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.

Q. 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 Flow Statement: An Overview

A cash flow statement provides insights into the cash inflows and outflows of an organization during a specific period. It helps in understanding the liquidity position, solvency, and financial flexibility of a company by tracking the actual cash movements, distinct from accounting income and expenses, which may involve non-cash transactions. In the context of accounting standards such as AS-3 (Accounting Standard 3) in India, the preparation of a cash flow statement is guided by specific principles for classifying cash flows, as well as a defined approach for calculating cash flows under different activities, such as operating, investing, and financing activities. The method used to present cash flows can either be the direct method or the indirect method, with the direct method offering a more granular view of cash inflows and outflows.

To understand this in depth, we will break down key concepts such as "cash and cash equivalents," classifications of cash flows, how cash flows are calculated in each category per AS-3, and the step-by-step preparation of a cash flow statement under the direct method.

Cash and Cash Equivalents

In the context of a cash flow statement, cash refers to the money available for immediate use by the company. This includes currency, coins, and any deposits that are readily accessible and can be used to settle debts or other financial obligations. On the other hand, cash equivalents are short-term, highly liquid investments that are easily convertible into known amounts of cash and have an insignificant risk of changes in value. Typically, cash equivalents have a maturity of three months or less from the date of acquisition.

Examples of cash equivalents include:

1. Short-term investments, such as marketable securities, that can be readily sold.

2. Treasury bills, which are short-term government securities.

3. Money market funds, which are low-risk, short-duration investments.

4. Certificates of deposit with a short-term maturity of less than three months.

The cash and cash equivalents together represent the resources that a company has to meet its short-term obligations and other liquidity needs. Therefore, it is important to differentiate these from items like stocks or long-term investments, which are not readily liquid.

Classification of Cash Flows under AS-3

The AS-3 (Cash Flow Statements) provides the framework for classifying cash flows into three main categories:

1. Operating Activities

2. Investing Activities

3. Financing Activities

Each of these categories reflects different aspects of a company’s cash flows and helps analysts understand how cash is being generated and used in the business. Let's explore each category in detail.

1. Operating Activities

Operating activities refer to the principal revenue-generating activities of the company and other activities that are not investing or financing activities. Cash flows from operating activities represent the cash generated or used by the company in its core operations. These include cash inflows from the sale of goods or services and cash outflows for expenses related to operating activities, such as payments to suppliers, employees, and other operating costs.

Calculation of Cash Flow from Operating Activities

· Direct Method: The direct method directly lists the cash inflows and outflows from operating activities, such as cash receipts from customers, cash payments to suppliers, and cash payments for operating expenses.

o Cash inflows from operating activities include receipts from customers (sales revenue), receipts from royalties or fees, and other operating receipts.

o Cash outflows from operating activities include payments to suppliers, payments to employees, and other operating expenses.

Under the direct method, the cash flow from operating activities is calculated as:

$Cash flow from operating activities=Cash inflows from customers−Cash outflows to suppliers and employees\text{Cash flow from operating activities} = \text{Cash inflows from customers} - \text{Cash outflows to suppliers and employees}$ Cash flow from operating activities=Cash inflows from customers−Cash outflows to suppliers and employees

· Indirect Method: Under the indirect method, the net income is adjusted for changes in working capital (such as changes in receivables, payables, inventory) and non-cash expenses (like depreciation). This is a more common method due to its simplicity and ease of reconciling with the company's income statement.

The formula used in the indirect method is:

$Cash flow from operating activities=Net income+Non-cash charges−Changes in working capital\text{Cash flow from operating activities} = \text{Net income} + \text{Non-cash charges} - \text{Changes in working capital}$ Cash flow from operating activities=Net income+Non-cash charges−Changes in working capital

2. Investing Activities

Investing activities relate to the acquisition and disposal of long-term assets and investments. These activities reflect the company's investment in its future growth and include purchases of property, equipment, and securities, as well as the proceeds from the sale of assets.

Calculation of Cash Flow from Investing Activities

Cash inflows from investing activities include the proceeds from the sale of physical assets like land, buildings, machinery, and investments in other companies.
Cash outflows from investing activities typically involve the purchase of assets like land, buildings, or machinery, as well as purchasing investments in securities.

