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Q.What is a Cash flow statement?

Haryana BsehTextbookSubjective· 2mImportance★★★★★
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A Cash Flow Statement is a financial statement that summarises the cash inflows and outflows of a business over a specific period, classified into Operating, Investing, and Financing activities.

The Concept: Why Cash Flow Matters

You already know the Income Statement (Profit & Loss Account) and the Balance Sheet. They tell you whether the business made a profit and what it owns and owes. But here's the catch: profit is not cash.

A business can show a healthy profit on paper yet run out of cash to pay its bills. Why? Because of credit sales, depreciation (a non-cash expense), or heavy investment in fixed assets. The Cash Flow Statement bridges this gap. It answers the single most practical question: "Where did the cash come from, and where did it go?"

The Accounting Standard (AS-3) in India mandates that listed companies present a Cash Flow Statement alongside the Balance Sheet and Profit & Loss Account. It is not an alternative to the P&L; it is a supplement that reveals the liquidity and solvency of the business.

The Three Pillars of Classification

Every cash transaction falls into one of three categories. This classification is the heart of the statement.

1. Operating Activities

These are the principal revenue-producing activities of the business. Think of them as the cash effects of transactions that enter into the determination of net profit.

Examples:

  • Cash received from customers (from cash sales and collection from debtors)
  • Cash paid to suppliers (for purchases and creditors)
  • Cash paid to employees (salaries, wages)
  • Cash paid for operating expenses (rent, electricity)
  • Cash paid for taxes
  • (Note: for a non-financial enterprise under AS-3, interest and dividends received are classified under investing activities and interest and dividends paid under financing activities - not operating; they are operating only for a financial enterprise such as a bank)
Watch out

Common Pitfall

Do NOT include depreciation, goodwill amortisation, or provisions in the Cash Flow Statement. These are non-cash items. They are added back to net profit when calculating cash from operations using the indirect method, but they never appear as a separate line item of cash flow.

2. Investing Activities

These relate to the acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Examples:

  • Purchase of fixed assets (Plant, Machinery, Building, Furniture)
  • Sale of fixed assets
  • Purchase of long-term investments (shares, debentures of other companies)
  • Sale of long-term investments
  • Loans given to subsidiaries or others
  • Cash received from repayment of loans given

3. Financing Activities

These are activities that result in changes in the size and composition of the equity capital and borrowings of the entity.

Examples:

  • Issue of shares or debentures (cash inflow)
  • Redemption of shares or debentures (cash outflow)
  • Proceeds from long-term borrowings (bank loan, debentures)
  • Repayment of long-term borrowings
  • Dividend paid
  • Interest paid (on borrowings)
Tip

Shortcut for Classification

Ask yourself: "Does this transaction affect the Profit & Loss (Operating), the Fixed Assets/Investments (Investing), or the Capital/Loans (Financing)?" If it changes the size of the business's long-term funding structure, it's Financing.

The Two Methods of Preparation

You can prepare a Cash Flow Statement using either the Direct Method or the Indirect Method. AS-3 encourages the direct method, but the indirect method is far more common in practice and in Indian exams.

Direct Method

You list actual cash receipts and payments from operating activities. For example:

  • Cash received from customers = Sales + Opening Debtors - Closing Debtors
  • Cash paid to suppliers = Purchases + Opening Creditors - Closing Creditors

This method is straightforward but requires detailed cash book data, which is often not available from just two Balance Sheets.

Indirect Method (The Exam Standard)

You start with Net Profit before Tax and Extraordinary Items from the P&L Statement. Then you adjust it for:

  1. Non-cash items (Depreciation, Goodwill written off, Provisions)
  2. Non-operating items (Profit on sale of asset, Interest income)
  3. Changes in Current Assets and Current Liabilities (Working Capital changes)

The formula is:

Cash from Operations = Net Profit before Tax + Non-cash Expenses - Non-cash Incomes + Decrease in Current Assets - Increase in Current Assets + Increase in Current Liabilities - Decrease in Current Liabilities

A Simple Illustration (Indirect Method)

Let's build a mini Cash Flow Statement.

Given:

  • Net Profit before Tax: ₹1,00,000
  • Depreciation charged: ₹20,000
  • Profit on sale of land: ₹10,000
  • Increase in Debtors: ₹15,000
  • Decrease in Creditors: ₹5,000
  • Purchase of Machinery: ₹50,000
  • Issue of Share Capital: ₹40,000
  • Dividend Paid: ₹25,000

Step 1: Cash Flow from Operating Activities

ParticularsAmount (₹)
Net Profit before Tax1,00,000
Adjustments for non-cash / non-operating items:
Add: Depreciation20,000
Less: Profit on sale of land(10,000)
Operating Profit before Working Capital changes1,10,000
Adjustments for Working Capital changes:
Less: Increase in Debtors(15,000)
Less: Decrease in Creditors(5,000)
Cash Generated from Operations90,000
Less: Tax Paid (assume nil for simplicity)—
Net Cash from Operating Activities90,000

Step 2: Cash Flow from Investing Activities

ParticularsAmount (₹)
Purchase of Machinery(50,000)
Net Cash used in Investing Activities(50,000)

Step 3: Cash Flow from Financing Activities

ParticularsAmount (₹)
Proceeds from Issue of Share Capital40,000
Dividend Paid(25,000)
Net Cash from Financing Activities15,000

Step 4: Net Increase/Decrease in Cash

ParticularsAmount (₹)
Net Cash from Operating Activities90,000
Net Cash used in Investing Activities(50,000)
Net Cash from Financing Activities15,000
Net Increase in Cash and Cash Equivalents55,000
Add: Opening Cash and Cash Equivalents (assume ₹10,000)10,000
Closing Cash and Cash Equivalents65,000
✓Final answer

A Cash Flow Statement classifies all cash transactions into Operating, Investing, and Financing activities to explain the net change in cash and cash equivalents during a period. In the illustration, the net increase in cash was ₹55,000, resulting in a closing balance of ₹65,000.

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