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.

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

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.

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)

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:

$\text{Net Debt} = \text{Borrowings} - \text{Cash} + \text{Liquid Resources}$

Where:

• Borrowings = Debentures + Overdraft + Other loans
• Liquid Resources = Current asset investments

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.

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