Cash Flow Statement

CASH FLOW STATEMENT: COMPREHENSIVE NOTES FOR CBSE CLASS 12

Definition and Concept of Cash Flow Statement

A **Cash Flow Statement** is the third important financial statement (after Balance Sheet and Profit & Loss Statement) that shows the **inflows and outflows of cash and cash equivalents** from various activities of an enterprise during a specific accounting period.

**Key Point:** Cash Flow Statement is mandatory under **Section 133 of the Companies Act, 2013** and must be prepared in accordance with **Accounting Standard 3 (AS-3)**.

**Distinction from other financial statements:**

**Balance Sheet:** Shows financial position on a particular date (static)

**P&L Statement:** Shows results of operations over a period (accrual basis)

**Cash Flow Statement:** Shows actual cash movements (cash basis) and sources/uses of cash over a period

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Objectives of Cash Flow Statement

The primary objective is to provide **useful information about cash flows (inflows and outflows) of an enterprise during a particular period** under three distinct heads:

Operating Activities

Investing Activities

Financing Activities

**Secondary objectives:**

Enable users to assess the **ability of the enterprise to generate cash and cash equivalents**

Evaluate the **timing and certainty of cash generation**

Support economic decision-making by stakeholders

Assess changes in **liquidity and solvency** position

Evaluate **financial structure** of the company

Help management balance cash inflows and outflows

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Benefits of Cash Flow Statement

1. **Enhanced Financial Analysis:** When used with other financial statements, it reveals changes in net assets, financial structure (liquidity and solvency), and the enterprise's ability to adapt to changing circumstances.

2. **Cash Generation Assessment:** Enables users to evaluate the enterprise's ability to generate cash and develop models to compare present values of future cash flows of different enterprises.

3. **Comparability:** Eliminates effects of using different accounting treatments for the same transactions, making inter-firm comparisons more reliable.

4. **Profitability vs. Cash Flow Analysis:** Helps examine the relationship between profitability (accounting profit) and net cash flows, identifying whether high profits translate to strong cash positions.

5. **Impact of Changing Prices:** Useful in assessing the effect of inflation and changing prices on cash flows.

6. **Verification Tool:** Helps check the accuracy of past assessments of future cash flows.

**Exam Point:** Always remember that **high profit ≠ high cash flow**. A company can be profitable but still face liquidity crisis.

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Cash and Cash Equivalents

Definitions (As per AS-3):

**Cash** comprises:

Cash in hand

Demand deposits with banks

**Cash Equivalents** are:

Short-term, highly liquid investments that are **readily convertible into known amounts of cash**

Subject to **insignificant risk of changes in value**

Maturity of **3 months or less** from the date of acquisition (general rule)

What Qualifies as Cash Equivalents:

✓ **Included:**

Treasury bills

Money market funds

Short-term government bonds

Bank certificates of deposit (maturity ≤ 3 months)

Preference shares shortly before redemption date (insignificant failure risk)

Short-term marketable securities (readily convertible to cash without loss of value)

✗ **Excluded:**

Equity shares (ordinary shares)

Long-term investments

Inventory

Fixed deposits beyond 3 months

Investments with significant valuation risk

**Exam Note:** Cash management includes investment of excess cash in cash equivalents. Therefore, **purchase of marketable securities or short-term investments is NOT shown in cash flow statement** as it represents cash management, not a true cash flow.

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Cash Flows: Definition and Examples

**Cash Flows** implies **movement of cash in and out** due to transactions and events.

**Types:**

**Cash Inflow (Receipt):** Cash received from an activity. *Example:* Collection from trade receivables, proceeds from sale of machinery, receipt of dividend.

**Cash Outflow (Payment):** Cash paid for an activity. *Example:* Payment to suppliers, purchase of machinery, payment of employee benefits.

