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Chapter 7 Statement of Cash Flows Purpose of a statement of cash flows Statement of Cash Flows = reports an entitys cash inflows

ows & 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)

Chapter 7 Statement of Cash Flows


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.

Chapter 7 Statement of Cash Flows


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 o o o Generate cash flows Meet financial commitments, including servicing of borrowings + payment of dividends Fund changes in scope of its activities Obtain external finance

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

Chapter 7 Statement of Cash Flows 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 o An entity has to invest in order to generate future income & cash flows. 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 borrowings, 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 being available 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

Chapter 7 Statement of Cash Flows


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