increase in accounts receivable                            (10,000)
Decrease in merchandise inventory                             2,000
Increase in prepaid expenses                                        (1,000)
Decrease in accounts payable                                          (9,000)
Increase in wages payable                                         3,000
Depreciation expense                                                 50,000
Loss on sale of equipment                                             1,000
Net cash provided by operating activities                                       236,000

Cash flows from investing activities

Cash received from sale of equipment              5,000
Cash paid for purchase of equipment            (30,000)
Net cash used in investing activities                                                             (25,000)

Cash flows from financing activities

Cash received from issuing stock                            50,000
Cash paid to retire debt                                     (20,000)
Net cash provided by financing activities                                                  30,000

Net increase in cash                                                                                         241,000

Cash and cash equivalents at prior year-end                                                    100,000
Cash and cash equivalents at current year-end                                               341,000

The cash and cash equivalents balance at current year-end must agree with the balance for
cash and cash equivalents reported on the balance sheet.