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How to Prepare Cash Flow Statement

Delving into the world of Business Studies, you'll discover the critical role of financial documents, particularly the cash flow statement. This guide offers a comprehensive look into 'How to Prepare a Cash Flow Statement'. Starting from understanding the basics, deciphering its importance in Business Studies, it provides a practical, step-by-step approach to prepare a cash flow statement from balance sheets. It further details the difference in preparing direct and indirect cash flow statements, along with their respective merits and demerits. Arm yourself with this essential financial skill and master the art of cash flow statements.

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How to Prepare Cash Flow Statement

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Delving into the world of Business Studies, you'll discover the critical role of financial documents, particularly the cash flow statement. This guide offers a comprehensive look into 'How to Prepare a Cash Flow Statement'. Starting from understanding the basics, deciphering its importance in Business Studies, it provides a practical, step-by-step approach to prepare a cash flow statement from balance sheets. It further details the difference in preparing direct and indirect cash flow statements, along with their respective merits and demerits. Arm yourself with this essential financial skill and master the art of cash flow statements.

Understanding How to Prepare Cash Flow Statement

A cash flow statement is an invaluable tool in the world of business finance. It provides a comprehensive overview of the money flowing in and out of a business over a specified period. You'll learn about its three main sections: operations, investing, and financing. Firstly, cash flow from operations details the company's net income and losses. Secondly, the investing section informs you about the company's capital expenditures, such as purchasing new equipment. Lastly, the financing division illustrates changes in equity and debt.

Cash Flow Statement: A financial statement that measures how much cash a company creates and uses over a given period.

Basics of Cash Flow Statements

Before preparing a cash flow statement, it's important to gather all necessary financial data, including income statements and balance sheets. When this is in place, start by calculating the cash flow from operating activities. This is typically the first section of the cash flow statement. Here you'll need to adjust net income for items that did not affect cash. \n For example, depreciation doesn't use cash but is often included in net income.

Let's imagine a company that had a net income of £80,000, but also £20,000 worth of depreciation. In this situation, the cash flow from operating activities would be £100,000 (80,000 + 20,000).

\n Next is the cash flow from investing activities. This records cash spent or received from long-term investments like property or equipment. It can also include spending on research and development. \n
Purchase of property -£100,000
Sale of investments £150,000
Purchase of equipment -£75,000
Total Cash Flow from Investing -£25,000
\n Finally, you have cash flow from financing activities. This involves cash from investors or banks and cash paid to shareholders. This could be funds raised from issued shares or borrowing, or paid out as dividends or debt repayment. \n Remember, the sum of all these sections will result in your total change in cash. \( \text{ Total Change in Cash = } \) \( \text{ Cash Flow from Operating Activities + } \) \( \text{ Cash Flow from Investing Activities + Cash Flow from Financing Activities } \)

Importance of Cash Flow Statements in Business Studies

Cash flow statements are an integral part of understanding the financial health of a company. It shows how efficiently a business generates cash to pay its debts and fund its operating expenses. The cash flow statement is commonly used by investors, creditors, and others to assess:
  • The company's ability to generate positive cash flows in future years
  • The company's capacity to pay dividends and fulfill its obligations
  • The reasons for discrepancies between net income and net cash provided (or used) by operating activities
  • In the investing and financing cash flow sections, users can see a company's investment in resources and their sources of cash

Going beyond the basics, it’s crucial to note that the cash flow statement is a more realistic representation of a company's financial performance as it’s harder to manipulate cash information compared to other financial metrics. Therefore, investors use the cash flow statement to understand a company's financial strength.

How to Prepare Cash Flow Statement from Balance Sheet

A cash flow statement can always be prepared using data from the company's balance sheet and income statement. By comparing balance sheets from two consecutive periods and complementing this with data from the income statement, you can construct a functional cash flow statement, breaking the data into operating, investing and financing activities.

Explanation of the Connection between Cash Flow Statement and Balance Sheet

A balance sheet reflects a company's assets, liabilities, and shareholders' equity at a specific point in time. It is static because it represents a particular moment. In contrast, a cash flow statement discloses the amount of cash generated and used by a company in a given period. Therefore, the cash flow statement captures the dynamic flow of cash into and out of the company. This might make more sense when you consider the following:
  • Balance sheets provide a précis of what a company owns and owes at a certain point in time.
  • A cash flow statement traces the flow of cash in and out during an entire period.
The balance sheet and cash flow statement are connected as cash from operating activities in the cash flow statement links to the current assets and current liabilities from the balance sheet. Furthermore, the cash flow from investing and financing activities correspond with long-term assets (property, plant, equipment) and long-term liabilities (loans), and equity changes respectively from the balance sheet. Understanding these connections are essential because they reveal how operations, investing and financing actions manifest in the balance sheet's composition.