**Common Examples of Cash Flows:**

Collection of receivables

Payment to payables

Employee salary payments

Interest receipts and payments

Dividend receipts

Loan repayments

Asset purchases and sales

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Classification of Activities for Cash Flow Statement

As per **AS-3**, cash flows must be classified into **three distinct categories** to show separately the cash generated or used by each type of activity.

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Cash Flows from Operating Activities

Definition:

Operating activities are the **primary or main revenue-generating activities** of an enterprise. These constitute the principal business operations (not investing or financing).

**Example:** For a garment manufacturing company: procurement of raw materials, manufacturing expenses, sale of finished goods.

Importance:

**"Cash from operations"** indicates the **internal solvency level** of the company

Shows whether operations have **generated sufficient cash** to:

Maintain operating capability

Pay dividends

Make new investments

Repay loans (without external financing)

Cash Inflows from Operating Activities:

Cash receipts from **sale of goods and rendering of services** (main business)

Cash receipts from **royalties, fees, commissions, and other revenues**

Cash receipts from **insurance claims**

Cash proceeds from **deals in securities/loans held for trading** (for financial companies)

Cash Outflows from Operating Activities:

Cash payments to **suppliers for goods and services**

Cash payments to and on behalf of **employees**

Cash payments to **insurance enterprises** (premiums, claims, annuities, policy benefits)

Cash payments of **income taxes** (unless specifically identified with financing/investing activities)

Operating expense payments

Special Cases:

**Trading/Dealing Securities:** For enterprises (especially financial firms) that hold securities or loans for dealing/trading purposes, these constitute inventory held for resale. Therefore:

Purchase of trading securities = Operating activity cash outflow

Sale of trading securities = Operating activity cash inflow

**Advances and Loans by Financial Enterprises:** Usually classified as operating activities since they relate to the main activity of financial institutions.

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Cash Flows from Investing Activities

Definition:

Investing activities are the **acquisition and disposal of long-term assets and other investments** (not including cash equivalents).

Importance:

Separate disclosure is important because:

Shows **extent of capital expenditures** for resources intended to generate future income

Reveals management's **investment strategy**

Indicates **growth and expansion plans**

Cash Outflows from Investing Activities:

Cash payments to **acquire fixed assets** (machinery, equipment, vehicles, furniture, land, building)

Cash payments to **acquire intangibles** (patents, copyrights, licenses)

Cash payments for **capitalised research and development**

Cash payments to acquire **shares, warrants, debt instruments** of other enterprises (excluding trading securities)

**Advances and loans made to third parties** (except loans given by financial enterprises, which are operating)

**Brokerage, commissions, and fees** paid on purchasing investments

Cash Inflows from Investing Activities:

Cash receipts from **disposal/sale of fixed assets** (machinery, land, building)

Cash receipts from **disposal of intangibles**

Cash receipts from **repayment of advances or loans** made to third parties

Cash receipts from **disposal of shares, warrants, debt instruments** of other enterprises (excluding trading securities)

**Interest received** in cash (from loans and investments)

**Dividend received** from investments in other enterprises

**Insurance claim receipts** (where related to fixed assets)

Key Exam Points:

**Interest and Dividend (For Non-Financial Enterprises):**

Interest **received** = Investing activity (cash inflow)

Dividend **received** = Investing activity (cash inflow)

Interest **paid** = Financing activity (cash outflow)

Dividend **paid** = Financing activity (cash outflow)

**For Financial Enterprises:** Interest received, interest paid, and dividend received are operating activities (since lending/borrowing is their main business); dividend paid remains financing.

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Cash Flows from Financing Activities

Definition:

Financing activities result in **changes in the size and composition of the owners' capital (equity and preference share capital) and borrowings** of the enterprise.

