📌 Summary: Cash Flow Fundamentals
A Cash Flow Statement tracks the actual inflows and outflows of cash and cash equivalents within a business during a specific period.
💰 Cash Inflow (+) [Cash In]
- Sales / Services Revenue
- Other Income Generated
- Decrease in Assets (e.g., selling fixed assets)
- Increase in Liabilities & Capital (e.g., loans, issuing shares)
💸 Cash Outflow (-) [Cash Out]
- Purchases / Cost of Goods Sold
- Operating & Other Expenses
- Increase in Assets (e.g., buying equipment)
- Decrease in Liabilities (e.g., repaying debts)
🔄 Three Core Business Activities
- Operating Activities: Covers main revenue activities, operating expenses and changes in working capital. It may be prepared through the Direct Method or Indirect Method.
- Investing Activities: Relates mainly to the purchase and sale of long-term assets and investments.
- Financing Activities: Relates to shares, debentures, long-term borrowing, bank loans and dividend payments.
🧠 QUICK REVISION
Cash Flow Ratios & Formulae for Remembrance
Remember the relationship between operating cash flow, debt-paying ability, earnings quality and investment requirements.
1. Free Cash Flow
Free Cash Flow =
Cash Flow from Operating Activities − Purchase of Long-term Assets − Debt Payment − Dividend Paid
2. Quality Income Ratio
Quality Income Ratio =
Net Cash Flow from Operating Activities + Interest PaidNet Income + Interest Expenses + Depreciation & Amortization Expenses
3. Cash Interest Coverage Ratio
Cash Interest Coverage Ratio =
Net Cash Flow from Operating Activities + Interest Paid + Tax PaidInterest Paid
4. Cash Debt Coverage Ratios
Cash Flow from Operating Activities to Current Liability =
Net Cash Flow from Operating ActivitiesAverage Current Liability
Cash Flow from Operating Activities to Long-term Debt Ratio =
Net Cash Flow from Operating ActivitiesAverage Long-term Debt
Cash Flow from Operating Activities to Total Debt Ratio =
Net Cash Flow from Operating ActivitiesAverage Total Debt
5. Cash Flow from Operating Activities to Cash Flow from Investing Activity
Ratio =
Net Cash Flow from Operating ActivitiesNet Cash Flow from Investing Activity
6. Gross Cash Flow Margin
Gross Cash Flow Margin =
Cash Collection from Customer − Cash Paid to SupplierCash Collection from Customer
7. Cash Holding Ratio
Cash Holding Ratio =
Ending Balance of CashEnding Balance of Current Liabilities
8. Cash & Cash Equivalent to Sales Ratios
Net Increase in Cash & Cash Equivalent to Sales =
Net Increase in Cash and Cash EquivalentSales Revenue
Ending Cash & Cash Equivalent to Sales =
Ending Balance of Cash and Cash EquivalentSales Revenue
9. Important Operating Cash Flow Ratios
Cash Flow Margin Ratio =
Net Cash Flow from Operating ActivitiesSales Revenue
Operating Cash Flow per Share =
Net Cash Flow from Operating ActivitiesNumber of Shares Outstanding
Operating Cash Flow per Employee =
Net Cash Flow from Operating ActivitiesAverage Number of Employees
Debt Affordability Ratio =
Net Cash Flow from Operating ActivitiesDebt Payment
Cash Flow Adequacy Ratio =
Net Cash Flow from Operating ActivitiesPurchase of Long-term Assets + Debt Payment + Dividend Paid
Priority Obligation Ratio =
Cash Flow from Operating Activities + Interest Paid + Tax PaidPriority Outflows
Cash Realization Ratio =
Net Cash Flow from Operating ActivitiesNet Income
🌿 Memory Tip: Most cash flow ratios begin with Net Cash Flow from Operating Activities because operating cash flow represents the cash generated from the firm's normal business operations.
