In addition to an income statement [profit and loss account] and balance sheet, companies are required to include in their annual report a “cash flow statement“. A cash flow statement presents cash flows under three main headings: “cash flow from operating activities, cash flow from investing activities and cash flow from financing activities“. But what kind of transactions [what accounts] grouped to each above activities? How is it presented? Or in short question; “how to prepare a cash flow statement?” This post provides basic knowledge about how to prepare it and give you some practice at analyzing the cash flows into the appropriate headings [cash flow from operating, investing and financing activities].

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Preparing a Simple Cash Flow Statement

Let’s start it with an example:

Lie Dharma Putra Inc. began trading on 1 January year 2008. Shares were issued for $120,000 cash and a $54,000 long-term loan was raised. The following transactions occurred during Year 2008:

  • Non-current (fixed) assets were purchased for $185,000 cash
  • Sales to customers amounted to $156,000; the receivables (also known as debtors) balance at 31 December was $7,200
  • Purchases from suppliers amounted to $64,900; the payables (also known as creditors) balance at 31 December was $5,600
  • Salaries and wages paid during the year were $61,100
  • Interest paid on the loan was $6,500; no interest payments were outstanding at the end of the year
  • $4,000 of the long-term loan was repaid during the year
  • Taxation paid during the year amounted to $620

 

The cash flow statement for the year ended 31 December 2008 will look like below figure. The notes at the end of the statement will help you to understand the derivation of some of the figures [see the numberings on each end of the description]:

A Simple Cash Flow Statement

Notes:

(1) Cash received from customers = $156,000 – $7,200 not yet received = $148,800

(2) Cash paid to suppliers = $64,900 – $5,600 not yet paid = $59,300

Total paid to suppliers and employees = $59,300 + $61,100 salaries and wages = $120,400

(3) The second column is being used simply to deduce a subtotal of the net cash flows from financing activities.

(4) Cash received and cash paid back in respect of the loan must be shown separately and not netted off against each other.

 

Next, we are going to discuss about how to prepare cash flow statement from income statement and balance sheet. This is a must skill for accountants to make sure the cash balance presented on the balance sheet is well tied with the other accounts on the balance sheet and the income statement at once. But before that you need to really understand how to determine the cash flow from operating activities. Move on…

 

Determining The Cash Flows From Operating Activities

There are two different methods which can be used to determine “cash flows from operating activities”, they are: “Direct Method” and “Indirect Method”.

The direct method shows the major types of operating cash receipts and operating cash payments. This is the method we have used so far in the cash flow statements in the simple cash flow statement previously.

The indirect method is more common in practice but at first it can seem more complicated. The indirect method begins by adjusting the profit or loss for the period for any non-cash transactions“.

An example will help to demonstrate how the indirect method works. Let’s have a look:

Extracted from the accounting records of Lie Dharma Putra Inc. are as follows:

  • Profit for the year before taxation = $422

Charges included in the profit calculation:

Cash payments made during the year:

  • Interest paid = $12
  • Taxation paid = $102
  • Dividends paid = $97

                                                    Balance at the                            Balance at the
                                                beginning of the year                   end of the year

Inventories                                            28                                          22
Trade and other receivables                  31                                          39
Trade payables                                      26                                          24

 

The calculation of the cash flows from operating activities begins by adjusting the profit figure for non-cash items. Use the notes below the calculations to help you to understand the adjustments being made [pay attention on the numberings on each of the description]:

How To determine Cash flow from Operating Activities

Notes:

(1) Depreciation is not a cash flow. It is the sharing out of the original amount paid for the non-current asset when it was first purchased. Since we are trying to derive the potential cash flow from profit the amount of depreciation that has been charged must be added back into profit.

(2) Interest expense is a cash flow but the amount charged against profit is not likely to be the actual cash flow figure because of the timing of cash payments. Since the amount of cash paid for interest must be shown further down the statement we eliminate the effect of interest here by adding it back to the profit figure.

(3) A decrease in inventories will increase the cash balance because less cash is tied up in the investment in inventory.

(4) An increase in receivables will decrease the cash balance because less cash has been received from customers.

(5) A decrease in payables will decrease the cash balance because more cash has been used to pay suppliers and others.

(6) Note this is the actual cash paid for interest, not the amount of interest expense charged in the income statement for the year.

 

How To Prepare A Cash Flow Statement From The Income Statement And Balance Sheets

Now that you understand the indirect method of determining the “cash flow from operating activities” we will look at a more advanced example of cash flow statement preparation. This example will demonstrate how a cash flow statement can be derived from an income statement and the balance sheets for two consecutive years. It should help you to undertsand the relationship between the income statement, the balance sheet and the cash flow statement.

Example:

The income statement for Year 2007 and the two consecutive balance sheets as of 31 December  2007 and 2008 for the Lie Dharma Putra Inc. are as follows:

Income Statement

A Two Consecutive Year Balance Sheet

The following information also relates to Year 2008:

  • The company paid $250,000 for new equipment.
  • No non-current assets were disposed of during the year.
  • No new long-term loans were arranged during the year.

 

Work carefully through the cash flow statement for Year 2008 which follows. Once again, use the notes below the statement to help you to understand the content and pay attention on the numberings.

Cash Flow Statement for the year ended 31 December 2008 would become as below:

How To Prepare Cash Flow Statement with Indirect Method

Notes:

(1) The addition of the new equipment would have increased the net book value of property, plant and equipment to $1,430,000 = $1,180,000 + $250,000. The balance sheet for Year 6 shows a net book value of $1,300,000. Therefore the charge for depreciation during Year 6 must have been $1,430,000 – $1,300,000 = $130,000.

(2) The cash paid for interest must be shown further down the statement, after we have presented a subtotal for the cash generated from operations. Since the interest expense has already been charged in deriving the profit figure we must add it back at this stage.

(3) Inventories have increased from $122,000 in Year 2007 to $178,000 in Year 2008. Investing an additional $56,000 in inventories would reduce the cash balance.

(4) Trade receivables have increased from $207,000 in Year 2007 to $272,000 in Year 2008. Allowing credit to more customers would reduce the cash balance.

(5) Trade payables have increased from $276,000 in Year 2007 to $288,000 in Year 2008. Taking more credit from suppliers would increase the cash balance.

(6) All of the interest for the year must have been paid in cash. Otherwise we would see an amount for interest owing listed as a current liability on the balance sheet.

(7) The balance that was owed for taxation at the end of Year 2007 is shown by the taxation creditor of $26,000 on the balance sheet. The income statement shows that an additional amount of $73,000 must be paid for Year 6 tax. However, not all of this has been paid because the balance sheet shows that $37,000 is still owed at the end of Year 2008. Therefore we can deduce the amount of tax that must have been paid as cash during Year 2008 as follows:

Cash Paid For Taxation

(8) The share premium balance has increased in year 2008 and so has the share capital account. Therefore shares must have been sold at a premium and the total cash received is calculated as follows:

Share Premium Calculation

(9) The balance on the long-term loan has reduced by $285,000 – $154,000 = $131,000

(10) These are the balance sheet figures for Year 2007 and Year 2008.