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.
A
Cash Flow Statement is one of the core financial statements, alongside
the Balance Sheet and Income Statement. The primary objective of
a Cash Flow Statement is to provide detailed information about the cash inflows
and outflows of a company during a given period. This financial statement helps
users assess the liquidity, solvency, and financial flexibility of an
organization. It reflects how changes in the Balance Sheet and Income
Statement affect cash and cash equivalents, categorizing cash flows into
specific operating, investing, and financing activities.
Cash and Cash Equivalents
In
the context of a Cash Flow Statement, cash refers to the money a company
holds in the form of coins, currency, and demand deposits that can be accessed
immediately. Cash equivalents are short-term, highly liquid investments
that are easily convertible into known amounts of cash and subject to an
insignificant risk of changes in value. These typically include treasury
bills, marketable securities, and money market funds. The key
characteristic of cash equivalents is their short-term nature—generally, they
must have an original maturity of three months or less from the date of
acquisition. It is essential to note that for an item to be classified as a cash
equivalent, it must be easily convertible into cash with a negligible risk of
change in value.
Cash
equivalents, by definition, are not restricted in use and can be used for
transactions without significant effort. In preparing the Cash Flow Statement, it
is crucial to include all cash equivalents along with cash because they are, in
essence, a substitute for cash in short-term transactions.
Categories of Cash Flows
According
to Accounting Standard AS-3 (Revised), the Cash Flow Statement is
divided into three main categories:
1.
Operating
Activities
2.
Investing
Activities
3.
Financing
Activities
Each
category represents a distinct aspect of the cash movements within a business,
helping stakeholders better understand the sources and uses of cash.
1. Operating Activities
Operating
activities are the primary revenue-generating activities of a company and
generally include transactions involving the sale of goods and services. Cash
flows from operating activities represent the cash generated or spent on the
day-to-day operations of the company. These activities reflect the company’s
core business operations, such as sales revenue, payments to suppliers and
employees, interest received, and income taxes paid.
Operating
activities are calculated as follows:
- Cash Inflows: Cash inflows from operating activities arise from the
sale of goods or services, interest received, and dividends received.
- Cash Outflows: Cash outflows include payments to suppliers, wages and
salaries, interest paid, income taxes paid, and other operating costs.
Under
AS-3, there are two methods for calculating cash flow from operating
activities: the Direct Method and the Indirect Method. The direct
method is discussed in greater detail later, but it is important to note that
it directly computes cash inflows and outflows, while the indirect method
adjusts the net income for changes in non-cash items.
2. Investing Activities
Investing
activities refer to the acquisition and disposal of long-term assets and
investments. This includes cash flows related to purchasing or selling
property, plant, equipment (PPE), investments in securities, and loans made to
other entities. In essence, investing activities represent the company’s
efforts to invest in assets that will generate future income or cash flows.
- Cash Inflows: Cash inflows from investing activities can come from
the sale of fixed assets, sale of investments, or the collection of
principal from loans.
- Cash Outflows: Cash outflows in investing activities include
purchases of tangible or intangible assets, investments in securities, and
lending activities (where the company provides loans to others).
Investing
cash flows provide insight into the company’s strategy for future growth and
how it plans to generate future income from its investments. For example, heavy
investment in capital assets might indicate an expansion plan, while selling
assets may indicate an effort to liquidate or scale down operations.
3. Financing Activities
Financing
activities involve changes in the company’s equity and debt capital. These cash
flows are related to borrowing and repaying debt, issuing and repurchasing
stock, and paying dividends to shareholders. Financing activities reflect the
company’s structure of financial management, indicating how the business raises
capital and repays obligations.
- Cash Inflows: Cash inflows from financing activities include the
issuance of equity (stock issuance) or debt (loans or bonds).
- Cash Outflows: Cash outflows are related to repayments of loans or
debt, repurchase of shares, or payment of dividends to shareholders.
Financing
activities are critical because they show how the company is funded—whether it
is through debt, equity, or a combination of both—and how it manages its
capital structure. A company with significant debt payments may face liquidity
risks, while a company issuing new stock may be trying to raise capital for
expansion.
How Cash Flow is Calculated as Per
AS-3
The
calculation of cash flow under AS-3 involves the categorization of all
cash flows into operating, investing, and financing activities. The statement
must provide a reconciliation between net income (from the Income Statement)
and cash flows from operating activities if the indirect method is used. The
direct method does not require this reconciliation, as it directly presents the
cash inflows and outflows.
Indirect Method of Cash Flow
Calculation
Under
the Indirect Method, cash flow from operating activities is derived by
adjusting the net profit (or loss) for changes in non-cash items, non-operating
items, and changes in working capital. Here’s how cash flow from operating
activities is calculated using this method:
1.
Start with
the net profit from the Income Statement.
2.
Adjust for
non-cash items, such as depreciation,
amortization, and impairment losses. These are added back to the net income
because they do not involve actual cash transactions.
3.
Adjust for
changes in working capital: This
includes changes in current assets and liabilities such as accounts receivable,
accounts payable, inventories, and accrued expenses. Increases in current
assets represent an outflow of cash, while decreases represent an inflow.
4.
Exclude
non-operating items such as gains or losses from the
sale of assets or investments, as these do not relate to core operating
activities.
The
net result of these adjustments gives the net cash flow from operating
activities.
Direct Method of Cash Flow Statement
Preparation
The
Direct Method provides a more straightforward view of cash inflows and
outflows by directly reporting the major categories of gross cash receipts and
payments. Under the Direct Method, cash flow from operating activities is
calculated by directly listing cash inflows and outflows related to operating
activities, as follows:
1.
Cash
Inflows:
o Cash received from customers for goods or services.
o Cash received from interest and dividends (if any).
2.
Cash
Outflows:
o Cash paid to suppliers for goods and services.
o Cash paid to employees for wages and salaries.
o Cash paid for interest and taxes.
o Other operating expenses, such as administrative costs.
The
net result of these cash inflows and outflows represents cash flow from
operating activities.
The
advantage of the Direct Method is its simplicity and the transparency it offers
in understanding the sources and uses of cash. However, many companies prefer
the Indirect Method because it is easier to prepare, especially for large
companies with complex financial structures.
Summary of the Key Differences
Between Direct and Indirect Methods
Aspect |
Direct
Method |
Indirect
Method |
Presentation |
Directly lists cash inflows and
outflows. |
Starts with net income and adjusts
for changes. |
Complexity |
More detailed and accurate in
reflecting cash activities. |
Easier to prepare and more
commonly used. |
Transparency |
Provides a clear view of operating
cash flows. |
Less transparent as it uses
adjustments. |
Compliance |
Requires more detailed
information. |
Simplifies the reconciliation
process. |
Conclusion
In
conclusion, a Cash Flow Statement provides valuable insights into the cash
position of a company, detailing how cash is generated and spent across
operating, investing, and financing activities. Understanding cash and cash
equivalents is vital for interpreting the Cash Flow Statement, as it
includes all liquid assets that can be quickly converted into cash. The
statement helps to assess the company's liquidity, solvency, and financial
health.
Cash
flows are classified into three categories—operating, investing, and
financing—each representing a different aspect of a company’s financial
activities. The Direct Method offers a straightforward presentation of
cash flows, directly listing cash receipts and payments, whereas the Indirect
Method adjusts net income for non-cash items and changes in working
capital. Both methods are acceptable under AS-3, although the indirect
method is more widely used due to its practicality in reporting. By using
either method, the Cash Flow Statement provides stakeholders with essential
information about how a company generates and uses its cash, ensuring
transparency and better decision-making for investors, creditors, and
management.
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