In previous tutorials here and here, we have looked at how to construct a set of financial statements from a list of transactions; understanding that is core to having sound accounting knowledge. However, what we haven't looked at fully is the cash flow statement. In those tutorials we simplified the matter using a "Simple Cash Flow Statement". In this tutorial we will look more closely at the general structure of a cash flow statement, plus seek to create one from a given income statement and balance sheet. This 'indirect' method of creating a cash flow statement will seek to further your understanding of this key financial statement.
Cash Flow Statement Structure
The cash flow statement is broken down into three sections:
1. Cash flows from Operating Activities
This section seeks to separate out where the pre-tax profits came from. The overall purpose is to identify how much cash the underlying operations of the business generated hence you start with Pre-tax profits and then adjust for non-cash costs or profits. After identifying the cash generated from operations, we then subtract interest outflows, tax outflows and dividend outflows. For example, one item that usually comes under this section is Depreciation; we have looked at how depreciation is a non-cash charge in this tutorial. Since it is a non-cash cost, we add it back to the profit figure.
A subsection of this looks at working capital changes; this subsection looks at how the value of receivables, payables and inventory changed over the period.
2. Cash flows from Investing Activities
This section looks at movements relating to investing, as the title suggests. Therefore it includes real cash flows associated with acquiring or disposing of assets or businesses. It can also include any interest inflows received on cash held by the company.
3. Cash flows from Financing Activities
This section looks at any cash flows associated with financing, such as the issuance or repayment of debt or equity. Sometimes it may also include the dividend outflows, although these are often shown in section 1.
Similarly to the rule of balance sheets where Total Assets = Total Liabilities + Total Equity, the cash flow statement also has a strict rule that must hold:
Net Change in Cash & Cash Equivalents = Cash at Period End - Cash at Period Start
Cash & Cash Equivalents = Cash + Cash Equivalents - Bank Overdraft. These figures can be found on the company's balance sheet. If the above equation does not hold, then the cash flow figures are incorrect. This equation will become clearer when we look at the example below.
An Example: Using the Indirect Method
There are two ways to construct a cash flow statement; the direct method and the indirect method. To understand the cash flow statement better, we will look at the indirect method. This involves working out the cash flow statement from a given balance sheet and income statement. To use the indirect method, two consecutive years' worth of data is required for both the balance sheet and income statement. We will try to work out the cash flow statement for 2014. To construct the cash flow statement we effectively have to compare a lot of the figures against each other to work out the change across the year.
Let's work through the example below, where the balance sheet and income statement are the figures given.
There is one key other fact that has occurred that we need to know. Tangible assets of net book value £15,000 were sold during the year for a total cash consideration of £18,000. This figure was included in the sales figure. No intangible assets were purchased/disposed of during the period.
Below is a copy of the cash flow answer, which we can then look through step-by-step.
|Values in brackets mean the number is negative and is being subtracted. |
Values without brackets mean the number is positive and is being added.
We will start with the Cash Flows from Operating Activities.
- Profit before taxation is lifted directly from the 2014 column of the income statement.
- Depreciation and amortisation is lifted directly from the 2014 column of the income statement
- Interest expense is lifted directly from the 2014 column of the income statement.
- The profit on disposal needs to be subtracted from the profit figure since it is not recurring and does not relate to cash generation from operating activities. it amounts to £3,000 since the net book value was £15,000 and it was sold for £18,000 (i.e. £3,000 above its balance sheet worth).
- The fair value gain on investment does not relate to the underlying business either. So we subtract this from the pre-tax profit figure, to the tune of £40,000, which is equivalent to the rise in investments in 2014 to £180,000.
Now for the working capital movements.
- Trade receivables increased by £15,000 between 2013 and 2014. A receivables increase is a cash outflow.
- Trade payables increased by £50,000 between 2013 and 2014. We add back payables increases.
- Inventories increased by £25,000 between 2013 and 2014. An inventory increase is a cash outflow.
Now for other cash outflows.
- The £15,000 interest paid is usually the same as the interest expense noted earlier. However, it is not always the same if the interest it unpaid during the year, so we don't assume they are the same to be sure.
- The £46,000 taxation paid may first appear puzzling. After all, the tax charge for 2014 was only £36,000. The clue is that the tax payable figure on the balance sheet changed. The below table outlines where the £46,000 was derived from.
Now we move onto the Cash Flows from Investing Activities.
- Proceeds from disposal can be identified from the narrative we found from underneath the given balance sheet and cash flow statement. Here we book the total proceeds from the disposal, which were £18,000.
- The Capital Expenditure on tangible assets is the most tricky of all the figures to work out. The table for working it out is below, which I will then talk through.
To work out the capital expenditure you start with this template and input the tangibles figures from the balance sheet into the first and fifth rows. That leaves depreciation and disposals to work out before we can calculate the capital expenditure figure. Let's get disposals out of the way. The company sold tangible assets of net book value £15,000 during the year. Net book value means the balance sheet value, hence the disposals figure is simply £15,000.
Depreciation may appear odd; where has the £59,000 come from? Well, what references do we have to depreciation? We know that both depreciation and amortisation for 2014 totalled £115,000. We also know that depreciation refers to tangible assets and amortisation refers to intangible assets. We also have the intangible assets figure at both the end of 2013 and 2014. We need to calculate the amount of amortisation and subtract it from the £115,000, to give us the depreciation.
Intangibles fell by £56,000 from £230,000 in 2013 to £174,000 in 2014. That means that depreciation was £115,000 - £56,000 = £59,000. This is the figure we put into the template. Now working out the capital expenditure is simple; what figure to we have to add to 350 - 59 - 15 = 276 to get to 590? The answer is 314, or £314,000.
Finally we move onto the Cash Flows from Financing Activities.
- Issue of new shares is an easy figure to find. Look at the equity section of the balance sheet and add together the increase in both the share capital and share premium. In this case, £305,000 worth of new shares have been issued since the share capital has increased by £210,000 and the share premium has increased by £95,000. A share issue is a cash inflow.
- Similarly easily, the repayment of the bank loan, in this case, is just the reduction in the bank loan between 2013 and 2014. For this example, the bank loan has fallen from £250,000 to £150,000, hence there has been a £100,000 cash outflow to reduce the bank loan.
Remember to double check that the cash figures reconcile
This is the final check that needs to be made, and to do this we need the cash figures at the start of the year, the end of the year, and the net cash change that we have calculated. The net cash change that we have calculated is A+B+C in the table shown earlier, and it is simply the sum total of cash inflows/outflows from operating activities, investing and financing. For this example, we get a net cash inflow of £90,000.
This means that the cash position minus overdrafts should have improved by £90,000 between 2013 and 2014, if our calculations are correct. We start the period with a net overdraft of £40,000 (i.e. negative net cash and equivalents). We end 2014 with net cash of £50,000 (i.e. positive net cash and equivalents). This tallies with the figure we calculated.
This tutorial should have assisted in understanding the nature of the cash flow statement more closely. We can now use the knowledge from these tutorials in the future, to look at more complex and niche circumstances that a company might face, which are reflected in a cash flow statement, but extend beyond the borders of basic accounting.