Step-by-step Guide on Extracting Information from a Balance Sheet

To transition from the balance sheet to the cash flow statement, you extract changes in the balance sheet's lines from one period to the next and integrate those changes with data from the income statement. Here's how to break that down:

Step 1: Identify Changes in Non-Cash Operating Accounts

You start by addressing changes in non-cash operational accounts on the balance sheet. These often include accounts receivable, inventory, accounts payable, and accrued expenses. Usually, an increase in an operational asset account (like inventory) indicates the use of cash, so it is subtracted from net income.

Step 2: Resolve Changes in Investing Activities

The next step involves analysing changes within the investment accounts found on the balance sheet. This includes changes in long-term asset accounts like property, plant, and equipment (PP&E). If PP&E increased from the prior period, the difference would represent the cash used for investing activities.

Step 3: Evaluate Changes in Financing Activities

The final step for extracting information from the balance sheet concerns financing accounts. These could include long-term debt, short-term debt, and shareholders' equity. If long-term debt increased during the period, for instance, it signifies that the company borrowed cash. After all these steps, the resulting value should be the change in cash between the two balance sheet periods. This refined change in cash should reconcile with the already reported change in the company's cash account. Remember that the ultimate aim is to express accurately how cash has changed during the period and where those cash flows occurred. This can illuminate even complex business activities, contributing to a more complete picture of a firm's financial health.

How to Prepare a Cash Flow Statement Step by Step

The key to drafting an accurate cash flow statement lies in following the right steps and knowing what financial data to include. The cash flow statement broadly separates into three categories: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. It's vital to understand each thoroughly and account for each section accurately to end up with an informative perspective of the company's cash movement.

Collecting and Organising Relevant Information

The first step in creating a cash flow statement involves obtaining and organising all the necessary financial information. This primarily consists of two main sources - the income statement and the balance sheet. \n First, find the net income at the bottom of the income statement. This figure becomes the starting point for calculating cash flows from operating activities. \n Secondly, you should collect two consecutive balance sheets, using the latter period one for extracting the cash at the end of the period and the former for gaining the initial cash and changes in balance sheet items. \n Here a few pointers when preparing to create a cash flow statement:
  • Extract the net income from the income statement
  • Obtain two consecutive balance sheets. The more recent one will provide the final cash balance
  • Gather all costs, expenses, losses, revenue, and gains that involved cash movements
  • Identify non-cash expenses such as depreciation or amortisation
You'll then need to order these figures in a structured way, separating them into operating, investing, and financing activities. This ensures that calculations are properly performed within their respective sections. \n

Let's use a fictional example. Suppose you have a net income of £1,200. You've also paid £1,000 in dividends and had £500 in depreciation expenses. Gather this information and keep it at hand as you move on to creating the cash flow statement.

Completing the Cash Flow Statement With Detailed Instructions

Now that you've collected and organised your financial data, you're ready to complete your cash flow statement. \n
Start of Cash Balance £x
Cash Flow from Operating Activities £y
Cash Flow from Investing Activities £z
Cash Flow from Financing Activities £w
\n Start the cash flow from operating activities section by noting down the net income as the first line item. Subtract or add changes in the current assets and current liabilities. Furthermore, non-cash expenses like depreciation or amortisation should be added back in this section, as net income from the income statement is an accrual-based figure rather than cash-based. \n Next, it’s about recording investing activities. It entails noting down changes in your long-term assets. If a company sold long-term assets, the investment section would show a cash inflow. If it purchased long-term assets, you would record a cash outflow. \n Finally, to compute the cash flow from financing activities, note down activities that affect long-term liabilities and equity. Examples would be issuing new shares, repurchasing shares, taking on a new loan, or repaying a loan. \n After considering operating income and investing and financing activities, calculate the ending balance of the cash and cash equivalents. The formula is: \[ \text{ End of Year Cash Balance = } \] \[ \text{ Start of Year Cash Balance + Operating Cash Flows + Investing Cash Flows + Financing Cash Flows } \] You should compare this figure to the cash and cash equivalents reported on the most recent balance sheet. The two numbers should agree. If they do not, recheck your calculations to identify any discrepancies. Through this step-by-step process, you can navigate the many elements involved in creating a detailed and accurate cash flow statement.

How to Prepare an Indirect Cash Flow Statement

In financial reporting, the indirect method of creating a cash flow statement uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual accounting used in the income statement into cash accounting.

