Unit 6: Cash Flow Statement - Subjective Questions

Meaning:

A Cash Flow Statement is a financial statement that summarises the inflows (sources) and outflows (uses) of cash and cash equivalents of an enterprise during a specific accounting period. It shows how changes in the balance sheet accounts and income affect cash and cash equivalents.

Components of Cash and Cash Equivalents (AS-3):

• Cash: Comprises cash on hand and demand deposits with banks.
• Cash Equivalents: Short-term, highly liquid investments that are readily convertible into known amounts of cash and which are subject to an insignificant risk of change in value. Examples include treasury bills, commercial paper, and short-term investments with maturity of three months or less.

Key Point: An investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition.

Significance / Objectives of Cash Flow Statement:

• Assessing Liquidity and Solvency: It helps in assessing the ability of the enterprise to generate cash and meet its obligations, dividends, and other commitments.
• Cash Planning and Control: Assists management in short-term financial planning and budgeting of cash.
• Evaluating Cash Position: Reveals reasons for the difference between net profit and net cash flow from operations.
• Comparability: Enables comparison of operating performance of different firms since it eliminates the effects of using different accounting treatments.
• Predicting Future Cash Flows: Helps users estimate the amount, timing, and certainty of future cash flows.
• Dividend Decisions: Helps in taking decisions regarding payment of dividends and repayment of loans.

Conclusion: It is a vital tool for financial analysis, focusing purely on the movement of cash rather than accrual-based profits.

Difference between Cash Flow Statement and Fund Flow Statement:

Conclusion: While both trace sources and uses of resources, the Cash Flow Statement is more precise for short-term liquidity while the Fund Flow Statement gives a broader view of financial position.

As per AS-3 (Revised), cash flows are classified into three activities:

1. Operating Activities:

These are the principal revenue-producing activities of the enterprise.

• Inflows: Cash receipts from sale of goods/services, royalties, fees, commissions.
• Outflows: Cash payments to suppliers, employees, taxes.

2. Investing Activities:

These involve acquisition and disposal of long-term assets and other investments.

• Inflows: Sale of fixed assets, sale of investments, interest and dividend received.
• Outflows: Purchase of fixed assets, purchase of investments.

3. Financing Activities:

These are activities that result in changes in the size and composition of owner's capital and borrowings.

• Inflows: Issue of shares, issue of debentures, raising loans.
• Outflows: Repayment of loans, redemption of debentures, payment of dividends, buy-back of shares.

Note: Proper classification is essential as the same item may be treated differently for financial and non-financial enterprises.

Direct Method:

Under this method, major classes of gross cash receipts and gross cash payments are disclosed.

• Cash received from customers
• Less: Cash paid to suppliers and employees
• Less: Cash paid for operating expenses and taxes
• = Net Cash from Operating Activities

Indirect Method:

Under this method, net profit or loss is adjusted for the effects of non-cash items and changes in working capital.

Steps:

• Start with Net Profit before Tax and Extraordinary Items
• Add: Non-cash and non-operating expenses (depreciation, goodwill written off, loss on sale of assets, interest paid)
• Less: Non-operating incomes (profit on sale of assets, interest/dividend received)
• Adjust for changes in current assets and current liabilities
• Less: Income tax paid
• = Net Cash from Operating Activities

Preferred Method:

The Indirect Method is more commonly used in practice because:

• It reconciles net profit with net cash flow.
• It is easier to prepare from readily available financial statement data.
• It highlights the difference between profit and cash generation.

Cash Flow from Operating Activities (Indirect Method):

Working Note:

• Depreciation is added back as it is a non-cash expense.
• Increase in current assets (Debtors, Prepaid) reduces cash; decrease in current liabilities (Creditors) reduces cash.

Answer: Net Cash from Operating Activities = ₹1,75,000

Treatment of Items in Cash Flow Statement:

(a) Depreciation:

• It is a non-cash expense.
• Added back to net profit under Operating Activities (indirect method).

(b) Proposed Dividend:

• Previous year's proposed dividend (declared and paid) is shown as an outflow under Financing Activities.
• Current year's proposed dividend is added back to compute net profit before tax (if already deducted).