The cash flow from investing activities is calculated as:

$Cash flow from investing activities=Proceeds from sale of assets−Purchases of long-term assets\text{Cash flow from investing activities} = \text{Proceeds from sale of assets} - \text{Purchases of long-term assets}$ Cash flow from investing activities=Proceeds from sale of assets−Purchases of long-term assets

For example, if a company sells a piece of equipment for ₹1,00,000, the inflow from that activity would be recorded in the investing section. Conversely, purchasing a new machinery worth ₹2,00,000 would be recorded as an outflow.

3. Financing Activities

Financing activities represent the flow of cash between the company and its investors or creditors. This category includes cash flows from transactions involving the company’s equity and debt.

Calculation of Cash Flow from Financing Activities

Cash inflows from financing activities include proceeds from issuing shares, borrowing funds (taking loans), and other forms of raising capital.
Cash outflows from financing activities include repayments of debt (loan principal), repurchase of equity (stock buybacks), and dividend payments to shareholders.

The cash flow from financing activities is calculated as:

$Cash flow from financing activities=Proceeds from borrowings and equity issuance−Repayments of debt, repurchase of shares, and dividends paid\text{Cash flow from financing activities} = \text{Proceeds from borrowings and equity issuance} - \text{Repayments of debt, repurchase of shares, and dividends paid}$ Cash flow from financing activities=Proceeds from borrowings and equity issuance−Repayments of debt, repurchase of shares, and dividends paid

Preparation of the Cash Flow Statement under the Direct Method

Under the direct method, the cash flow statement is presented by directly calculating the inflows and outflows from each category of activity. The direct method provides a detailed breakdown of cash receipts and payments from operating activities, which gives a clearer view of the company’s cash management during the period.

Here’s a step-by-step guide to preparing a cash flow statement under the direct method:

Step 1: Cash Flow from Operating Activities

1. Cash Inflows: Start by calculating the cash inflows from operating activities, which typically include:

o Receipts from customers: This is the total cash received from customers for sales of goods and services during the period.

o Other receipts: Include any other operating cash receipts, such as interest or royalties.

These amounts can be gathered from the company’s sales records, bank statements, or customer payment reports.

2. Cash Outflows: Next, calculate the cash outflows from operating activities, which typically include:

o Payments to suppliers: Cash payments made to suppliers for goods or services.

o Payments to employees: This includes wages, salaries, and other employee-related payments.

o Other operating payments: These could include rent, utilities, insurance, and other day-to-day operational expenses.

These amounts are derived from the company’s accounting records, invoices, and payment receipts.

Step 2: Cash Flow from Investing Activities

1. Cash Inflows: Record cash received from the sale of property, plant, equipment, or investments.

2. Cash Outflows: Record cash payments made for the purchase of assets, such as new property, plant, and equipment or investments in securities.

This data can be obtained from the company’s investment portfolio and asset transaction logs.

Step 3: Cash Flow from Financing Activities

1. Cash Inflows: Include funds raised through the issuance of stock or debt. This can come from issuing shares, taking loans, or other capital-raising activities.

2. Cash Outflows: This includes the repayment of debt, payment of dividends, and repurchase of stock.

Details for these transactions can be sourced from the company’s financing records and payment schedules.

Step 4: Net Increase or Decrease in Cash and Cash Equivalents

Once all inflows and outflows have been calculated under each activity (operating, investing, and financing), the net change in cash and cash equivalents can be determined.

$Net change in cash=Cash inflows−Cash outflows\text{Net change in cash} = \text{Cash inflows} - \text{Cash outflows}$ Net change in cash=Cash inflows−Cash outflows

This change is then added to the beginning cash balance (from the previous period) to determine the ending cash balance for the current period.

Step 5: Final Cash Flow Statement

Finally, the cash flow statement is presented in a structured format that includes:

1. Cash flow from operating activities (calculated through the direct method).

2. Cash flow from investing activities (calculated).

3. Cash flow from financing activities (calculated).

The sum of these will give the net increase or decrease in cash for the period, which is then reconciled with the opening and closing balances of cash and cash equivalents.