In context of Cash Flow Statement, what is cash and cash equivalent? In what categories cash flows are classified and explain how cash flow in each activity is calculated as per AS-3. Describe how cash flow statement is prepared under Direct Method

Cash and Cash Equivalents in the Context of Cash Flow Statement

In the context of the Cash Flow Statement, cash and cash equivalents represent the liquidity of a business and play a critical role in understanding the cash inflows and outflows within a given period. They are fundamental components that affect the calculation and presentation of a company’s cash position over time.

Cash

The term "cash" refers to physical currency and demand deposits. In the context of the cash flow statement, cash refers to the actual cash held by a company, which includes coins, banknotes, and funds that are immediately available for use. This would also include amounts that are readily available for payment, such as cash in hand and at the bank that are unrestricted and can be accessed for daily operations.

Cash Equivalents

Cash equivalents are short-term, highly liquid investments that are readily convertible to a known amount of cash with an insignificant risk of changes in value. These include investments in instruments such as treasury bills, commercial paper, money market funds, or short-term government bonds that mature within 3 months or less from the date of acquisition. Cash equivalents have a very low risk of fluctuation in value, which is why they are treated similarly to cash in the cash flow statement.

Therefore, cash and cash equivalents collectively refer to the sum of all liquid assets that are available for immediate use, including both cash at hand and any highly liquid, short-term financial instruments that can be quickly converted into cash without significant loss of value.

Classification of Cash Flows as Per AS-3 (Revised)

The Cash Flow Statement is classified into three main categories under the Accounting Standard AS-3 (Revised), issued by the Institute of Chartered Accountants of India (ICAI). These categories help in organizing the cash inflows and outflows of the company in a manner that is useful for understanding its financial health and its ability to generate cash from different business activities. The three categories are:

Operating Activities
Investing Activities
Financing Activities

Each of these categories reflects different aspects of the company's operations, and the cash flows under each are calculated differently.

1. Operating Activities

Operating activities are the principal revenue-generating activities of a business. These activities include transactions and events that directly relate to the core operations of the company. In essence, operating activities represent the cash flows that result from the company's regular business activities, such as selling goods or providing services.

Calculation of Cash Flows from Operating Activities (AS-3)

There are two methods to calculate the cash flow from operating activities: Direct Method and Indirect Method. AS-3 recommends the Indirect Method, though the Direct Method is also permitted.

Under the Indirect Method, the cash flow from operating activities is derived by adjusting the net profit for non-cash items, changes in working capital, and any other cash-related adjustments. The process follows these steps:

Start with Net Profit After Tax (PAT).
Adjust for Non-Cash Items: These include depreciation, amortization, impairment losses, provisions, and any other non-cash charges.
Adjust for Non-Operating Income/Expenses: Adjust for any income or expenses not related to the core business activities (e.g., interest income, gains or losses on the sale of assets).
Adjust for Changes in Working Capital: Working capital refers to the difference between a company’s current assets and current liabilities. Changes in current assets (like accounts receivable, inventories, etc.) and current liabilities (like accounts payable) are reflected as part of cash flows in operating activities.
For example:
- An increase in accounts receivable would represent a use of cash, so it is subtracted.
- An increase in accounts payable represents cash inflow since the company is delaying its payments to suppliers, so it is added.
Adjust for Other Cash Flows from Operating Activities: Cash payments and receipts for operating activities that are not captured in the other adjustments should also be included.

Example of Operating Activity Calculation under Indirect Method:

Net profit: ₹10,00,000
Add: Depreciation: ₹1,50,000
Less: Increase in Accounts Receivable: ₹2,00,000
Add: Increase in Accounts Payable: ₹50,000
Cash Flow from Operating Activities: ₹10,00,000 + ₹1,50,000 - ₹2,00,000 + ₹50,000 = ₹9,00,000

2. Investing Activities

Investing activities include transactions related to the purchase and sale of long-term assets, investments, and any cash flows that result from the acquisition or disposal of property, plant, equipment, and investments in financial instruments (excluding cash equivalents). This category reflects the cash impact of the company's investments in its future growth and operations.

Calculation of Cash Flows from Investing Activities (AS-3)

Investing activities typically include:

Cash inflows from the sale of fixed assets (property, plant, equipment), investments, or loans made to third parties.
Cash outflows for purchasing fixed assets, acquiring companies or other businesses, or investing in securities or bonds.

For example:

If a company sells a piece of equipment for ₹50,000, the inflow is recorded as a cash inflow from investing activities.
If the company buys land for ₹200,000, that amount is recorded as a cash outflow under investing activities.

3. Financing Activities

Financing activities involve transactions with the company’s owners and creditors that affect the company’s equity and debt. This category reflects cash flows from borrowing and repaying debts, issuing or repurchasing shares, and paying dividends.

Calculation of Cash Flows from Financing Activities (AS-3)

Financing activities typically include:

Cash inflows from issuing shares or borrowing funds (e.g., through loans or issuing bonds).
Cash outflows for repaying borrowed capital, repurchasing shares, or paying dividends.

For example:

If the company issues new shares and raises ₹1,00,000, this is recorded as a cash inflow under financing activities.
If the company repays a loan worth ₹50,000, that is recorded as a cash outflow under financing activities.

Preparation of Cash Flow Statement Using the Direct Method

Under the Direct Method of preparing a Cash Flow Statement, cash flows from operating activities are calculated by directly analyzing the receipts and payments of cash during the period. This method is more straightforward than the indirect method because it involves calculating cash inflows and outflows directly without adjusting for non-cash items.

Steps in Preparing Cash Flow Statement Using the Direct Method:

Start with Cash Receipts: The first step is to list all the receipts of cash during the period, which are directly related to the core operating activities of the business. These receipts generally include:
- Cash receipts from customers: All cash received from the sale of goods or services.
- Other operating receipts: This could include interest and dividends received, if they are part of the regular operations.
List the Cash Payments: Next, list all the cash payments made during the period, which are also related to the company's operating activities. These payments include:
- Cash paid to suppliers: Payments for goods and services purchased.
- Cash paid to employees: Salaries, wages, and other employee-related payments.
- Cash paid for operating expenses: Rent, utilities, insurance, etc.
- Other operating payments: This may include taxes paid, interest paid, or any other operating costs that involve cash.
Calculate the Net Cash from Operating Activities: The net cash from operating activities is simply the difference between the cash receipts and the cash payments. This provides a clear picture of how much cash was generated or used by the company’s core business operations.
Investing and Financing Activities: After calculating the cash from operating activities, the cash flows from investing and financing activities are added to the statement. These are calculated similarly to the indirect method, focusing on cash inflows from the sale of assets and investments, and cash outflows from purchases and investments.
Final Cash Position: After adding or subtracting the cash flows from operating, investing, and financing activities, the total change in cash is calculated. The final figure is the ending cash balance at the end of the period, which is reconciled with the opening balance of cash.

Example of Cash Flow Statement under Direct Method:

Let's assume the following:

Cash receipts from customers: ₹5,00,000
Cash payments to suppliers: ₹2,00,000
Cash paid to employees: ₹1,50,000
Other cash operating payments: ₹50,000

Cash Flows from Operating Activities (Direct Method):

Cash received from customers: ₹5,00,000
Less: Cash payments to suppliers: ₹2,00,000
Less: Cash paid to employees: ₹1,50,000
Less: Other cash payments: ₹50,000

Net Cash from Operating Activities = ₹5,00,000 - ₹2,00,000 - ₹1,50,000 - ₹50,000 = ₹1,00,000

The process for investing and financing activities would follow similarly by directly listing the receipts and payments under those categories.