(c) Interest on Debentures:

• Added back to net profit to arrive at operating profit.
• Interest actually paid is shown as an outflow under Financing Activities.

(d) Provision for Tax:

• Current year's provision is added back to net profit to arrive at Net Profit before Tax.
• Tax actually paid during the year is deducted under Operating Activities.

Note: These adjustments ensure that only actual cash movements are captured while non-cash items are eliminated.

Treatment of Interest and Dividend under AS-3:

For a Financial Enterprise (e.g., Banks, NBFCs):

• Interest Paid, Interest Received, and Dividend Received: Classified under Operating Activities, since these constitute their main business operations.
• Dividend Paid: Classified under Financing Activities.

For a Non-Financial (Other) Enterprise:

• Interest Paid: Classified under Financing Activities.
• Interest and Dividend Received: Classified under Investing Activities.
• Dividend Paid: Classified under Financing Activities.

Summary Table:

Conclusion: The classification differs because for financial enterprises these items are part of core operations, whereas for others they relate to financing/investing decisions.

Non-Cash Transactions:

These are transactions that do not involve any actual movement of cash or cash equivalents. Since a Cash Flow Statement records only actual cash inflows and outflows, non-cash transactions are excluded from it.

Reason for Exclusion:

• The primary objective of the statement is to report the sources and uses of cash. Non-cash items do not affect cash balances and hence including them would distort the statement.

Examples of Non-Cash Transactions:

• Depreciation on fixed assets.
• Issue of shares or debentures for consideration other than cash (e.g., against purchase of assets).
• Conversion of debentures into shares.
• Amortisation of goodwill and preliminary expenses.
• Revaluation of fixed assets.
• Acquisition of an asset by taking over a liability.

Disclosure: As per AS-3, such significant non-cash transactions should be disclosed separately by way of a note so that users get complete information.

Step 1: Prepare Machinery Account (at written down value) to find purchases.

WDV of machine sold = Cost − Accumulated Depreciation =

*Profit on sale = Sale price − WDV =

Step 2: Cash Flow from Investing Activities:

Answer: Net Cash used in Investing Activities = ₹1,90,000

Limitations of Cash Flow Statement:

• Ignores Non-Cash Transactions: It excludes important non-cash items like depreciation and issue of shares against assets, giving an incomplete picture.
• Not a Substitute for Income Statement: It shows cash position but not profitability; a firm may have high cash yet low profits or vice versa.
• Historical in Nature: It is based on past data and may not reflect the current cash position accurately.
• Ignores Accrual Concept: By focusing only on cash, it ignores the fundamental accrual basis of accounting.
• Manipulation Possible: Timing of receipts and payments can be adjusted to project a favourable cash position (window dressing).
• Not Suitable for Judging Liquidity Alone: Cash balance alone does not indicate liquidity; it must be read with the balance sheet.

Conclusion: Despite these limitations, when used alongside other financial statements, it remains a valuable analytical tool.

Cash Flow from Financing Activities:

Working:

• Total Inflows =
• Total Outflows =
• Net =

Answer: Net Cash from Financing Activities = ₹3,20,000

Steps in Construction of Cash Flow Statement (Indirect Method):

Step 1 — Compute Net Cash from Operating Activities:

• Take Net Profit before Tax and Extraordinary Items.
• Add non-cash and non-operating expenses (depreciation, interest paid, loss on sale of assets).
• Deduct non-operating incomes (interest/dividend received, profit on sale of assets).
• Adjust changes in current assets and current liabilities.
• Deduct income tax paid.

Step 2 — Compute Net Cash from Investing Activities:

• Add inflows from sale of fixed assets/investments, interest and dividend received.
• Deduct outflows for purchase of fixed assets/investments.

Step 3 — Compute Net Cash from Financing Activities:

• Add inflows from issue of shares, debentures, and loans raised.
• Deduct outflows for redemption, repayment of loans, dividend and interest paid.

Step 4 — Net Increase/Decrease in Cash:

• Add the results of the three activities.

Step 5 — Reconcile:

• Add Opening Cash and Cash Equivalents.
• The result should equal the Closing Cash and Cash Equivalents.

