Preparation of cash flow statement: Introduction
To recap the previous post in the cash flow statement series, cash flow statements can be prepared under two methods, cash flow statement direct method and cash flow statement indirect method. Both the methods are allowed under GAAP and IFRS. So let us see how to prepare cash flow statement in detail. The difference in preparation of cash flow statement under the two methods comes from the presentation of operating cash flows.
Operating cash flows are presented differently under the two methods however; the end result is the same. Preparation of cash flow statement for investing cash flows and financing cash flows are exactly the same manner under both the methods.
The difference in timing between receipt and payment of cash and recognition of the revenue or expense on the income statement due to accrual accounting results in an increase or decrease in assets or liabilities or equity on the balance sheet.
Changes in assets have an indirect relationship with changes in the cash balance. An increase in an asset results in the use of cash and thus reduces the cash balance while a decrease in an asset is a source of cash and increases the cash balance.
On the other hand, change in liabilities has a direct relationship with change in cash balance. An increase in liabilities (debt) is a source of cash and increases the cash balance while a decrease in liabilities is a use of cash and decreases the cash balance.
Now let us examine the preparation of cash flow statement under the two methods in detail.
How to prepare cash flow statement: Direct Method
So how to prepare cash flow statement under the direct method? Preparation of cash flow statement under the direct method involves recording the cash receipts and payments during an accounting period. The main items that appear on a cash flow statement presented under the direct method are;
- Cash collected from customers
- Cash paid to suppliers
- Cash operating expenses
- Interest paid
- Taxes paid
Operating cash flows are the cash flows resulting from the main operations of the firm. Investing cash flows on the other hand are cash flows resulting from the investing activities of the firm. Sol et us see how to prepare cash flow statement for investing cash flows.
For calculating investing cash flows the changes in asset accounts due to investing activities are examined. The depreciation and amortization accounts linked to the assets are ignored as they are non cash expenses.
Cash paid for a new asset is calculated using the formula;
Beginning gross assets + cash paid for new assets –gross cost of old assets sold = ending gross assets
(Note here that gross assets and not net assets are considered as depreciation and amortization are ignored on a cash flow statement as they are non cash expenses).
You know the beginning and ending values of the assets from the balance sheet and the cost of old assets sold, so you can determine the cash paid for new assets.
Cash realized from the sale of an asset is calculated as;
Cash from sale of asset = book value of the asset + gain (- loss) on sale
Now that we have seen how to prepare cash flow statement for investing cash flows, let us examine how to prepare cash flow statement for financing cash flows.
Financing cash flows result from changes made to a firm’s capital structure. Financing cash flows are cash flows between a firm and its capital providers. Suppliers of a firm’s capital are either creditors or shareholders. Therefore financing cash flows are a summation of the following two measures;
Net cash flows from creditors = New debt issued – principal of existing debt repaid
(Note that interest paid on debt is not deducted here as it included under operating cash flows under GAAP)
Net cash flows from shareholders = new equity issued – shares bought back – cash dividends paid
The total cash flow for a period is the summation of operating cash flow, investing cash flow and financing cash flow and should equal the difference in the opening and closing cash balance on the balance sheet. For solved examples of calculations under the direct method refer to the Schweser CFA study notes and CFA Institute books.
(Click here to see an example of the direct method of presentation of the cash flow statement)
How to prepare cash flow statement: Indirect Method
As already mentioned before, operating cash flows are presented differently under the indirect method. So let us now see how to prepare cash flow statement under the indirect method.
For preparation of cash flow statement under the indirect method, we begin by recording the net income from the income statement and make adjustments to it for non cash transactions and non operating items to arrive at the net operating cash flow.
Non operating and non cash income is deducted from the Net Income and non operating and non cash expenses (such as depreciation and amortization) are added back to the Net Income to arrive at the net operating cash flow in the accounting period. Removing the effect of the non cash and non operating items from the Net Income leaves you with only the net operating cash flows in the period.
Net income is also adjusted for changes in balance sheet accounts. For example, if sales revenue exceeded cash collections during the period, it means sales made on credit were more and therefore account receivables increased during the period, thus reducing the cash balance. Therefore, increase in accounts receivable need to be deducted from net income.
Similarly, if cash payments during the year were less than purchases made, it means purchases made on credit were more during the year and led to an increase in accounts payable thus increasing the cash balance. Increase in accounts payable needs to be added to the net income.
(Click here to see an example of the indirect method of presenting the cash flow statement)
That’s all in this post folks…hope you liked reading it and wont forget to share….in the next post we move on to common size cash flow statement…tune in again then…bye
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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