Cash Flow Statement

The cash flow statement reports the sources and uses of cash and cash equivalents of an entity during a reporting period, classified into operating, investing, and financing activities. It complements the income statement, which is prepared on the accrual basis, by showing the actual movement of cash, and explains the change in the cash balance between two balance sheet dates. Under Accounting Standards for Private Enterprises (ASPE), the statement is governed by Section 1540 Cash Flow Statement; under IFRS, by IAS 7 Statement of Cash Flows.

PURPOSE

• To assess the entity's ability to generate cash from operations, meet obligations as they fall due, and fund growth without external financing.

• To explain differences between net income and cash flow from operations, arising from accruals, deferrals, and non-cash items.

• To disclose the investing and financing activities of the period, including capital expenditures, borrowings, repayments, and distributions to owners.

• To support forecasting, credit analysis, and valuation.

CASH AND CASH EQUIVALENTS

• Cash comprises cash on hand and demand deposits.

• Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value, generally with a maturity of three months or less from the date of acquisition.

• Bank overdrafts repayable on demand that form an integral part of cash management may be included as a component of cash and cash equivalents.

• The components of cash and cash equivalents must be disclosed and reconciled to the balance sheet.

CLASSIFICATION OF CASH FLOWS

Operating activities

The principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Typical items include:

• Cash receipts from the sale of goods and rendering of services.

• Cash payments to suppliers for goods and services, and to and on behalf of employees.

• Payments and refunds of income taxes, unless specifically identified with investing or financing activities.

• Under ASPE, interest and dividends received and interest paid that are included in the determination of net income are classified as operating activities; dividends paid that are charged to retained earnings are classified as financing activities.

Investing activities

The acquisition and disposal of long-term assets and other investments not included in cash equivalents:

• Payments to acquire, and receipts from the disposal of, property, plant and equipment, intangible assets, and other long-term assets.

• Payments to acquire, and receipts from the sale of, equity or debt instruments of other entities.

• Advances and loans made to other parties, and their collection.

Financing activities

Activities that result in changes in the size and composition of the equity capital and borrowings of the entity:

• Proceeds from issuing shares, and payments to redeem or repurchase shares.

• Proceeds from, and repayments of, loans, mortgages, bonds, and other borrowings.

• Principal payments under capital leases.

• Owner contributions and drawings (sole proprietorships), partner contributions and withdrawals (partnerships), and dividends paid (corporations).

METHODS OF PRESENTING OPERATING CASH FLOWS

Direct method

Major classes of gross cash receipts and gross cash payments are presented, such as cash collected from customers, cash paid to suppliers and employees, interest paid, and income taxes paid. ASPE and IFRS encourage, but do not require, the direct method because it provides information useful in estimating future cash flows.

Indirect method

Net income is adjusted for the effects of non-cash items, deferrals and accruals, and items related to investing or financing cash flows. The procedure is as follows:

1. Begin with net income (or net loss) for the period.

2. Add back non-cash expenses: amortisation of property, plant and equipment and intangible assets, impairment losses, and future income tax expense.

3. Deduct gains, and add back losses, on the disposal of long-term assets and investments, because the related cash proceeds are reported in investing activities.

4. Adjust for changes in non-cash working capital: deduct increases (and add decreases) in current operating assets such as accounts receivable, inventory, and prepaid expenses; add increases (and deduct decreases) in current operating liabilities such as accounts payable, accrued liabilities, income taxes payable, and unearned revenue.

5. The result is cash flow from (or used in) operating activities.

PREPARATION PROCEDURE

1. Obtain comparative balance sheets, the income statement for the period, and supporting details of long-term asset, debt, and equity transactions.

2. Compute the change in each balance sheet account.

3. Determine cash flows from operating activities by the direct or indirect method.

4. Analyse changes in long-term asset accounts, together with amortisation and disposal information, to determine investing cash flows.

5. Analyse changes in long-term liabilities and equity accounts, together with net income and distributions, to determine financing cash flows.

6. Sum the three categories to determine the net increase or decrease in cash and cash equivalents, and reconcile to the opening and closing balances.

7. Prepare the required disclosures.

NON-CASH TRANSACTIONS AND DISCLOSURE

• Investing and financing transactions that do not require the use of cash, such as the acquisition of assets by assuming liabilities or by issuing shares, the conversion of debt to equity, and the acquisition of assets under capital leases, are excluded from the statement and disclosed elsewhere in the financial statements.

• The policy for determining the composition of cash and cash equivalents is disclosed.

• Cash flows arising from interest and dividends received and paid are disclosed separately where they are not apparent from the statement.

ANALYTICAL MEASURES

• Free cash flow = Cash flow from operating activities − Capital expenditures (a non-GAAP measure).

• Operating cash flow ratio = Cash flow from operating activities ÷ Current liabilities.

• Cash flow to debt ratio = Cash flow from operating activities ÷ Total debt.

• Cash conversion cycle = Days inventory outstanding + Days sales outstanding − Days payables outstanding.

• Quality of earnings ratio = Cash flow from operating activities ÷ Net income.

CASH FLOW CONSIDERATIONS BY BUSINESS TYPE

• Sole proprietorship: owner contributions and drawings are financing activities; personal income tax and CPP paid by the proprietor are personal and are not cash flows of the business unless paid from business funds, in which case they are drawings.

• Partnership: partner contributions and withdrawals are financing activities; no income tax is paid by the partnership.

• Corporation: share issuances, share redemptions, and dividends paid are financing activities; income taxes paid are operating activities; shareholder loans are classified according to their substance (investing for advances to shareholders; financing for advances from shareholders).

SOURCES

• CPA Canada Handbook, Accounting, Part II (ASPE), Section 1540 Cash Flow Statement.

• IAS 7 Statement of Cash Flows.

• Canada Revenue Agency, Guide RC4088 General Index of Financial Information.