The financial statements of any business entity tell a lot about financial health and profitability. If we talk about the income statement alone, the firm’s profitability, revenues, and expenses are covered in it. The last item on the income statement is profit that tells how much the company has made during a financial period after paying the expenses.
However, the profit stated does not necessarily mean the cash in hand. In other words, the income statement of a business entity does not reflect the actual cash inflows and outflows during a financial year.
Since the accrual accounting system focuses on recording a transaction when it happens irrespective of the cash payment or receipt. Therefore, the cash in hand of a company is another story. As more companies follow the accrual accounting system, a comprehensive statement is needed to cover the cash transactions of the entity.
Therefore, the cash flow statement is one of the four major financial statements any business entity prepares at the year-end. This article will talk about the cash flow statement and, most specifically, the operating activities section of any cash flow statement.
What Is Statement Of Cashflow?
The statement of cash flow or Cash flow statement can be defined as,
It is one of the major financial statements prepared by any business entity to record the amount of cash and cash equivalents that entered or left the company during the financial period.
According to IFRS’s IAS 7,
The cash flow statement of any business entity is a central component of financial statements that reflects the information about the company’s financial health and its capacity to generate cash flows.
The IAS 7 further classifies the cash flow statement as,
The cash flow statement tells how a business entity’s cash and cash equivalents changed during a financial period. Cash is defined as cash in hand, bank, and demand deposits. Whereas the cash equivalents are highly volatile and short-term investments that can readily be converted into cash.
What Is Included?
IAS 7 of IFRS explains and classifies what information is included in the cash flow statement for financial reporting. It includes:
- Operating Activities
- Investing Activities
- Financing Activities
The operating activities of a business entity are the most important ones as they are a major source of revenues. These are also called the revenue-generating activities of a company. The operating expenses are treated as cash outflows, and the cash sales make the operating cash inflow for any entity.
The second part of the cash flow statement comprises the investing activities of a business entity. Investing activities are defined as the activities that increase or decrease the productivity, revenues, and worth of a business entity. Therefore, cash acquisition or disposal of a long-term asset or long-term investments are part of investing activities.
The net balance of the acquisitions or losing cash in investing activities is shown as the net cash flow of investing activities.
Finally, the third part of the cash flow statement represents the cash inflows and outflows from the financing activities of any business entity. Financing activities are defined as the transactions that impact the size, composition, or nature of the company’s capital(equity or borrowed).
Cashflow From Operating Activities
Since our main focus is on the cash flow from operating activities, we will define operating activities more elaboratively.
Cash Flow From Operating Activities
Cash flow from operating activities represents the net cash flows(inflows- outflows) from the regular business activities during a specific financial period. The operating cash flow part of the cash flow statement starts with the net income in the indirect method and cash receipts in the direct method.
Operating Activities Explained
Operating activities, as earlier discussed, are the revenue-generating activities of a business entity. The operating activities can also be defined as day-to-day business operations performed by a business entity to make sales and profits. There are different ways that an entity can adopt to report its operating activities.
The direct method is the most commonly used method in small businesses and large corporations alike. The major classes of gross cash payments and receipts are disclosed for reporting.
On the other hand, the indirect method starts from the profit or loss calculated at the end of the income statement. The deferrals or accruals of the past or future operating cash payments or receipts are adjusted to report the cash from operating activities.
Items In Operating Activities
Several operating activities are included in the cash flow statement. What is included in operating cash flow depends on the method used to calculate the net cash flow. We will discuss for direct as well as the indirect method.
The direct method simply starts with recording all the cash receipts and subtracting the cash payments from the receipts to find the net cash flow from operating income. It, therefore, includes:
All the sales made by the company on a cash basis are recorded as the firm’s cash receipts.
Account Receivables Collected
The cash proceeds by the account receivables can include the account receivables of the previous financial period and the current financial period.
All the cash payments by the business entity during the financial period are recorded in the operating cash flow cash payments. These cash payments usually include:
- Cash Expenses of the current financial period
- Account payables honored from last and current financial period
- Deferred expenses of the last financial period
- Prepaid expenses for the next financial period
The indirect method starts from the net profit or loss, and several adjustments are made to finally calculate the cash inflow from operating activities. This method is practically more favorable from the investors’ point of view because they can easily understand the calculation. The indirect method includes the following items:
Net Income(Profit or Loss)
The last line item of the income statement is profit or loss during a specific financial period.
Adjustments Related To Net Income From Operating Activities
The non-cash items(expenses or revenues) are added back to the net income of the company. These items include:
- Depreciation expense
- Stock-based compensation in the form of share issuance
- Any expense or income such as unrealized gains or losses or accrued items
- Deferred taxes
Change In Working Capital
Finally, the change in working capital is the difference between operating assets and operating liabilities. These items include:
- Change in inventory(if inventory increases, the cash is reduced and vice versa)
- Change in account receivables(if the account receivable decreases, cash is increased and vice versa)
- Change in account payable(if account payable or unearned revenue decreases, the cash is reduced and vice versa)
Formula To Calculate Net Cash Flow From Operations
Let’s look at the formula for calculating net cash flow from the operations of a business entity.
The direct method formula is as follow:
Net Operating Cash Flow = Operating Cash Receipts – Operating Cash Payments
The formula for the indirect method of calculating net operating cash flow is as follow:
Net Cash Flow Of Operating Activities = Funds from operations + change in working capital.
Adjustments Related To Net Income
- Add depreciation, depletion, amortization
- Add deferred taxes
- Add Other Non-cash expenses
- Add Outstanding Expenses
- Subtract Non-cash Income
Change In Operating Assets
- Subtract Increase In Inventories/Add decrease in inventories
- Add decrease in account receivables/ subtract increase in account receivables
- Add the increase in account payable/ Subtract decrease in account payables
- Add the increase in accrued expenses/ Subtract decrease in accrued expenses
- Add the increase in unearned revenues/ Subtract decrease in unearned revenues
How To Calculate Cash From Operating Activities
Let’s understand the calculation of cash flow from operating activities using the indirect method. Here is an example for elaboration.
A company has reported a profit of 1,700,000 USD for the year 2020. Other figures are as follows:
- The gain on sale of land is 15,000 USD
- Depreciation on fixed assets is 65,000 USD
- Goodwill has written off by 20,000 USD
The change in the current assets and current liabilities on December 31st, 2020:
Debtors = USD 18,000 increase
Creditors = USD 30,000 decrease
Bill Receivables = USD 17,000 decrease
Prepaid Expenses = USD 8,000 decrease
Cash Flow From Operating Activities
|Add: non-cash expenses and amortization|
|Less: Gain on sale of land||15,000|
|Increase in debtors||(18,000)|
|Decrease in creditors||(30,000)|
|Decrease in prepaid expenses||8,000|
|Decrease in bill receivables||17,000||(23,000)|
|Net Cash Flow from Operating Activities||1,777,000|
Similarly, the cash flow from operating activities can be found by using the direct method.
We have discussed the cash flow from the operating activities. The cash flow from operating activities is the first part of the cash flow statement. The next sections of the cash flow statement are investing activities and financing activities, respectively.
One thing to note here is that operating activities do not include any long-term capital expenditure or revenues. This is an important measure as it reflects on the short-term financial health of the business entity.