Cashflow Statements (Leaving Cert Accounting): Revision Notes
Cashflow Statements
What are cashflow statements?
Cashflow statements are financial documents that explain the difference between cash balances at the beginning and end of a financial year. Unlike profit and loss accounts which show profitability, cashflow statements track the actual movement of money in and out of a business.
Cash balances represent the actual amounts held in cash or on deposit at the bank, minus any bank overdraft. This gives a true picture of the company's liquid position.
The preparation of cashflow statements follows FRS 1 (Financial Reporting Standard 1), which sets out specific layouts and requirements that must be strictly followed.
Understanding these statements is crucial because profit doesn't always equal cash - a profitable business can still face cashflow problems.
Key learning objectives
When studying cashflow statements, you need to understand:
- Reconciliation processes - converting operating profit to net cash flow and identifying non-cash items
- Statement preparation - creating properly formatted cashflow statements
- Movement reconciliation - tracking changes from cash movements to net debt changes
- Abridged accounts - preparing condensed profit and loss accounts when required
- Statement purposes - why businesses prepare these statements
- Profit vs cash - understanding why profit figures don't equal cash amounts
Step 1: Reconciliation of operating profit to net cash flow
The first step involves adjusting operating profit to show the actual cash generated from day-to-day business operations. This reconciliation is necessary because profit figures include non-cash items and don't account for working capital changes.
Adjustments made in reconciliation
The reconciliation process adjusts operating profit for changes in:
- Stock levels - increases reduce cash flow, decreases improve it
- Debtors - increases reduce cash flow, decreases improve it
- Creditors - increases improve cash flow, decreases reduce it
- Non-cash items - items affecting profit but not involving cash movements
The key principle is that any increase in current assets (stock, debtors) reduces cash flow, while increases in current liabilities (creditors) improve cash flow.
Common reconciliation items
Items added to operating profit:
- Depreciation charges (non-cash expense)
- Loss on disposal of fixed assets
- Decrease in stock
- Decrease in debtors
- Increase in creditors
- Increase in bad debt provision
- Patents written off
Items subtracted from operating profit:
- Profit on disposal of fixed assets
- Increase in stock
- Increase in debtors
- Decrease in creditors
Understanding non-cash items
Non-cash items are transactions that affect net profit but don't cause an actual inflow or outflow of cash. Common examples include depreciation, profit or loss on asset disposals, changes in bad debt provisions, and patent write-offs.
Worked Example: Depreciation Adjustment
If a company shows operating profit of £50,000 and has depreciation charges of £8,000:
Step 1: Identify the non-cash item Depreciation = £8,000 (reduces profit but no cash payment)
Step 2: Add back to operating profit Adjusted cash flow = £50,000 + £8,000 = £58,000
This shows that £8,000 more cash was generated than the profit figure suggests.
Step 2: Cashflow statement structure
The main cashflow statement begins with the net cash flow from operating activities (calculated in Step 1) and details all other cash movements under specific headings.
Main sections of the cashflow statement
Operating activities: This shows the net cash generated from day-to-day business operations after the reconciliation process.
Return on investment and servicing of finance:
- Interest received (cash inflow)
- Interest paid (cash outflow)
- Preference dividend paid (cash outflow)
- Dividends received (cash inflow)
Taxation:
- Tax paid during the year (cash outflow)
Capital expenditure and financial investment:
- Payments to acquire fixed assets (outflow)
- Receipts from sale of fixed assets (inflow)
- Payments to acquire investments (outflow)
- Receipts from sale of investments (inflow)
Equity dividend paid:
- Ordinary dividends paid to shareholders (outflow)
Each section must be clearly labelled and show whether items represent cash inflows (+) or outflows (-). The specific headings and order are required by FRS 1.
Management of liquid resources
Liquid resources refer to short-term investments such as government securities or short-term deposits. These are treated as current assets on the balance sheet.
Key transactions include:
- Purchases of government securities (outflow)
- Sale of government securities (inflow)
- Payments into current asset investments (outflow)
- Withdrawals from current asset investments (inflow)
Financing section
This section covers:
- Receipts from share issues (inflow)
- Receipts from share premium (inflow)
- Repayment of debentures/loans (outflow)
- Receipts from new debentures/loans (inflow)
Step 3: Reconciliation of movement in cash to movement in net debt
This final step shows how cash movements relate to changes in the company's overall debt position.
Understanding net debt
Net debt is calculated as:
Where:
- Borrowings = Debentures + Overdraft + Other loans
- Liquid Resources = Current asset investments
If this calculation results in a positive figure, it represents net debt. The net debt figure at year-end must be consistent whether calculated by adding the change in net debt to the opening balance or by calculating total borrowings minus cash plus liquid resources at the year-end.
Items affecting this reconciliation
Positive effect on debt (added):
- Payments into liquid resources
- Repayment of debentures
Negative effect on debt (subtracted):
- Withdrawals from liquid resources
- Receipts from new debenture issues
Abridged profit and loss account
Sometimes you may need to prepare an abridged profit and loss account alongside the cashflow statement. This condensed version shows the key profit figures needed for the cashflow reconciliation.
You'll need to work backwards from profit and loss balance sheet figures to find the retained profit, then work back to operating profit. This is necessary when full profit and loss account details aren't provided but are needed for the cashflow statement reconciliation.
The abridged account typically includes:
- Operating profit
- Interest for the year
- Profit before taxation
- Taxation for the year
- Profit after taxation
- Dividends (interim and proposed)
- Retained profits for the year
- Opening and closing retained profits balances
Why profit does not equal cash
Understanding why profit doesn't equal cash is fundamental to cashflow analysis. Several factors create this difference:
Items affecting cash but not profit
- Amounts paid for fixed assets or received from their sale
- Capital introduced by owners or withdrawn by them
- Loans received or repaid by the business
Items affecting profit but not cash
- Non-cash expenses such as depreciation, profit on disposal of fixed assets, and bad debt provision reductions
- Credit transactions involving sales and purchases that haven't yet been settled in cash
A business might show strong profits but struggle with cash flow if customers haven't yet paid their invoices, or if the business has invested heavily in stock or fixed assets. This is why cashflow statements are essential for understanding a company's true financial position.
Key Points to Remember:
- Cashflow statements track actual money movements, not just profit calculations - they show where cash came from and where it went
- The three-step process is essential - reconcile operating profit to cash flow, prepare the main statement, then reconcile cash movement to net debt changes
- Non-cash items must be adjusted - depreciation, bad debt provisions, and asset disposal profits/losses affect the reconciliation but don't involve cash movements
- Layout and format are crucial - FRS 1 requirements must be followed exactly in exams, with specific headings and structure
- Profit never equals cash - understanding the differences between profit-making transactions and actual cash movements is key to mastering this topic
Study Tips for Success:
- Exam frequency: Cashflow statements can appear in Section 2 for 100 marks or Section 1 for 60 marks, sometimes with abridged profit and loss accounts
- Three-step process: Always remember the three distinct steps - reconciliation, cashflow statement, and movement reconciliation
- Layout precision: The format and wording must be followed exactly as specified
- Answer checking: Verify your cashflow statement by checking that the movement in cash matches the change shown in the final reconciliation