Distinction between Direct and Indirect Cash Flow Statements

There are two key methods of presenting the cash flow statement: the direct and indirect methods, each with its unique steps and purposes. Understanding the difference between these two methods is fundamental in comprehending how to prepare an indirect cash flow statement. The direct method entails listing operating cash receipts, for instance from sales of goods and services, and operating cash payments, such as payments for goods and services, interest, and taxes. Therefore, the direct approach focuses more on cash inflows and outflows and avoids much of the accrual accounting entries. Conversely, the indirect method, which is more commonly used due to its simplicity, starts the cash flow from operations section with net income from the income statement. Then, it adjusts for non-cash transactions, accrual-based transactions and deferrals, movements in working capital (current assets and liabilities except for cash), and other items. A few points worth noting in differentiating these methods include:
  • The direct method provides information about cash receipts & payments while the indirect method presents info on reasons for differences between net profit and net cash flow.
  • The indirect method is easier to prepare and less time-consuming.
  • On the other hand, the direct method can provide more detailed insights and is often preferable for internal management purposes.

Step-by-step Instructions for Indirect Cash Flow Statement

The indirect method for creating a cash flow statement begins with net income and adjusts for all non-cash items such as depreciation and changes in working capital. Follow the steps below to prepare a cash flow statement using the indirect method:

Step 1: Start with Net Income

The first line of the cash flow statement, "Net income," is the bottom line of the income statement.

Step 2: Adjust for Non-Cash Items

Next, adjust net income for items that did not involve actual cash or were not operational. Common non-cash adjustments include:
  • Depreciation
  • Deferred tax
  • Share-based compensation
Non-cash items are added back to net income, as they do not contribute to the cash inflows or outflows of the business.

Step 3: Adjust for Changes in Operations

The third step in the indirect method is to adjust net income for changes in operations. These adjustments translate the income statement from accrual accounting to cash accounting:
  • If accounts receivable increase during a period, it means sales are up, but no cash was received at the time of sale. Therefore, the increase in receivables should be subtracted from net income.
  • Conversely, if accounts payable increase, expenses are up, but cash was not paid at the time of the transaction. So, the increase in payables is added back to net income.
Accruals and deferrals are significant factors causing differences between net income and net cash flow. To arrive at the operating cash flow using the indirect method, use this formula: \[ \text{Operating Cash Flow = Net Income + Depreciation + Changes in Working Capital} \] After calculating the operating cash flow, continue with the investing cash flow, and finally, financing cash flow to complete the statement. This step-by-step guide should assist you in compiling an indirect cash flow statement, accurately representing your firm's cash inflows and outflows.

How to Prepare Cash Flow Statement - Direct Method

The Direct Method of preparing a cash flow statement provides a clear insight into the cash flow generated from operating, investing, and financing activities. Unlike the Indirect Method, which begins with net income, the Direct Method focuses on actual cash inflows and outflows, providing a clearer view of where money is coming from and going to within an organisation. This would generally involve showing the receipts from customers, payments to suppliers and employees, interest payments and receipts, and tax paid. However, the preparation often requires more detail, especially since the data required may not always be readily available.

The Direct Method of Cash Flow Statement Preparation

Understanding the steps involved in the direct method of preparing a cash flow statement is crucial to accurately report a business's cash activities. Here's an illustration with detailed steps:

Step 1: Operating Activities

In this step, you would calculate cash from operating activities by examining actual cash inflow from customers and actual cash paid to suppliers and employees. This is typically calculated using the receipts and payments method. The key components involve:
  • Cash collected from customers: Usually, this starts with sales revenue, with adjustments made for changes in accounts receivable and unearned revenue.
  • Cash paid to suppliers: This begins with cost of goods sold (COGS), and adjustments are made for changes in inventory and accounts payable.
  • Cash paid to employees: This typically includes salaries, wages, and other payments made to employees.
  • Interest and Taxes: These are calculated separately to ensure accurate recording and tracking.
The resulting figure is the 'Net cash flow from operating activities'.

Step 2: Investing and Financing Activities

Investing activities typically involve the income or expense from the acquisition or disposal of long-term assets, like property, plant, and equipment. Financing activities encompass changes in size and composition of the owner’s capital and borrowings from creditors by the company. Investing and financing activities can significantly impact the company's cash flow and generally involve large amounts of cash, so these figures should be accurate.

Step 3: Calculate Net Change in Cash

After adjusting for all activities, you can calculate the 'Net change in cash during the period' using the equation: \[ \text{Net Change in Cash = } \text{Cash Flow from Operating Activities + } \text{ Cash Flow from Investing Activities + Cash Flow from Financing Activities} \] This should reconcile with the actual change in the company's cash and cash equivalents during the period.

