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Business Financials – The Cashflow Statement – How to construct a cash flow statement
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Published on Thursday, 25 January 2018 08:11
Last month we explained what the Cash Flow Statement tells us and how it is used. This month is how to construct a cash flow statement, using an example, so we understand where it comes from.
Three sources are used to gather information for the cash flow statement rather than from the Trail Balance -
1. Comparative balance sheets / statement of position provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period
2. Current profit & loss / income statement to determine the amount of cash provided by or used by operations during the period
3. Selected transaction data from the general ledger to provide additional detailed information needed to determine how cash was provided or used during the period – eg asset purchase.
Three steps lead to preparing the statement of cash flows from these sources -
Step 1. Calculate the change in cash:
The change is the difference between the beginning and the ending cash balance from the beginning and end period on the balance sheet.
Step 2. Calculate the net cash flow from operating activities:
This procedure can be complex. It involves analysing not only the current year’s income statement but also comparative balance sheets and selected transaction data.
Step 3. Calculate net cash flows from investing and financing activities:
All other changes in the balance sheet accounts must be analysed to determine their effects on cash.
A worked Example – Compiling the Cash Flow Statement
To illustrate a statement of cash flows we will use the first year of operations for Business Pty Ltd.
The company started on July 1, 2014, when it issued 60,000 shares of $1 value common stock for $60,000 cash.
The company rented its office space and furniture and equipment, and it performed services throughout the first half year.
The balance sheets at the beginning and at the end of the 6 months are as follows.
The Profit & Loss or Income statement and additional information for Business Pty Ltd are -
Business Pty Ltd
Profit & Loss Statement
For the period ended December 31, 2014
|
Sales / Revenue
Operating expenses
Net Profit before income taxes
Income tax expenses
Net Profit/Income
|
$125,000
$ 85,000
———
$ 40,000
$ 6,000
———-
$ 34,000
|
Step 1. Calculate the change in cash:
The company has no cash on hand at the beginning of the period, but $49,000 at the end of 2014. This is an increase of $49,000
Step 2. Calculate the net cash flow from operating activities:
First the net profit/income must be converted. Under generally accepted accounting principles (GAAP), most companies must use the ACCRUAL basis of accounting, requiring revenues be reported when earned/invoiced and that expenses be recorded when incurred/authorised. Net income can also include credit sales that have not been collected in cash and expenses incurred that have not have been paid in cash. Thus, under the accrual basis of accounting, net income will not indicate the net cash flow from operating activities.
To calculate net cash flow from operating activities, it is necessary to report revenue and expenses on cash basis and can be calculated via either a direct method or an indirect method
1. Direct Method: (also called the income statement method) –
Business Pty Ltd shows sales/revenues of $125,000. However, because the company’s accounts receivable increased during 2003 by $36,000, only $89,000 ($125,000 − $36,000) in ACTUAL cash was collected on these revenues.
The company also shows operating expenses of $85,000, but accounts payable increased during the period by $5,000. Assuming that payables related to operating expenses, the ACTUAL cash operating expenses were $80,000 ($85,000 − $5,000).
Because no taxes payable exist at the end of the year on the Balance Sheet, the $6,000 income tax expense must have been paid in cash during the year. Then the computation of net cash flow from operating activities is as follows:
“Net cash provided by operating activities” is equivalent of cash-basis net income or the CASH Profit & Loss.
2. Indirect Method: (or reconciliation method) – starts with Net Profit/income and converts it to net cash.
Increase in Accounts Receivable―Indirect Method:
If accounts receivable increase during the year, sales/revenues on an accrual basis are higher than on a cash basis because goods sold on account are reported as sales/revenues. In other words, operations for the period led to increased revenues, but not all of these revenues resulted in actual cash, but appear as an increase in accounts receivable. Therefore the increase of $36,000 in accounts payable must be deducted from net income.
Increase in Accounts Payable―Indirect Method:
If accounts payable increase during the period, expenses on an accrual basis are higher than they are on a cash basis because expenses are incurred for which payment has not taken place yet. Therefore the increase of $5,000 in accounts payable must be added back to net income.
As a result of the accounts receivable and accounts payable adjustments, net cash provided by operating activities is calculated to be $3,000 for the year 2003. This calculation is shown as follows.
Observe that net cash provided by operating activities is the same whether the direct or indirect method is used.
Step 3: Calculate Net Cash Flows from Investing and Financing Activities:
Finally, we need to determine whether any other changes in balance sheet accounts caused an increase or decrease in cash.
For example, an examination of the remaining balance sheet accounts shows that both common shares and retained earnings have increased. The common shares increase of $60,000 resulted from the issuing of common shares for cash. This is a receipt of cash from a financing activity and is reported as that in the statement of cash flows. The retained earnings increase of $20,000 is caused by two items:
1. Net income of $34,000 increased retained earnings, less
2. Dividend declared of $14,000 decreased retained earnings.
Net income has been converted into net cash flows from operating activities, as explained earlier. The additional data indicates that the dividend was paid. Thus, the dividend payment on common stock is reported as cash outflow, and classified as financing activity.
We are now ready to prepare the statement of cash flows. We start with the operating activities section. Either the direct or indirect method may be used to report net cash flow from operating activates.
The statement of cash flows under indirect method for Tax Consultation Inc. is as follows.
Business Pty Ltd
cash flow statement-Indirect Method
For the period end 31 Dec 2014
As shown, the $60,000 increase in common shares results in a cash inflow from a financing activity. The payment of $14,000 in cash dividends is classified as a use of cash from a financing activity. By coincidence in this example, the $49,000 increase in cash reported in the statement of cash flows agrees with the increase of $49,000 shown as the change in the cash account in the balance sheet.
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