Importance:

Separate disclosure is useful for:

**Predicting future claims** on cash flows by capital and debt providers

Understanding **long-term financing structure**

Assessing **debt servicing capacity**

Cash Inflows from Financing Activities:

Cash proceeds from **issuing equity shares** (including share premium)

Cash proceeds from **issuing preference shares**

Cash proceeds from **issuing debentures, bonds, and other debt instruments**

Cash proceeds from **raising long-term bank loans and advances**

Cash proceeds from **issuing short-term borrowings** (if part of financing policy)

Cash Outflows from Financing Activities:

Cash repayments of **amounts borrowed** (debentures, loans, bonds)

**Interest paid** on debentures and long-term loans (for non-financial enterprises)

**Dividend paid** on equity shares

**Dividend paid** on preference shares

**Preference share redemptions**

**Buy-back of own equity shares**

**Lease payments** (if capitalized as finance lease)

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Treatment of Peculiar/Special Items

1. Extraordinary Items

**Definition:** Non-regular, non-recurring transactions such as:

Loss due to theft, earthquake, flood, fire

Gain/loss from government requisition of assets

One-time write-offs

**Treatment:**

Should be **classified and disclosed separately** as arising from operating, investing, or financing activities

Necessary to enable users to understand their nature and impact on present and future cash flows

**Example:** If machinery is destroyed by fire and insurance proceeds are received, classify as investing activity cash inflow (asset disposal); the loss is adjusted in net profit.

2. Interest and Dividend

**For Non-Financial Enterprises:**

**Interest paid** = Financing activity (cash outflow)

**Interest received** = Investing activity (cash inflow)

**Dividend paid** = Financing activity (cash outflow)

**Dividend received** = Investing activity (cash inflow)

**For Financial Enterprises (Banks, Insurance, NBFCs):**

**Interest paid** = Operating activity

**Interest received** = Operating activity

**Dividend received** = Operating activity

**Dividend paid** = Financing activity

**Rationale:** For financial institutions, lending and borrowing are main activities, not financing activities.

3. Taxes on Income and Gains

**General Rule:** Cash flows from taxes should be classified as **operating activities** unless they can be specifically identified with investing or financing activities.

**Specific Classification:**

| Type of Tax | Classification | Reason |

|---|---|---|

| **Income tax on operating profit** | Operating activity | Related to main business |

| **Capital gains tax on fixed asset sale** | Investing activity | Related to capital transaction |

| **Dividend tax/tax on distributed profit** | Financing activity | Related to distribution to owners |

**Practical Application:** When fixed assets are sold at a gain:

Sale proceeds (gross) = Investing activity cash inflow

Capital gains tax paid = Investing activity cash outflow

Net proceeds = Sale price − Capital gains tax

4. Non-Cash Transactions

**Definition:** Investing and financing transactions that do **not involve cash or cash equivalents**.

**Examples:**

Acquisition of machinery by issue of equity shares

Redemption of debentures by issue of equity shares

Bonus shares issued

Rights issue without new cash contribution

Merger by share swap

**Treatment:**

**EXCLUDED from Cash Flow Statement** (since no cash movement)

**DISCLOSED elsewhere** in financial statements (Notes to Accounts) with all relevant information

**Essential to show:** This ensures transparent reporting of all transactions despite non-cash nature

**Exam Point:** If an asset is acquired for equity shares, it appears in the Balance Sheet but NOT in the cash flow statement.

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Structure of Cash Flow Statement

```

Cash Flow Statement

─────────────────────────────────────────────

A. Cash flows from operating activities XXX

B. Cash flows from investing activities (XXX)

C. Cash flows from financing activities (XXX)

─────────────────────────────────────────────

Net increase/(decrease) in cash XXX

Add: Cash at beginning of period XXX

═════════════════════════════════════════

Cash at end of period XXX

```

**Key Features:**

Operating activities usually show **net position** (inflows − outflows)

Investing activities typically show **net outflow** (capital expenditure)

Financing activities show **net inflow** or **outflow** depending on financing needs

**Final line:** Reconciles opening cash with closing cash

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Test Your Understanding - Classification Exercise

