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 Returns on investments and servicing of finance Interest received Interest paid Dividends paid Net cash inflow/ (outflow) from returns on investments and servicing of finance Taxation Corporation tax paid Tax paid Investing activities Payments to acquire intangible fixed assets Payments to acquire tangible fixed assets Receipts from sales of tangible fixed assets Net cash inflow/ (outflow) from investing activities Net cash inflow before financing Financing Issue of ordinary capital Repurchase of debenture loan Expenses paid in connection with share issues Net cash inflow/ (outflow) from financing Increase/ (Decrease) in cash and cash equivalents X (X) (X) X or (X) X (X) (X) X X or (X) X (X) (X) X (X) (X) X X $

NOTES ON THE CASH FLOW STATEMENT 1. Reconciliation of operating profit to net cash inflow from operating activities
$ Operating profit Depreciation charges Loss on sale of tangible fixed assets Increase/(decrease) in stocks Increase/(decrease) in debtors Increase/(decrease) in creditors Net cash inflow from operating activities (X) (X) X X X X X

2. Analysis of changes in cash and cash equivalents during the year
Balance at 1 January 19X4 Net cash inflow X 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 Short term investments Bank overdrafts X (X) X X X (X) X $ (X) X (X) X $

4. Analysis of changes in finance during the year
Share capital Debenture loan $