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51. Cash flow statement: Illustrative example part 2
Prof. Mrityunjay Tiwary Finance
Overview
This video explains the second part of preparing a cash flow statement using the indirect method, focusing on adjustments to net profit. It details how to handle non-cash expenses (like depreciation), non-operating items (like gains on asset sales or interest received), and changes in working capital. The process involves reconciling asset accounts, adjusting the income statement items, and finally incorporating balance sheet changes to arrive at the net change in cash. The instructor emphasizes understanding the 'why' behind each adjustment to ensure accurate cash flow reporting.
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Chapters
- The indirect method for cash flow statements starts with net profit.
- Reconciling asset accounts (like machinery) helps identify hidden cash transactions (purchases or sales).
- Non-cash expenses (e.g., depreciation) are added back to net profit because they reduced profit without using cash.
- Non-operating gains (e.g., gain on sale of machinery) are subtracted from net profit because they are not from core business operations.
Understanding these initial adjustments is crucial because net profit from the income statement doesn't directly reflect cash generated from operations; these steps bridge that gap.
Depreciation is added back to net profit because it's an expense that reduces profit but doesn't involve an outflow of cash.
- Non-operating items, such as gains or losses from selling long-term assets, need to be removed from operating profit.
- These items are subtracted from net profit (if gains) or added back (if losses) to isolate operating activities.
- The actual cash received or paid for these non-operating transactions is reported in the investing or financing activities sections.
- Interest received is treated as an investing activity under Indian Accounting Standards, so it's removed from operating profit and added to investing activities.
Properly classifying non-operating items ensures that the cash flow from operations accurately reflects the business's core activities, while investing and financing activities capture other financial movements.
A gain on the sale of machinery is subtracted from net profit because the cash generated from the sale belongs in the investing activities, not operating activities.
- Changes in current assets and current liabilities affect cash flow from operations.
- An increase in current liabilities (like outstanding salaries) generally means cash was saved, so it's added to net profit.
- A decrease in current liabilities (like accounts payable) means cash was used to pay off obligations, so it's subtracted.
- An increase in current assets (like accounts receivable) means cash was tied up, so it's subtracted.
- A decrease in current assets (like inventory) means cash was freed up, so it's added.
Tracking changes in working capital reveals how efficiently a company manages its short-term assets and liabilities, impacting its operational cash flow.
If accounts receivable increase, it means sales were made but cash wasn't collected, so this increase is subtracted from operating cash flow.
- Items in the balance sheet not yet addressed (like land or long-term loans) are examined for cash flow implications.
- Increases in non-current assets (like land) typically represent cash outflows (purchases) in investing activities.
- Changes in equity (like issuing new shares) represent cash inflows in financing activities.
- Retained earnings reconciliation is always performed, starting with the opening balance, adding net profit, and accounting for dividends, to ensure accuracy.
This step ensures all significant balance sheet movements are accounted for, providing a complete picture of cash generated and used across all business activities.
An increase in the land account from 17 lakh to 22 lakh indicates a purchase of land, which is a cash outflow of 5 lakh reported in the investing activities.
- After all adjustments, the net change in cash from operating, investing, and financing activities is calculated.
- This net change in cash should equal the difference between the opening and closing cash balances on the balance sheet.
- A balanced cash flow statement confirms the accuracy of the calculations and the underlying financial data.
- The process involves careful reconciliation and application of rules for each type of transaction.
The final reconciliation confirms the integrity of the entire cash flow statement, demonstrating that the reported cash movements accurately explain the change in the company's cash balance.
If the sum of cash flows from operations, investing, and financing is a positive 20 lakh, this must match the increase in cash shown on the balance sheet (e.g., from 50 lakh to 70 lakh).
Key takeaways
- The indirect method adjusts net profit for non-cash and non-operating items to derive cash flow from operations.
- Gains/losses on asset sales and interest received are typically investing activities, not operating.
- Changes in working capital directly impact operational cash flow; increases in current assets use cash, while increases in current liabilities generate cash.
- All significant balance sheet changes must be accounted for in either operating, investing, or financing activities.
- A reconciled retained earnings account helps identify potential dividend payments.
- The cash flow statement serves as a reconciliation between a company's opening and closing cash balances.
Key terms
Indirect MethodCash Flow from Operations (CFO)Cash Flow from Investing Activities (CFI)Cash Flow from Financing Activities (CFF)Non-cash expensesNon-operating itemsWorking CapitalRetained Earnings ReconciliationDepreciationGain on Sale of Machinery
Test your understanding
- Why are non-cash expenses like depreciation added back to net profit when calculating cash flow from operations?
- How does an increase in accounts receivable affect the cash flow from operations?
- Explain the rationale for treating interest received as an investing activity rather than an operating activity under Indian Accounting Standards.
- What is the purpose of reconciling retained earnings, and what hidden information might it reveal?
- How does the final calculation of the cash flow statement confirm the accuracy of the entire process?