Inventory or stock-in-trade is the goods or commodities held by an entity for the purpose of resale or trade. At the end of an accounting year, companies usually have unsold goods in their warehouses which are referred to as closing inventory or closing stock-in-trade.
This item is not reported in the income statement, but it is recorded in the statement of financial position, and also has effects on the statement of cash flow. In this article, we are going to talk about how changes in inventory affect the statement of cash flow.
Motive of Statement of Cash flow:
The cash flow statement is annually prepared and is audited along with the income statement and statement of financial position. It shows the cash inflow and outflow of the company for a specific time period (a month, a quarter or a year).
The main purpose of this statement is for the shareholders and the public to understand how liquid the company is and how its cash or cash equivalents are managed throughout the year.
Format of Statement of Cash flow:
According to any of the applicable financial reporting framework around the world, a cash flow statement is to be formatted and classified in the following three categories respectively:
- Operating Activities
- Investing Activities
- Financing Activities
The total cash flow from each activity are summed up and then reconciled with the closing cash or cash-equivalent balance.
Hence, the cash flow statement summarizes and identifies each cash transaction that has occurred during the year.
The change or movement of inventories during the period is normally present in the statement of cash flow under the operating activities section and under the changing in the working capital categories. We will discuss in detail below how it is affected the statement of cash flow.
And before we start discussing on how it is present it is present in the statement of cash flow, let us discuss about the accounting treatment of inventories first.
Accounting treatment of closing inventory:
The closing inventory is reported through the cost of goods sold in the income statement. The cost of goods sold is calculated as follows:
Opening Inventory xx
Add: Purchases xx
Less: Closing inventory (xx)
Cost of Sales xxx
As we can see, the closing inventory is reducing the amount of cost of sales and as a result increasing the net profit.
However, in the balance sheet, closing inventory is reported as a current asset.
Effect on Statement of Cash flow:
Any changes in stock in trade are adjusted in the operating activities section of the cash flow statement. The operating activities section reports all the principal business activities that occurred during the year and accounts for any working capital changes.
Any increase in stock-in-trade is subtracted from the profit or loss before tax whereas any decrease in stock-in-trade is added to the profit or loss before tax for the year in order to get the net amount of cash flow from operating activities. I’ll explain the logic through the following example:
Assume that a business was commenced this year with no cash and received $100,000 against sales made during the year. The cost of goods sold for such sales was $50,000.
Even though the purchases made during the year were worth $100,000 the business only sold the stock of $50,000 resulting in a closing inventory of $50,000. So, the net profit for the year would be $50,000 and the balance summary becomes as follows:
|Stock in trade
Hence, we conclude that in order to obtain the cash balance the increase in stock in trade shall be deducted from the net profit since only $50,000 were charged to the income statement even though $100,000 were spent on purchases.
Let’s take this example further to the next year and assume that the business did not make any purchases but used last year’s inventory.
Cash sales for the year amounted to $100,000 and the cost of goods sold was $50,000. So, the net profit for the year would be $50,000 and the balance summary would be as follows:
|Stock in trade
Thus, we conclude that, decrease in stock in trade would be added in the net profit in order to get the net cash flow because the amount of stock in trade charged to the income statement was paid in the preceding year.
Hence, the net cash balance would be the amount received against the sales of $100,000 instead of net profit of $50,000.