The statement of cash flows (IAS 7)

BA3 – Fundamentals of Financial Accounting · CIMA (CGMA Professional Qualification) · 6 min read

Welcome to the Statement of Cash Flows (IAS 7)!

Ever wondered why a company can report a massive profit but still struggle to pay its electricity bill? It sounds like a paradox, doesn’t it? In this chapter, we are going to solve that mystery. You’ll learn how to track the actual "physical" money moving in and out of a business.

The Statement of Cash Flows is a vital part of the financial accounts because, at the end of the day, cash is king. While profit is an accounting estimate based on rules, cash is a hard fact. Let’s dive in and see how it all fits together!

1. Why do we need a Statement of Cash Flows?

In your previous BA3 chapters, you learned about Accrual Accounting. This means we record income when it is earned and expenses when they are incurred, regardless of when the cash actually changes hands.

Example: If you sell a laptop for \$1,000 on credit today, you record a \$1,000 profit now. However, your bank account doesn't see a penny until the customer pays you in 30 days. The Statement of Cash Flows bridges this gap.

Key Reasons for this Statement:

It shows the liquidity of a business (can they pay their bills right now?).
It is much harder to "manipulate" cash than it is to manipulate profit.
It helps users see where the money came from and where it went.

Quick Review: Profit is a matter of opinion (due to estimates like depreciation), but cash is a matter of fact!

2. The Three Big Buckets: Classification of Cash Flows

IAS 7 requires us to group every single cash movement into one of three categories. Don't worry if this seems tricky at first; think of it as sorting your laundry into three baskets.

A. Operating Activities

This is the "day job" of the business. It includes cash earned from selling goods and cash spent on everyday expenses (like wages and rent). This is the most important section because it shows if the company’s core business is actually sustainable.

B. Investing Activities

Think of this as the "future" of the business. It involves buying and selling Non-Current Assets (like machinery, vans, or buildings) and receiving income from investments (like interest or dividends from other companies).

C. Financing Activities

This is how the business is "funded." It involves getting money from owners (issuing shares) or lenders (bank loans), and paying it back. It also includes dividends paid to shareholders.

Memory Aid (OIF): Just remember O.I.F. — Operating (Daily), Investing (Future Assets), Financing (Funding).

3. Calculating Cash from Operating Activities: The Indirect Method

In the BA3 exam, you will most likely use the Indirect Method. We don't just list every sale; instead, we start with the Profit Before Tax and "adjust" it until it looks like cash.

Step 1: Add back Non-Cash Expenses

Some things reduce our profit but never involve cash leaving the bank. The biggest culprit is Depreciation. We subtract it to find profit, so we must add it back to find cash.

Step 2: Adjust for Profits/Losses on Disposals

If you sell a van and make a "profit on disposal," that profit is just a bookkeeping entry, not the actual cash received. We subtract profits on disposal and add back losses on disposal.

Step 3: The "Working Capital" Dance

This is where students often get confused, but here is a simple trick to remember the direction:

Increase in Inventory: We bought more stock = Cash Outflow (Minus).
Increase in Receivables: Customers owe us more (they haven't paid yet) = Cash Outflow (Minus).
Increase in Payables: We owe our suppliers more (we are keeping our cash longer) = Cash Inflow (Plus).

Analogy: Think of your wallet. If you buy a new pair of shoes (Inventory), you have more shoes but less cash in your wallet. If a friend owes you \$20 (Receivable) and hasn't paid, you have less cash in your wallet!

4. Step-by-Step Format for Operating Activities

Here is the standard layout you should practice:

$ Profit \ Before \ Tax $
$ + \ Depreciation $
$ - \ Profit \ on \ Sale \ of \ Non-Current \ Asset $
$ + \ Loss \ on \ Sale \ of \ Non-Current \ Asset $
$ - \ Increase \ in \ Inventory \ (or \ + \ Decrease) $
$ - \ Increase \ in \ Receivables \ (or \ + \ Decrease) $
$ + \ Increase \ in \ Payables \ (or \ - \ Decrease) $
$ = \ Cash \ Generated \ From \ Operations $
$ - \ Interest \ Paid $
$ - \ Tax \ Paid $
$ = \ Net \ Cash \ from \ Operating \ Activities $

Common Mistake to Avoid: Always remember to subtract Interest and Tax at the very end of the Operating section. They are actual cash outflows!

