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Cash is important because organisations and people will not normally accept any other
form of settlement of claim against the business
Businesses fail as a result of inability to find sufficient cash to settle their responsibilities
These factors make cash the pre-eminent business asset, and therefore the one
analysts and others watch carefully in assessing survivability of the business and other
factors
Balance sheet and profit and loss reports show movements in wealth and the net
increase or decrease in wealth for the period concerned
The cash flow statement is required to be produced because the above two reports do
not concentrate sufficiently on liquidity (cash flow)
The accrual nature of the above two reports are thought to obscure the question of how
and where a company is generating the cash it needs to continue operating
The expression 'cash and cash equivalents' is used in the preparation of a cash flow
statement. This recognises that there are other items that are considered 'cash' from the
perspective of a cash flow statement.
Cash equivalents represent short-term, highly liquid investments that can readily be
converted to a fixed amount of cash
Examples include:
- Cash at Bank
- Bank Overdraft
- Short-term Money Market Deposits
- Bank Bills
Balance Sheet static report made at a given point in time and based on balances
in assets, liabilities and owners equity, normally based on accrual transactions
Income Statement (Profit & Loss) measures the financial performance over a
period of time - normally one year, related to revenues earned less expenses
incurred
Cash flow statement identifies all cash receipts and cash payments for the period.
All account types are included and is based on cash, not accrual transactions
Income statement
Balance sheet Balance sheet
at the start of at the end of
the accounting the accounting
period period
Owners Owners
Cash flow statement
claim claim
Cash Cash
Figure 5.1 - The relationship between the balance sheet, the income statement and the cash flow stateme
The cash flow statement is basically an analysis of the business cash movements over
the period concerned
All payments of a particular type are added together to give just one figure, which
appears in the statement
The net total of the statement is the net increase or decrease in cash of the business
over the period
Operating activities - represents net inflows from operations. Only cash received
and paid, not expenses earned and revenue incurred, are featured (that is, cash
flows associated with the operating activities of the business)
Financing activities - deals with financing the business excluding short-term credit
e.g. debt and equity sources, share issues, repayment of debt etc (that is, cash flows
from changes in Non Current Liabilities and Equity)
Cash flows from taxes on income, interest received, interest paid, dividends received and/or
dividends paid are shown separately in the Cash Flow Statement. Additionally, interest paid,
interest received and dividends received can be classified differently in the Cash Flow
Statement. These differing classifications are shown below:
Interest paid may be shown under Operating Activities (because it is used to help determine
profit or loss) or under Financing Activities (because it is a cost of obtaining financial
resources).
Interest received and dividends received can be shown under operating activities (because
they help determine profit or loss) or under Investing activities (because they are returns on
investment).
Non-cash Transactions
Most relate to the operating activity section of the cash flow statement and are linked to
the difference between cash-based and accrual-based transactions
Some relate to the investing and financing activity section e.g. direct exchanges such as
shares for assets, non-current assets for reduction in debt, bonus issues from reserves
etc
You will only be expected to use the first approach to prepare a Cash Flow Statement. You
will not be expected to use method 2 to prepare a cash flow statement.
Refer to Example 5.1 on page 231 for detailed information on how reconstructions are used
to prepare a cash flow statement. You will not be expected to use these reconstructions
in this course. However you may be interested in these calculations as a matter of interest.
The purpose of the reconciliation is to reconcile the net operating profit or loss after
tax with the cash flows from operating activities
The starting point is the operating profit after tax
We then effectively add back the depreciation charged in arriving at that profit and
adjust this total by movements in non-cash current asset and current liability
accounts to arrive at cash flow from operations