**Instructions:** Classify each item into Operating (OP), Investing (IN), Financing (FIN), or Cash Equivalent (CE).

| Item | Classification | Reason |

|---|---|---|

| Purchase of machinery | IN | Long-term asset acquisition |

| Proceeds from equity share issue | FIN | Changes owners' capital |

| Cash revenue from operations | OP | Main business activity |

| Proceeds from long-term borrowings | FIN | Long-term financing |

| Proceeds from sale of old machinery | IN | Fixed asset disposal |

| Cash receipt from trade receivables | OP | Collection from customers |

| Trading commission received | OP | Revenue from main activity |

| Purchase of non-current investment | IN | Long-term investment |

| Redemption of preference shares | FIN | Return of preference capital |

| Cash purchases | OP | Inventory for resale |

| Proceeds from sale of non-current investment | IN | Disposal of long-term investment |

| Purchase of goodwill | IN | Intangible asset acquisition |

| Cash paid to supplier | OP | Payment for inventory/supplies |

| Interim dividend paid on equity shares | FIN | Distribution to shareholders |

| Employee benefits paid | OP | Operating expense |

| Proceeds from sale of patents | IN | Disposal of intangible asset |

| Interest received on debentures | IN | Investment income (non-financial) |

| Interest paid on long-term borrowings | FIN | Financing cost |

| Office and administrative expenses | OP | Operating expense |

| Manufacturing overheads paid | OP | Production expense |

| Dividend received on shares held | IN | Investment income |

| Rent received on property held | IN | Investment income (if held for income) |

| Selling and distribution expenses | OP | Operating expense |

| Income tax paid (on operating profit) | OP | Tax on operations |

| Dividend paid on preference shares | FIN | Distribution to shareholders |

| Under-writing commission paid | OP/FIN | Context-dependent (if on share issue = FIN) |

| Rent paid | OP | Operating expense |

| Brokerage on non-current investment | IN | Related to investing activity |

| Bank overdraft | FIN | Short-term borrowing |

| Cash credit | FIN | Short-term borrowing |

| Short-term deposit | CE | Highly liquid, ≤3 months maturity |

| Marketable securities | CE | Readily convertible to cash |

| Refund of income tax received | OP | Related to tax on operations |

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Methods of Preparation: Direct vs. Indirect Method

As per **AS-3**, an enterprise may report cash flows from operating activities using **either** of two methods:

1. Direct Method

**Definition:** Major classes of **gross cash receipts and gross cash payments** are disclosed separately.

**Formula:**

```

Cash flows from Operating Activities =

Gross cash inflows from operations

− Gross cash outflows from operations

= Net cash from operations

```

**Key Features:**

Shows actual cash movements

Provides useful information for **estimating future cash flows**

More informative but requires detailed record-keeping

Less commonly used by companies

**Advantages:**

Shows specific sources and uses of cash

More understandable to non-accountants

Better for cash forecasting

**Disadvantages:**

Requires detailed classification of receipts and payments

More time-consuming to prepare

Detailed records may not be readily available

2. Indirect Method

**Definition:** Starts with **net profit or loss** and **adjusts for non-cash items** and working capital changes.

**Formula:**

```

Net Profit/Loss (before tax and extraordinary items)

Add/(Less):

− Depreciation and amortization

− Profit/Loss on sale of fixed assets

− Changes in working capital

= Cash flow from Operating Activities

```

**Key Features:**

Starts from **accrual basis profit** (from P&L Statement)

Converts to **cash basis** using adjustments

More commonly used in practice

Easier to prepare from standard financial statements

**Why Indirect Method is Preferred:**

Uses standard financial statements (Balance Sheet and P&L)

Reconciles accounting profit with cash flow

More commonly accepted by auditors and regulators

**Starting Point:** **Net Profit/Loss before taxation and extraordinary items** from the Statement of Profit and Loss.

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Adjustments in Indirect Method (Overview)

