Chapter 3 - Cash flow accounting

Chapter objectives
Structure of the chapter
Aim of a cash flow statement
Statements of source and application of funds
Funds use and credit planning
Key terms

It can be argued that 'profit' does not always give a useful or meaningful picture of a company's
operations. Readers of a company's financial statements might even be misled by a reported
profit figure.
Shareholders might believe that if a company makes a profit after tax of say $100,000, then this
is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash
available to stay in business and also to pay a dividend, the shareholders' expectations would
be wrong. Survival of a business depends not only on profits but perhaps more on its ability to
pay its debts when they fall due. Such payments might include 'profit and loss' items such as
material purchases, wages, interest and taxation etc, but also capital payments for new fixed
assets and the repayment of loan capital when this falls due (e.g. on the redemption of
debentures).
Chapter objectives
This chapter is intended to provide an explanation of:
• The aim, use and construction of cash flow statements
• The meaning and calculation of the source and application of funds statement and their
importance to business
• A discussion on credit and types of loans available to businesses
• An explanation of the cost of funds and capital
• The importance and calculation of ownership costs, including depreciation, interest, repair,
taxes and insurance.
Structure of the chapter
"Cash flow" is one of the most vital elements in the survival of a business. It can be positive, or
negative, which is obviously a most undesirable situation. The chapter develops the concept of
cash flow and then shows how the funds can be used in the business. Funds are not only
generated internally; they may be externally generated, and so the chapter finishes with a
discussion of externally generated funds.
Aim of a cash flow statement
The aim of a cash flow statement should be to assist users:
• to assess the company's ability to generate positive cash flows in the future
• to assess its ability to meet its obligations to service loans, pay dividends etc
• to assess the reasons for differences between reported and related cash flows
• to assess the effect on its finances of major transactions in the year.
The statement therefore shows changes in cash and cash equivalents rather than working
capital.
Indirect method cash flow statement
Figure 3.1 shows a pro forma cash flow statement.
Figure 3.1 Pro forma cash flow statement

Cash Flow Statement For The Year Ended 31 December 19X4

$ $

Net cash inflow from operating activities X

Returns on investments and servicing of finance

Interest received X

Interest paid (X)

Dividends paid (X)

Net cash inflow/ (outflow) from returns on investments and servicing of finance X

Taxation

Corporation tax paid (X)

Tax paid (X)

Investing activities

Payments to acquire intangible fixed assets (X)

Payments to acquire tangible fixed assets (X)

Receipts from sales of tangible fixed assets X

Net cash inflow/ (outflow) from investing activities X or (X)

Net cash inflow before financing X

Financing

Issue of ordinary capital X

Repurchase of debenture loan (X)

Expenses paid in connection with share issues (X)

Net cash inflow/ (outflow) from financing X or (X)

Increase/ (Decrease) in cash and cash equivalents X

NOTES ON THE CASH FLOW STATEMENT
1. Reconciliation of operating profit to net cash inflow from operating activities

Operating profit X

Depreciation charges X

Loss on sale of tangible fixed assets X

Increase/(decrease) in stocks (X)

Increase/(decrease) in debtors (X)

Increase/(decrease) in creditors X

Net cash inflow from operating activities X

2. Analysis of changes in cash and cash equivalents during the year

Balance at 1 January 19X4 X

Net cash inflow X

Balance at 31 December 19X4 X

3. Analysis of the balances of cash and cash equivalents as shown in the balance sheet

19X4 19X3 Change in year

$ $ $

Cash at bank and in hand X X (X)

Short term investments X X X

Bank overdrafts (X) (X) (X)

X X X

4. Analysis of changes in finance during the year

Share capital Debenture loan