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Chapter 4: Cash Flow Statement

4.1 Meaning and Objectives

A Cash Flow Statement is a statement that shows the flow of cash and cash equivalents during a specific period. It is designed to provide information about the historical changes in cash and cash equivalents of an enterprise.

Benefits of Cash Flow Statement:

  • Helps in assessing the liquidity and solvency of an enterprise.
  • Facilitates short-term financial planning.
  • Helps in evaluating past cash flows against expected cash flows.

Cash and Cash Equivalents

  • Cash: Comprises cash on hand and demand deposits with banks.
  • Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value (e.g., Treasury bills, commercial papers).

4.2 Classification of Activities

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

Cash Flow Activities Operating Activities Revenue-producing activities. Investing Activities Acquisition/disposal of long-term assets. Financing Activities Changes in equity and borrowings.

Fig 4.1: Three Classifications of Cash Flow

  1. Operating Activities: The principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
  2. Investing Activities: The acquisition and disposal of long-term assets and other investments not included in cash equivalents.
  3. Financing Activities: Activities that result in changes in the size and composition of the owner’s capital and borrowings of the enterprise.

4.3 Preparation of Cash Flow Statement (Indirect Method)

The Indirect Method determines the cash flows from operating activities by adjusting net profit or loss for the effects of:

  • Non-cash items (e.g., depreciation, amortization).
  • Non-operating items (e.g., loss/gain on sale of fixed assets, interest paid/received, dividend received).
  • Changes in Current Assets and Current Liabilities during the period.

Formula for Operating Cash Flow:

\[ \begin{array}{r l} & \text{Net Profit before Tax and Extraordinary Items} \\ + & \text{Non-cash and Non-operating Expenses (Depreciation, Loss on sale, etc.)} \\ - & \text{Non-operating Incomes (Interest/Dividend Received, Gain on sale, etc.)} \\ = & \textbf{Operating Profit before Working Capital Changes} \\ + & \text{Decrease in Current Assets and Increase in Current Liabilities} \\ - & \text{Increase in Current Assets and Decrease in Current Liabilities} \\ = & \text{Cash Generated from Operations} \\ - & \text{Income Tax Paid} \\ = & \textbf{Net Cash from Operating Activities} \end{array} \]

Important Adjustments

  • Depreciation and Profit/Loss on Sale: A separate Fixed Asset Account must be prepared to identify hidden purchases or sales of machinery when accumulated depreciation is given.
  • Proposed Dividend: The proposed dividend of the previous year is paid in the current year (Financing Activity Outflow), and added back to calculate Net Profit before Tax. The current year’s proposed dividend is ignored as per AS-4.
  • Tax: Provision for Tax made during the year is added back; Tax paid during the year is deducted at the end of Operating Activities.

Competency-Based Questions (CBQs)

Q1. An enterprise deals in the trading of shares. How will you classify the “dividend received on shares” and “dividend paid on shares” in its Cash Flow Statement? Context: Testing classification differentiation based on the primary nature of the business.

Q2. From the following information, calculate Cash from Operating Activities:

  • Operating Profit before Working Capital Changes: ₹ 1,50,000
  • Trade Receivables increased by ₹ 40,000
  • Inventory decreased by ₹ 20,000
  • Trade Payables decreased by ₹ 10,000
  • Outstanding Expenses increased by ₹ 5,000

Context: Numerical application of Working Capital changes in Indirect Method.

Q3. A company had a machine costing ₹ 50,000 with an accumulated depreciation of ₹ 20,000. It was sold for ₹ 35,000. Analyze the complete treatment of this transaction across the three activities of the Cash Flow Statement. Context: High-order integration of one transaction affecting multiple activities natively.

Q4. Explain why the Proposed Dividend of the current year is not considered while preparing the Cash Flow Statement as per the revised accounting standards. Context: Statutory understanding of Accounting Standard 4 and contingencies.

Q5. Based on the indirect method, evaluate why Depreciation and Amortization are added back to the Net Profit when calculating Cash Flow from Operating Activities. Context: Conceptual rationale behind the algebraic formulas of the Indirect Method.

Answers to CBQs

Ans 1. Since the enterprise is a financial/trading entity dealing in shares, its principal revenue-producing activity is investing in and selling shares.

  • Dividend Received on shares trading is a primary revenue, so it is classified under Operating Activities.
  • Dividend Paid on its own equity shares represents the cost of generating capital, so it is classified under Financing Activities (irrespective of whether it is a financial or non-financial enterprise).

Ans 2.

  • Operating Profit before WC Changes = ₹ 1,50,000
  • Less: Increase in Trade Receivables = (₹ 40,000) (outflow because cash is tied up in credit sales)
  • Add: Decrease in Inventory = ₹ 20,000 (inflow because stock was sold)
  • Less: Decrease in Trade Payables = (₹ 10,000) (outflow because cash was paid off)
  • Add: Increase in Outstanding Expenses = ₹ 5,000 (inflow because expense occurred but cash was retained) Calculation: \( 1,50,000 - 40,000 + 20,000 - 10,000 + 5,000 = ₹ 1,25,000 \) Cash flow from Operating Activities = ₹ 1,25,000.

Ans 3. Cost of machine = ₹ 50,000. Accumulated depreciation = ₹ 20,000. Book Value = Cost - Accumulated Depreciation = \( 50,000 - 20,000 = ₹ 30,000 \). Sale Price = ₹ 35,000. Gain on sale = \( 35,000 - 30,000 = ₹ 5,000 \). Treatment in Cash Flow:

  1. Operating Activities: The Gain on Sale (₹ 5,000) must be deducted from Net Profit because it is a non-operating income that already bloated the net profit.
  2. Investing Activities: The actual cash received from the sale (₹ 35,000) will be shown as a Cash Inflow under Investing Activities.
  3. No impact on Financing Activities.

Ans 4. According to AS-4 (Contingencies and Events Occurring After the Balance Sheet Date), the proposed dividend of the current year is a non-adjusting event as it is yet to be approved by shareholders in the Annual General Meeting. Since it is only a proposal and not a liability on the balance sheet date, it does not mandate a cash outflow and is ignored. Conversely, the previous year’s proposed dividend (which was approved) is treated as paid in the current year.

Ans 5. The Cash Flow Statement under the indirect method starts with Net Profit (derived from the Statement of Profit & Loss prepared on an accrual basis). In computing this Net Profit, non-cash charges like Depreciation and Amortization have been deducted, reducing the profit. However, these expenses did not result in an actual outflow of cash. Thus, to reach the “true cash” generated from operations, we must reverse this non-cash deduction by adding them back to the Net Profit.