A. Add Back Non-Cash Expenses:

**Depreciation** (reducing profit but not using cash)

**Amortization** of intangibles

**Impairment losses**

**Provisions** made

**Loss on sale of fixed assets**

**Decrease in fair value** of assets

B. Less Back Non-Cash Incomes:

**Gain on sale of fixed assets**

**Appreciation** in asset value

**Dividend/Interest accrued** but not received

**Recovery of written-off assets**

C. Working Capital Changes:

**Increase in Current Assets** = Use of cash (subtract)

**Decrease in Current Assets** = Source of cash (add)

**Increase in Current Liabilities** = Source of cash (add)

**Decrease in Current Liabilities** = Use of cash (subtract)

**Memory Aid:**

Increase CA/Decrease CL = Subtract (cash goes out)

Decrease CA/Increase CL = Add (cash comes in)

D. Finance Costs and Tax:

Interest on debentures (already deducted in profit, but classify as financing)

Tax paid (already deducted, but show separately)

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Proposed Dividend Treatment

**As per AS-4 (Contingencies and Events after Balance Sheet Date):**

**Definition:** Proposed dividend is a dividend recommended by the Board of Directors but **not yet approved** by shareholders.

**Accounting Treatment:**

| Stage | Treatment | Explanation |

|---|---|---|

| **At Balance Sheet Date** | Contingent Liability (in notes) | Not yet a legal liability |

| **After shareholder approval (AGM)** | Current Liability (on Balance Sheet) | Becomes a legal obligation |

| **In Cash Flow Statement** | Only paid dividend shown | Only actual cash payments are included |

**Cash Flow Implication:**

**Previous year's proposed dividend** (approved in current year) = Shown as dividend paid (financing activity)

**Current year's proposed dividend** = NOT shown in current year's cash flow (not yet paid)

Dividend is typically **paid within 30 days** of declaration

**Example:**

Proposed dividend for FY 2023-24 approved in July 2024 AGM = Shown in FY 2024-25 cash flow (paid in August 2024)

Proposed dividend for FY 2024-25 (shown in notes) = NOT shown in FY 2024-25 cash flow (paid in FY 2025-26)

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Summary Table: Activity Classification Quick Reference

| **Activity Type** | **Operating** | **Investing** | **Financing** |

|---|---|---|---|

| **Main Purpose** | Revenue generation | Asset acquisition/disposal | Capital structure changes |

| **Cash Inflow Examples** | Sales, royalties, fees | Asset sales, interest received, dividend received | Share issue, loan proceeds |

| **Cash Outflow Examples** | Supplier payments, wages, taxes | Asset purchases, loan advances | Interest paid, dividend paid, loan repayment |

| **Frequency** | Recurring, continuous | Periodic, less frequent | Strategic, less frequent |

| **Impact on** | Profitability, liquidity | Long-term growth capability | Financial leverage, solvency |

| **Key Metric** | "Cash from operations" | Capital expenditure (CapEx) | Debt servicing, equity changes |

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CBSE Exam Important Points

1. **Mandatory requirement:** Cash Flow Statement is mandatory under Companies Act, 2013 and AS-3.

2. **Three-activity classification:** Always classify cash flows into operating, investing, and financing for systematic presentation.

3. **Non-financial vs. financial enterprises:** Treatment of interest and dividend differs; always specify the type of enterprise in your answer.

4. **Non-cash transactions:** Remember that non-cash investing/financing transactions are excluded from the cash flow statement but disclosed in notes.

5. **Working capital changes:** Critical for indirect method; increases in current assets = use of cash; increases in current liabilities = source of cash.

6. **Starting point:** For indirect method, always start with **Net Profit before tax and extraordinary items**.

7. **Reconciliation:** Final cash position should reconcile: Opening cash + Net change = Closing cash.

8. **Cash vs. profit:** A company can have high profit but low cash flow due to working capital tie-up or high capital expenditure.

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**End of Cash Flow Statement Notes**