9.
How do we measure cash flows?

9.1 Introduction

Cash is the lifeblood of any organisation. Having cash available permits investment in growth opportunities and the ability to handle unexpected challenges: strong cash reserves help organisations to weather economic downturns and seize opportunities.

On the statement of financial position a figure will usually be included called ‘cash and cash equivalents’. What is included in this category is, to the surprise of many people, subject to judgement, but the key characteristic is that resources described in this way must be able to be accessed in a short amount of time and be readily convertible into a known amount of cash.

The statement of cash flows (CF) is an integral component of the financial reporting of larger reporting entities. It offers an important perspective on an organisation’s financial health by detailing the movement of cash within the business over a specific period. Despite this, few accounting standards require that medium or smaller entities prepare cash flow statements, which is a surprising omission on their part, yet all need to produce a statement of financial position (SoFP) and many produce an income statement (IS).

The CF tracks the actual inflows and outflows of cash, providing the story of the organisation’s liquidity and solvency. It can be visualised as follows:

This statement is essential for the users of the accounts of those reporting entities that are required to prepare them, including investors, creditors and management, as it helps them assess the organisation’s ability to generate cash, meet its financial obligations and fund future operations and growth.

To facilitate comparability, most organisations use three categories of cash to tell the story of their cash flow. The categories are operating, investing, and financing, and all cash inflows and outflows for an accounting period will fall under one of these.

The contents of each of the three categories are briefly shown in Figure 9.5.

9.2 Components of the statement of cash flows

9.2.1 Operating activities

Operating activities in the statement of cash flows represent the cash inflows and outflows directly related to the core business operations of an organisation. This section includes cash received from customers for sales of goods and services and cash paid to suppliers and employees for goods and services consumed in operations, and removes any expense categories which do not affect cash. The net cash flow from operating activities provides a clear indication of whether an organisation can generate sufficient cash flow to maintain and expand its operations, pay dividends, and meet its financial obligations.

Positive cash flow from operating activities is a strong indicator of an organisation’s financial health and operational efficiency. Conversely, negative cash flow may signal underlying problems in profitability or issues with receivables and payables management.

According to the International Accounting Standards Board (IASB), analysing the trends and components within this section helps users assess the efficiency of an organisation’s operating cycle and its ability to sustain itself without relying on external financing​ (Paolone, 2020).

9.2.2 Investing activities

The investing section of the CF details the cash flows associated with acquiring and disposing of non-current assets and investments, with cash inflows arising from selling and cash outflows resulting from buying. This includes acquisition and disposal of property, plant and equipment, other businesses, and investment securities.

This section provides insights into a organisation’s investment strategies and its capacity to generate future income through capital expenditures and strategic investments.

This section is important when evaluating how effectively an organisation is investing in its future growth and expansion. Significant outflows may indicate substantial investments in capital projects or acquisitions, which could enhance future earnings potential. However, persistent negative cash flows from investing activities without corresponding growth in operating cash flow could be a red flag, suggesting overextension or poor investment decisions.

9.2.3 Financing activities

IAS7 offers choice in presentation of both interest and dividend payments – either operating or financing. This helps organisations present a fair view of their cash flows, but can make it difficult to compare organisations.

The financing section of the CF captures the cash flows associated with transactions between the organisation and its owners or lenders. This includes cash inflows from issuing stocks and bonds, receiving loans, and other borrowings. Cash outflows in this section cover repayments of borrowed funds, dividends paid to shareholders and, for a company, repurchasing the company’s own shares.

This section is important for understanding how an organisation finances its operations and growth, whether through debt, equity or internal funds, and provides insights into the organisation’s capital structure and financial strategy.

Financing activities include transactions involving equity, debt and dividend payments. Analysing this section helps determine how an organisation funds its operations and growth, whether through internal cash generation or external financing. For example, high levels of borrowing may indicate aggressive expansion strategies but also raise concerns about debt sustainability.

9.3 Practical applications

The CF has many uses, such as understanding the impact of operating, investing and financing activities on the cash balance of the enterprise. Other practical applications include:

• short-term financial planning such as preparing a cash budget to manage immediate financial needs and ensure sufficient liquidity
• assessing the organisation’s ability to meet short-term obligations and manage cash flow effectively
• providing insight into available cash to be able to make dividend payments to shareholders
• informing management and users about the organisation’s ability to generate cash and fund future operations and expansions
• analysing changes in the net assets of the business
• evaluating changes in the financial structure and how finance from loans or investors is used
• assessing how expansion projects are financed.