Formula:

Analysis of Cash Flow Statement:

The pattern of cash flows across the three activities reveals the financial health and strategy of an enterprise.

1. Operating Activities:

• A positive and growing cash flow indicates the core business is generating sufficient cash — a sign of healthy operations.
• Persistent negative operating cash flow signals trouble in the main business.

2. Investing Activities:

• Negative cash flow (net outflow) often indicates the firm is expanding by purchasing assets — a positive sign for growth.
• Large positive flow may mean the firm is selling assets, possibly to raise cash under stress.

3. Financing Activities:

• Positive flow indicates raising funds (shares/loans); negative flow indicates repayment of loans or dividend payments.

Interpretation Example:

• A healthy growing firm typically shows: Positive Operating, Negative Investing, and Mixed Financing cash flows.

Conclusion: Cash flow analysis helps assess liquidity, quality of earnings, growth strategy, and the ability to meet obligations, complementing ratio and profitability analysis.

Treatment of Provision for Taxation:

(a) When treated as a Current Liability:

• The difference between opening and closing provision is adjusted as a change in working capital under Operating Activities.
• No separate adjustment for tax paid.

(b) When treated as an Appropriation of Profit (Non-Current Item) — Common Approach:

Here it is dealt with in two stages:

• Step 1: The current year's provision made is added back to net profit to determine Net Profit before Tax.
• Step 2: The tax actually paid during the year is deducted as an outflow at the end of Operating Activities.

Prepare Provision for Tax Account to find Tax Paid:

Formula:

Conclusion: The appropriation approach is generally preferred as it accurately reflects actual cash outflow on tax.

Step 1: Operating Profit before Working Capital Changes:

Step 2: Cash Generated from Operations:

Explanation:

• Non-cash expenses (Depreciation, Goodwill) added back; non-operating income (Profit on Sale) deducted.
• Increase in current asset and decrease in current liability both reduce cash.

Answer: Operating Profit = ₹1,80,000; Cash Generated from Operations = ₹1,52,000

Difference between Operating and Investing Activities:

Conclusion: Operating cash flows reflect the earning capacity of core operations, while investing cash flows reflect capital investment decisions.

Meaning:

Financing Activities are those activities that result in changes in the size and composition of the owner's capital (including preference share capital) and borrowings of the enterprise. They relate to how the enterprise is financed.

Cash Inflows (Sources):

• Proceeds from issue of equity shares.
• Proceeds from issue of preference shares.
• Proceeds from issue of debentures / bonds.
• Proceeds from long-term and short-term borrowings/loans.

Cash Outflows (Uses):

• Redemption of preference shares.
• Redemption of debentures.
• Repayment of loans and borrowings.
• Payment of dividends (equity and preference).
• Payment of interest on loans and debentures.
• Buy-back of equity shares.
• Payment of share issue expenses / underwriting commission.

Note: For a non-financial enterprise, interest and dividend paid are classified here.

Step 1 — Fixed Assets Purchased:

Step 2 — Cash Flow Statement (Indirect Method):

A. Operating Activities:

B. Investing Activities:

C. Financing Activities:

Net Increase in Cash =

Verification: Opening Cash ₹70,000 + ₹40,000 = Closing Cash ₹1,10,000 ✓

Reasons Why Net Profit Differs from Net Cash Flow from Operations:

Net Profit is calculated on the accrual basis of accounting, whereas cash flow is based on actual cash movements. The key reasons for the difference are:

• Non-Cash Expenses: Items like depreciation, amortisation of goodwill, and provisions reduce profit but do not involve cash outflow.
• Non-Cash / Non-Operating Incomes: Profit on sale of assets or revaluation gains increase profit but are not operating cash inflows.
• Changes in Current Assets: An increase in debtors/inventory means sales/purchases recorded but cash not yet received/tied up — reduces cash without affecting profit proportionately.
• Changes in Current Liabilities: An increase in creditors means expenses recorded but not yet paid — cash retained.
• Credit Transactions: Sales and purchases on credit affect profit immediately but cash later.
• Prepaid and Outstanding Items: These create timing differences between recording of expense and actual payment.

Conclusion: The indirect method of the Cash Flow Statement reconciles this difference by adjusting net profit for non-cash items and working capital changes.