Advantages and Disadvantages of Using the Direct Method

Like any method of financial reporting, the direct method comes with its own set of pros and cons that can influence a company's choice of reporting method. \n Advantages:
  • Clear Visualisation: The direct method provides a clear picture of the flow of cash within the organisation.
  • Useful in Forecasting: It is easier to use the direct method for forecasting future cash flows since it details cash inflows and outflows separately.
  • Compliance with International Standards: Internationally, many standards, such as IFRS, recommend using this method.
\n On the other hand, using the direct might not always be the optimal choice: Disadvantages:
  • Data Accessibility: Gathering the necessary information for the direct method can be time-consuming and challenging.
  • Administrative Hassle: It is complex and requires more administrative effort compared to the indirect method.
\n Through understanding the advantages and disadvantages of the direct method, you can make informed decisions when deciding whether it's appropriate for your situation. Regardless, the method offers valuable insights into a business's operations and financial health.

How to Prepare Cash Flow Statement - Key takeaways

  • The cash flow statement is a financial document that reveals the amount of cash generated and used by a company in a certain period.
  • A company's balance sheet and income statement data can be used to prepare a cash flow statement. The balance sheet reveals a company's assets, liabilities, and shareholders' equity at a point in time, while the cash flow statement traces the flow of cash in and out during a whole period.
  • Preparing a cash flow statement involves identifying changes in non-cash operating accounts, resolving changes in investing activities, and evaluating changes in financing activities from the balance sheet. These steps help in accurately expressing how cash has changed during a specific period and where that cash flow occurred.
  • The indirect method of creating a cash flow statement begins with net income and adjusts for all non-cash items such as depreciation and changes in working capital. In contrast, the direct method focuses on actual cash inflows and outflows.
  • Regardless of the method used, the understanding of cash flows is crucial. It gives insights into a company's financial health, its ability to generate positive cash flows in the future, pay dividends, and fulfill its obligations.

Frequently Asked Questions about How to Prepare Cash Flow Statement

The key sections to include when preparing a cash flow statement are: operating activities, investing activities, and financing activities. Additionally, the statement begins with the opening balance and ends with the closing balance.

Common mistakes when preparing a cash flow statement include failing to categorise cash flows correctly into operational, investing, and financing activities, neglecting non-cash transactions, miscalculating depreciation, and misunderstanding the difference between net income and cash flow.

The sequential order of steps when preparing a cash flow statement includes: starting with the net income, adjusting for non-cash transactions, adding/subtracting changes in operating assets and liabilities, considering investing activities and accounting for financing activities.

To prepare an accurate cash flow statement, you need information from your company's balance sheet and income statement. Specifically, you'll require details about net income, changes in working capital, and all cash inflows and outflows from operating, investing, and financing activities.

Cash flow statements can be used to analyse a company's financial health by showing how much cash is generated and spent during a specific period. They highlight the company's ability to generate cash for operating expenses, pay debts and fund growth. It can also reveal potential liquidity problems.

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What is a Cash Flow Statement?

What does Cash Flow refer to in terms of a business?

What are Cash Equivalents, in terms of a business?

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What is a Cash Flow Statement?

A Cash Flow Statement, also known as the Statement of Cash Flows, is a financial document that shows how changes in balance sheet accounts and income affect cash and cash equivalents. It shows the flow of cash in and out of a business.

What does Cash Flow refer to in terms of a business?

Cash Flow refers to the net amount of cash being transferred in and out of a business. If the cash coming into the business surpasses the cash going out, it's a net positive cash flow; if not, it's a net negative cash flow.

What are Cash Equivalents, in terms of a business?

Cash Equivalents are short-term investments that can be quickly converted into cash. They are considered equivalent to cash as they are highly liquid and not subject to significant value changes.

How do you prepare a Cash Flow Statement?

When preparing a Cash Flow Statement, compile financial data from your balance sheets and income statements, classify cash inflows and outflows into the three sections: Operating, Investing, and Financing Activities, then compute net cash flow for each section, and finally, sum up all net cash flows to get the total change in cash.

What are the two methods of formulating a cash flow statement?

The two methods of formulating a cash flow statement are the direct method and the indirect method.

What are the steps involved in preparing a cash flow statement using the direct method?

Steps include gathering data on cash receipts from customers and cash paid to suppliers, calculating cash paid to employees, deducting income tax paid and totalling these values to achieve net cash from operating activities.

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