Classification of cash flows

IAS 7, Statement of Cash Flows requires an entity to present a statement of cash flows
as an integral part of its primary financial statements. A statement of cash flow classifies
and presents cash flows under three headings:

(i) Operating activities

(ii) Investing activities and
(iii) Financing activities

Operating activities can be presented in two different ways. The first is the direct
method which shows the actual cash flows from operating activities – for example, the
receipts from customers and the payments to suppliers and staff. The second is the
indirect method which reconciles profit before tax to cash generated from operating
profit. Under both of these methods the interest paid and taxation paid are then
presented as cash outflows deducted from the cash generated from operations.

Investing activity cash flows are those that relate to non-current assets including
investments. Examples of investing cash flows include the cash outflow on buying
property plant and equipment, the sale proceeds on the disposal of non-current assets
and any cash returns received arising from investments.

Financing activity cash flows relate to cash flows arising from the way the entity is
financed. Entities are financed by a mixture of cash from borrowings from third parties
(debt) and by the shareholders (equity). Examples of financing cash flows include the
cash received from new borrowings or the cash repayment of debt as well as the cash
flows with shareholders in the form of cash receipts following a new share issue or the
cash paid to them in the form of dividends.

Operating activities – the indirect method and direct method

There are two different ways of starting the cash flow statement, as IAS 7, Statement of
Cash Flows permits using either the 'direct' or 'indirect' method for operating activities.

The direct method is intuitive as it means the statement of cash flow starts with the
source of operating cash flows. This is the cash receipts from customers. The operating
cash out flows are payments for wages, to suppliers and for other operating expenses
which are deducted. Finally the payments for interest and tax are deducted.

Alternatively, the indirect method starts with profit before tax rather than a cash receipt.
The profit before tax is then reconciled to the cash that it has generated. This means
that the figures at the start of the cash flow statement are not cash flows at all. In that
initial reconciliation the profit before tax is adjusted for expenses that have been
charged against profit that are not cash out flows; for example depreciation and losses
on disposal of non-current assets, have to be added back, and non-cash income; for
example, investment income and profits on disposal of non-current assets are
deducted. The changes in inventory, trade receivables and trade payables (working
capital) do not impact on the measurement profit but these changes will have impacted
on cash and so further adjustments are made. For example, an increase in the levels of
inventory and receivables will have not impacted on profit before tax but will have had
an adverse impact on the cash flow of the business. Thus, in the reconciliation process,
the increases in inventory and trade receivables are deducted from profit before tax.
Conversely, decreases in inventory and trade receivables are added back to the profit
before tax. The opposite is applicable for trade payables. Finally, the payments for
interest and tax are presented – usually as a further deduction.

Format of Direct Method of Cash flow

Cash flow from Operating Activities

Receipts from Customer xxx
Payment to Supplier (xxx)
Cash paid to Staff (xxx)
Other Operating Payments (xxx)
____
Cash Generated from Operations xxx
Interest Paid (xxx)
Tax Paid (xxx)
____
Net Cash from Operating Activities xxx
____
Format of Indirect Method of Cash flow

Operating activities

Profit before tax X

Less: Investment income (X)

Add: Finance cost X

Add: Depreciation X

Add: Amortization of intangible assets X

Add: Impairment loss charged in profit or loss X

Add/(Less): Loss on disposal of assets (profit) X/(X)

Add/(Less): Increase in provisions (decrease) X/(X)

Changes in working capital

Add/(Less): Decrease/(Increase) in inventory X/(X)

Add/(Less): Decrease/(Increase) in receivable X/(X)

Add/(Less): Increase / (decrease) in trade payables X/(X)

_____

Cash generated from operations X

Less: Interest paid (X)

Less: Taxation paid (X)

_____

Net cash from operating activities X

Investing activities

Less: Purchase of PPE / Intangibles /Investments (X)

Add: Proceeds from sale of PPE / Intangibles /Investments X

Add: Dividends received from investments X

____
Net cash used in investing activities X

Financing activities

Add: Proceeds from an equity share issue X

Less: Dividends paid (X)

Add: Proceeds from the issue of new debt X

Less: Repayment of debt (X)

_____
Net cash from/used in financing activities X/(X)

Net Change in cash and cash equivalents X/(X)

Add: Opening cash and cash equivalents X/(X)

____

Closing cash and cash equivalents X/(X)

____

NB: Cash and cash equivalents comprise cash on hand and demand deposits, together
with short-term, highly liquid investments that are readily convertible to a known amount
of cash, and that are subject to an insignificant risk of changes in value. A bank
overdraft should be treated as a negative cash balance when arriving at the cash and
cash equivalents.