9.4 Preparation of the statement of cash flows

The statement of cash flows is a much more recent statement than the statement of financial position, which comes from Pacioli’s work on double-entry bookkeeping in the fifteenth century. Merchants in Pacioli’s time would use bank records directly to verify cash movements.

In the United States in 1863, the Northern Central Railroad was one of the first organisations to issue a summary of its financial transactions that included an outline of its cash receipts and cash disbursements for the year.

One of the first organisations to show the links between the SoFP, IS and CF was the US Steel Corporation in 1902, when they created a statement of cash flows that showed the difference between the profit for the year and the cash movement in the year.

Over time the following three categories of inflows and outflows of cash and cash equivalents have been internationally adopted:

• cash flow from operating activities
• cash flow from financing activities
• cash flow from investing activities.

The movement in cash is reconciled to the cash at the beginning and end of the period.

Preparing a statement of cash flows can be a complex task, especially for larger organisations with intricate financial operations. One of the primary challenges is reconciling the profit with the cash basis used for the CF, which involves adjusting for non-cash items such as depreciation, amortisation and gains/losses on asset sales.

Using information in the financial statement, the cash flow is calculated for each of the three categories separately. The first, and most complicated, is calculating the cash flow from operations.

9.4.1 Cash flow from operations

This data can be prepared using one of two methods: the direct method and the indirect method.

The direct method involves directly identifying and reporting all cash inflows and outflows from operating activities. This method provides a detailed breakdown of cash received from customers, and cash paid to suppliers, employees and for operating expenses. You already did this with Natural Toys (Case 9.1).

The indirect method starts with net profit and adjusts it for non-cash items (such as depreciation and amortisation) and changes in working capital accounts (like trade receivable, inventory and trade payable) to arrive at net cash flow from operating activities.

Both methods will result in the same net cash flow from operating activities. The difference lies in the level of detail provided in the statement.

To calculate cash flows from operations using the direct method:

1. Identify cash inflows from operating activities by looking for cash sales and other cash inflows related to the core business operations in the IS and accounting records.
2. Identify cash outflows from operating activities such as cost of goods sold, operating expenses and other expenses incurred during regular business operations.
3. Calculate cash flow from operating activities by subtracting the total cash outflows from operating activities from the total cash inflows from operating activities.

The indirect method is more common in published financial statements as it can be calculated from the totals provided in the SoFP and the IS.

To calculate cash flows from operations using the indirect method:

1. Start with operating profit before tax and after interest on the income statement.
2. Add back non-cash expenses that were subtracted in arriving at net profit. Common non-cash expenses are the interest expense and depreciation.
3. Adjust for changes in working capital. This means that you calculate the changes in working capital accounts (current assets minus current liabilities) between reporting periods. This typically involves looking at the changes in trade receivables, inventory and trade payable. A positive change in working capital (increase in current assets or decrease in current liabilities) would result in a subtraction from net profit, while a negative change (decrease in current assets or increase in current liabilities) would be added back.
4. Then we need to deduct actual cash payments made for interest and taxation (if classifying interest as a financing cash flow).

These adjustments reconcile the net profit to the net cash provided by operating activities, effectively converting accrual-based accounting figures into cash-based figures. The indirect method is favoured for its relative ease of preparation in larger entities because it uses existing financial statement data and can explain the relationship between net profit and cash flow from operations.

It is important to note that both the direct and indirect methods arrive at the same cash flow figure of operating activities. More on the merits of each of these methods can be found in Kent and Birt (2021).

9.4.2 Cash flow from investing activities

To calculate the net cash from investing activities, we look for cash flows associated with usually non-current assets. This includes identifying the proceeds (cash received) from the sale of any NCAs and cash paid to purchase NCAs. These can usually be found in the tangible asset note in the financial statements, adjusted by the profit or losses made from the sale of assets.

9.4.3 Cash flow from financing activities

To calculate the net cash from financing activities, we look for cash flows associated with an organisation’s financing – bank loans, long-term liabilities, or share capital issues. This could be on the SoFP or in the notes. Inflows from loans (whether current or non-current) must be included, as well as inflows from shares issued. Deducted from this are loan repayments.

