Statement of cash flows (excluding partnerships)

Welcome to the Statement of Cash Flows!

Hi there! Welcome to one of the most important chapters in your Financial Accounting (FA) journey. If you have ever wondered, "My company made a huge profit, but why is the bank account empty?" then this chapter is for you. We are going to learn how to track where every penny of cash came from and where it went. Don't worry if this seems a bit technical at first—we will break it down piece by piece until it clicks!

1. Why Do We Need a Statement of Cash Flows?

In accounting, we usually use accrual accounting. This means we record income when we earn it (even if the customer hasn't paid yet) and expenses when we incur them. Because of this, Profit is not the same as Cash.

The "Lemonade Stand" Analogy:
Imagine you sell a glass of lemonade for \$2. Your neighbor buys it but promises to pay you next week. Under accrual accounting, you have \$2 in profit. But if you look in your pocket, you have \$0! The Statement of Cash Flows exists to show that "missing" cash. It is vital because, at the end of the day, a business cannot pay its employees or suppliers with "profit"—it needs cold, hard cash.

Quick Review:
• Profit tells us how successful the business was over a period.
• Cash Flow tells us if the business has enough liquid money to survive.

2. What is "Cash and Cash Equivalents"?

Before we build the statement, we need to know what counts as "cash." Under IAS 7 Statement of Cash Flows, we look at two things:
1. Cash: Cash on hand and demand deposits (your bank account balance).
2. Cash Equivalents: Short-term, highly liquid investments that can be turned into cash very quickly (usually within 3 months) with very little risk of changing in value.

Key Point: Bank overdrafts are usually treated as part of cash and cash equivalents because they are repayable on demand and are part of the company's cash management.

3. The Three Main Buckets (O-I-F)

To make things easy to read, we group all cash movements into three categories. You can remember them with the acronym O-I-F:

1. Operating Activities (O): These are the "bread and butter" of the business. It’s the cash generated from selling goods or services. It also includes paying suppliers and employees.
2. Investing Activities (I): This is about the long-term. It’s the cash spent on buying (or received from selling) Non-Current Assets like machinery, buildings, or investments.
3. Financing Activities (F): This is how the business is funded. It includes cash from issuing new shares, taking out loans, or paying back loan principals and dividends.

4. Operating Activities: The Indirect Method

In the ACCA FA exam, you will mostly use the Indirect Method. We start with the Profit Before Tax and "fix" it until it looks like cash. We do this by reversing things that didn't involve cash.

Step 1: Add back Non-Cash Expenses
Depreciation and Amortization are "fake" expenses—no money actually leaves the bank! So, we add them back to the profit.
\( \text{Adjusted Profit} = \text{Profit Before Tax} + \text{Depreciation} \)

Step 2: Remove Profit/Loss on Disposal
If you sold a van and made a profit, that profit is already inside your "Profit Before Tax" number. However, the cash from the sale belongs in the Investing section. To avoid counting it twice, we deduct a profit on disposal or add back a loss on disposal.

Step 3: The Working Capital Changes (The "Inverse Rule")
This is where many students get confused. Think of it this way:
• Inventory: If inventory goes UP, it means we spent cash to buy it. So, Increase = Subtract cash.
• Receivables (Customers): If receivables go UP, it means customers haven't paid us yet. So, Increase = Subtract cash.
• Payables (Suppliers): If payables go UP, it means we are keeping our cash and haven't paid suppliers yet. So, Increase = Add cash (save cash).

Memory Aid:
If an Asset goes UP, Cash goes DOWN. (Inverse)
If a Liability goes UP, Cash goes UP. (Same direction)

5. Investing and Financing Activities

These sections are much simpler because we only care about the actual cash moving in or out.

Investing Activities

• Cash Out: Buying property, plant, or equipment (PPE).
• Cash In: Selling PPE (the total proceeds received) or receiving interest/dividends from other companies' shares.

Financing Activities

• Cash In: Issuing new shares or taking out a new bank loan.
• Cash Out: Repaying the principal of a loan or paying a dividend to our shareholders.

Key Takeaway: Be careful with Interest and Tax! Interest Paid and Tax Paid are usually shown at the bottom of the Operating Activities section.

6. Common Mistakes to Avoid

1. Confusion with Depreciation: Remember, depreciation is not a cash flow. We only add it back to profit because it was subtracted to reach the profit figure in the first place.
2. Dividends: Dividends received from investments go in Investing. Dividends paid to our own shareholders go in Financing.
3. Asset Sales: Don't just look at the profit/loss on a sale. You must find the Proceeds (the actual cash received) for the Investing section. Use this formula:
\( \text{Proceeds} = \text{Carrying Value} + \text{Profit (or } - \text{Loss)} \)

7. Final Summary Checklist

To finish a Statement of Cash Flows, follow this flow:
1. Start with Profit Before Tax.
2. Adjust for non-cash items (Depreciation, Profit/Loss on disposal).
3. Adjust for Working Capital (Inventory, Receivables, Payables).
4. Subtract Interest and Tax paid. This gives you Net Cash from Operating Activities.
5. List Investing Activities (Buying/Selling assets).
6. List Financing Activities (Loans/Shares/Dividends paid).
7. Add the totals of O + I + F. This should equal the Net Increase/Decrease in Cash for the year!

Don't worry if this seems tricky at first! The best way to master this is to practice "T-accounts" for Non-Current Assets and Tax to find the missing cash figures. You've got this!