chapter 7 statement of cash flows

7/27/2019 Chapter 7 Statement of Cash Flows

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Chapter 7 Statement of Cash Flows

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Purpose of a statement of cash flows

Statement of Cash Flows = reports an entitys cash inflows & outflows for a specific period.

Prepared on a cash basis & IS is prepared on an accrual basis.

Important for working capital management of an entity. Working capital is needed to fund inventory &

debtors while awaiting receipts from sales .o Working capital = difference b/w amounts of current assets & current liabilities

o

o The # of times an entity can cycle through ^ process generally the more profit it can make (@

appropriate prices)


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Difference b/w cash & accrual accounting

According to the income statement, profit made = $7900. Alexandra also purchased & paid $6000 worth

of hair products, but the cost of products sold during the month = $5600. (The other $400 will form part

of inventory & be recorded as an asset)

The statement of cash flows shows that the entitys cash position is -$4000 (i.e. the bank acc is in

overdraft).

A comparison shows that although the company was quite profitable, the business will have trouble

meeting its financial obligations. Although income of $20,000 was generated, only $5000 of sales were

collected in cash.

For an entity to survive, the net cash flows from OPERATING ACTIVITIES should be positive.

Why is a statement of cash flows needed?

It summarizes the cash & types of cash flows coming into and flowing out of the entity . For instance, if

the entity received cash from bank loans but no cash as coming into the entity through normal

operations, it would indicate that the business isnt a good investment. Likewise, if ample cash came in

through its normal operations, therefore had no need for cash from borrowing a good entity to invest

in.


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Relationship of the statement of cash flows to other financial statements

It helps identify changes in balance sheet items. E.g. the sale or purchase of an asset for cash would have

an effect on both the BS & the statement of cash flows. Borrowing money & paying a dividend will also

affect both statements.

Its purpose is to give additional info to that provided by other statements . Generally, info provided should assist decision makers in assessing an entitys ability to:

o Generate cash flows

o Meet financial commitments, including servicing of borrowings + payment of dividends

o Fund changes in scope of its activities

o Obtain external finance

Relationship between items in the statement of cash flows & the income statement & BS


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CASH = cash and cash equivalents

Cash on hand notes & coins & deposits at call w/ a financial institution

Cash equivalents highly liquid investments & short-term borrowings

Format & classification of cash flows in the statement of cash flows

Operating activities activities relate to the provision of G+S and other activities that are

neither investing nor financing activities. E.g. cash sale of G+S, cash received from customers, receipt of

interest/dividends, payment to suppliers, payment of salaries & wages, payment of tax & interest

o Normally profit would be lower than cash from operating activities as profit includes non-cash

deductions e.g. depreciation & amortisation

Investing activities activities relate to the acquisition and/or disposal of non-current assets

(e.g. PPE) not falling within the definition of cash

o E.g. sale of PPE, sale of shares, collection of loans from other entities, purchase of PPE, purchase

of shares, lending of money

o An entity has to invest in order to generate future income & cash flows.

o If an entity has a desire to grow, net cash flow from investing activity would be negative

Financing activities activities that change the size and/or composition of the financial

structure of the entity (including equity) and borrowings not falling within the definition of cash.

o Activities generally associated w/ changes in non-current liabilities & equity (i.e. cash received

from the issue of shares/debt MINUS cash paid to shareholders/to repay debt)

o E.g. issue of the entitys own shares, cash from b orrowings, dividends paid to shareholders,

repurchase of shares from shareholders etc.

o Usually +ve inflow of cash from financing activities as generally entities borrow cash to fund

expansion healthy step to growth

o If over a long period of time borrowings are significant & the cash from operating activities is

struggling to pay interest costs solvency problem

o Paying cash out to owners weakens financial position of entity as it results in less money beingavailable for creditors & for the purchase of investments

o Why do entities buy back shares?

Generally entities buy back shares if they have surplus funds & there are no immediate

worthwhile investments that could earn the required rate of return

Having excess cash sitting on the BS earning minimal interest from a financial institution

decreases the overall return on equity for the entity


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Reconciliation of cash from operating activities w/ operating profit

The reconciliation of cash from operating activities w/ profit from income statement is presented to reinforce the

link b/w the cash received from operating activities & the profit/loss reported in the income statement

Producing a statement of cash flows using the direct method & a reconciliation using the indirect method

Direct method discloses major classes of gross cash receipts & gross cash payments

Indirect method adjusts profit/loss for the effects of transactions of a non-cash nature &

deferrals/accruals of operating revenue & expense.

If the balance of prepayments increases then we have paid more for expenses, thus decreasing cash flow

If the balance of accruals increases then we have a greater amount owing and have therefore paid less,

thus increasing cash flow

chapter 7 statement of cash flows

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