Dividends are often deducted from this section too, although you may come across them being categorised differently. The most important element to consider here is that the classifications are consistent year on year, so if a transaction is classed as financing, similar cash flows in the future should be classified in the same way.

9.4.4 Reconciliation to cash on statement of financial position

Finally, the sum of operating, investing and financing cash flows is reconciled to the net movement in cash and cash equivalents on the statement of financial position. Bank overdrafts should be understood as negative cash when doing this reconciliation.

9.5 Example calculations for Rozim

We will apply these concepts to the case study of Rozim Fashion Limited. For each explanation, trace the figures through to the IS, SoFP and notes. The relevant calculations and source of each figure have been included on each line item.

9.5.1 Cash flow from operating activities: Direct method

The following cash inflows and outflows were identified from the records for Rozim (note, most of these figures can’t be found in the IS or SoFP).

9.5.2 Cash flow from operating activities: Indirect method

First, we select the balance on the IS which represents the profit before tax, after interest has been deducted, and add back non-cash items:

Next, adjustments are made for movements in working capital items. The balances come from the SoFP and the notes.

Notice here that corporation tax has been excluded from these calculations as it is dealt with separately.

This results in the following adjustments to profit before tax for working capital items:

The final deductions are for the corporation tax paid and the interest paid.

To determine the corporation tax paid, we can calculate the cash outflow by knowing the liabilities at the beginning and end of the year, along with the tax expense.

Since there are no interest liabilities at the beginning or end of the year, the interest expense must equal the cash paid for interest, which is £365.

Putting this together gives us the first category of cash inflows and outflows, known as net cash flow from operating activities.

9.5.3 Cash flows from investing activities

Here, Rozim has both intangible and tangible assets which will result in inflows and outflows in this category.

Rozim have sold equipment, which results in sales proceeds, a cash inflow. We know from their bank records that this cash inflow totals £3,900.

Rozim have also bought new motor vehicles (shown in Note 4) and new software (Note 5). Assuming this has been paid in cash, the cash outflow from buying the NCAs is £43,329 (£37,850 + £5,479).

Putting this together gives us cash flows from investing activities.

9.5.4 Cash flows from financing activities

Rozim secured new bank loans totalling £250,000 during the year (see Note 8). Note 9 further indicates an additional £500,000 in loans, making a total cash inflow from loans of £750,000. Rozim repaid £250,000 of director’s loans (see Note 8). No financing was raised through the issue of share capital and no dividends were paid out.

Putting this together gives us cash flows from financing activities.

9.5.5 Reconciliation of cash flows with cash and cash equivalents

Finally, we then add up the cash flows from operating, investing and financing activities to arrive at the net movement of cash and cash equivalents. This matches up with the cash and cash equivalents reconciliation show below.

This ties the CF back to the cash balance in the SoFP.

A cash flow statement offers a comprehensive view of an organisation’s cash inflows and outflows, revealing its liquidity, investment strategies, operational efficiency and overall financial health.

It complements the IS by focusing on cash rather than profits, providing insights into an organisation’s ability to generate cash, manage its cash position, and meet financial obligations, which is crucial for investors, creditors and management alike.

9.6 Limitations of statements of cash flows

While the CF is a very important summary for the users of the financial statements, it can give a distinctly skewed view of the organisation if it is relied upon for decision-making. An organisation could show high levels of cash inflows, but if these are from loans which need to be repaid rather than being generated by the organisation during its trading activities, they do not represent an organisation which is thriving.

Cash itself can be hard to define too – any elements which are ‘cash and cash equivalents’ should be included, but judgement is needed to confirm what this means for the organisation.

Also, the use of double-entry bookkeeping in the IS and SoFP are designed to help users make future decisions with historical data, hence expenses are allocated to the period in which they occurred. The CF focuses on explaining where historical cash flows came in and went out of the organisation, which arguably is of less use when making future decisions.

9.7 Summary

• Defining what is classified as cash requires professional judgement.

• The statement of cash flows can be put together using the balances in the statement of financial position and income statement and the notes to show three categorisations of cash inflows and outflows:

  • cash flow from operating activities
  • cash flow from investing activities
  • cash flow from financing activities.
• Cash is vital for the success of an organisation and being able to understand a cash flow statement gives important insight into how an organisation uses cash.