5. Investing and Financing: The Final Pieces

These sections are usually much simpler than the Operating section.

Investing Activities

Focus on Non-Current Assets (NCA).

Purchase of NCA: (Minus) – Cash is leaving to buy equipment.
Proceeds from sale of NCA: (Plus) – Cash is coming in from selling equipment.
Interest/Dividends received: (Plus) – Cash earned from investments.

Financing Activities

Focus on Equity and Loans.

Proceeds from issuing shares: (Plus) – New money from owners.
Proceeds from new bank loans: (Plus) – New money from the bank.
Repayment of loans: (Minus) – Paying the bank back.
Dividends paid: (Minus) – Giving cash back to shareholders.

6. Summary and The "Golden Check"

Once you have calculated the Net Cash for all three sections, you add them together. This total should equal the net change in Cash and Cash Equivalents for the year.

The Formula:
$ Net \ Operating \ Cash \ Flow $
$ + \ Net \ Investing \ Cash \ Flow $
$ + \ Net \ Financing \ Cash \ Flow $
$ = \ Net \ Increase/Decrease \ in \ Cash $

Did you know? "Cash Equivalents" are short-term, highly liquid investments that are easily converted to cash (usually within 3 months or less), such as short-term treasury bills.

Key Takeaways for your Revision:

Operating: Starts with Profit Before Tax and adjusts for non-cash items and working capital.
Investing: Relates to long-term assets (buying/selling).
Financing: Relates to how the company is funded (loans/shares/dividends).
Depreciation: Always add it back in the Operating section!
Working Capital: If an Asset (Inventory/Receivables) goes UP, Cash goes DOWN.

Keep practicing those "Indirect Method" reconciliations! They are the heart of this chapter and a favorite in exams. You've got this!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

Why is a Statement of Cash Flows necessary if a company already produces a Statement of Profit or Loss?

Conciliating the difference between profit and cash is essential because profit is based on accrual accounting and estimates, while cash represents actual liquidity and the ability to pay debts.

What are the three main categories (or 'buckets') of cash flows under IAS 7?

Operating Activities, Investing Activities, and Financing Activities.

What defines cash flows from Operating Activities?

Operating activities represent the daily 'core' business transactions, such as cash received from customers and cash paid for wages, rent, and inventory.

What is the focus of Investing Activities in the Statement of Cash Flows?

Investing activities relate to the purchase and sale of Non-Current Assets (e.g., machinery, buildings) and income from investments like interest or dividends received.

What activities are included in the Financing section?

Financing activities include cash flows related to how the business is funded, such as issuing shares, taking out or repaying bank loans, and paying dividends.

How does the Indirect Method calculate cash generated from operations?

It starts with the Profit Before Tax and adjusts it by adding back non-cash expenses and removing the effects of changes in working capital.

Why is depreciation added back to Profit Before Tax in the Statement of Cash Flows?

Depreciation is a non-cash expense that reduces profit but does not involve an actual outflow of cash from the bank account.

How are profits or losses on the disposal of non-current assets handled in the operating section?

Profits on disposal are subtracted from profit, and losses on disposal are added back to profit.

What is the rule for adjusting working capital (Inventory and Receivables) in the cash flow statement?

An increase in an asset (Inventory or Receivables) is a cash outflow (minus), while a decrease is a cash inflow (plus).

How does an increase in Trade Payables affect the Statement of Cash Flows?

An increase in payables is treated as a cash inflow (plus) because the business is keeping hold of its cash for longer rather than paying suppliers.

What final two items must be subtracted to move from 'Cash Generated from Operations' to 'Net Cash from Operating Activities'?

Interest paid and Tax paid.

What is the definition of a 'Cash Equivalent' under IAS 7?

Short-term, highly liquid investments that are readily convertible to known amounts of cash and are subject to an insignificant risk of changes in value.

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