Cash Flow vs. Net Profit
| Basis for Difference | Cash Flow | Net Profit |
|---|---|---|
| Definition | Actual cash moving in/out during a period. | Surplus after all expenses (incl. non-cash) are deducted from revenue. |
| What it Measures | Liquidity – ability to pay bills, debts, fund operations. | Profitability – overall financial performance & wealth generation. |
| Accounting Basis | Cash basis – records only when cash is received/paid. | Accrual basis – records revenue when earned, expenses when incurred. |
| Includes Non-Cash Items? | No – excludes depreciation, amortization, stock-based comp. | Yes – includes depreciation, amortization, non-cash expenses. |
| Impact of Credit Sales | Does not include credit sales until cash is collected. | Includes credit sales as revenue immediately. |
| Impact of Credit Purchases | Does not include credit purchases until cash is paid. | Includes credit purchases as expenses immediately. |
| Manipulation Risk | Harder to manipulate – cash is factual and verifiable. | Easier to manipulate – via depreciation, revenue recognition, etc. |
| Statement Used | Reported on the Statement of Cash Flows. | Reported on the Income Statement (P&L). |
| Key Indicator Of | Short-term survival, solvency, financial flexibility. | Long-term growth, business model viability, investor returns. |
| Can be Negative while other is Positive? | Yes – profitable company can have negative cash flow. | Yes – positive cash flow can have negative net profit. |
| ★ Summary Golden Rule | Cash Flow is financial reality – cash in hand. | Net Profit is an accounting concept – performance on paper. |
Statement of Cash Flows (Direct Method Format)
| Particulars | Amount | Amount |
|---|---|---|
| 1. Cash Flow from Operating Activities | ||
| A. Cash collection from customer and sales: | ||
| Net sales / (Cash sales + Credit sales - Sales return) | XXX | |
| Discount allowed | (XXX) | |
| B/R, A/R, Debtors, N/R (Current Assets) | XXX / (XXX) | |
| Bad debt written off | (XXX) | |
| Bad debt recovered | XXX | |
| Provision for bad debt (L) | XXX / (XXX) | XXX |
| B. Cash collection from other income: | ||
| Receipt from insurance claim | XXX | |
| Dividend received / Interest on investment | XXX | |
| Accrued income (A) | XXX / (XXX) | |
| Advance income (L) | XXX / (XXX) | XXX |
| C. Payment to suppliers and purchase: | ||
| Cost of Goods Sold (Opening + Purchase - Closing) | (XXX) | |
| Discount received | XXX | |
| Increase in inventories / stock (A) | XXX / (XXX) | |
| Creditors, B/P, A/P, N/P (L) | XXX / (XXX) | (XXX) |
| D. Payment for operating expenses: | ||
| Operating expenses (*Excl. depreciation, written up, amortization) | (XXX) | |
| Prepaid or advance expenses | XXX / (XXX) | |
| Outstanding or due expenses | XXX / (XXX) | (XXX) |
| E. Interest and tax paid: | ||
| Interest paid | (XXX) | |
| Outstanding interest | XXX / (XXX) | |
| Tax paid | (XXX) | |
| Outstanding tax | XXX / (XXX) | (XXX) |
| Net cash flow from operating activities (A + B + C + D + E) | XXX / (XXX) | |
| 2. Cash flow from investing activities | ||
| Purchase of fixed assets / Investment | (XXX) | |
| Sale of fixed assets / Investment | XXX | |
| Long term note receivable | XXX / (XXX) | |
| Marketable securities | XXX / (XXX) | |
| Net cash flow from investing activities | XXX / (XXX) | |
| 3. Cash flow from financing activities | ||
| Share / Debenture issue | XXX | |
| Share / Debenture redemption | (XXX) | |
| Bank loan / Bank overdraft | XXX / (XXX) | |
| Note payable (Long term) | XXX / (XXX) | |
| Dividend paid | (XXX) | |
| Net cash flow from financing activities | XXX / (XXX) | |
| Net cash change (1 + 2 + 3) | XXX / (XXX) | |
| Add: Opening balance of cash and bank | XXX | |
| Closing balance of cash and bank | XXX | |
Working Notes & Adjustments
Formulae Essentials
Bad Debt Written Off: Opening Provision + Current Year Provision - Closing Provision
Tax Paid: Opening Provision for Tax + Tax Expenses - Closing Provision for Tax
Dividend Paid: Opening Provision + Current Dividend - Closing Provision
Or: Opening Retained Earnings + Net Income - Closing Retained Earnings
Fixed Asset Account Ledger Format
| Dr. | Particulars | Amt | Particulars | Amt | Cr. |
|---|---|---|---|---|---|
| To Balance b/d (Opening) | XXX | By Depreciation A/c | XXX | ||
| To Profit & Loss A/c (Gain) | XXX | By Bank A/c (Sales) | XXX | ||
| To Bank A/c (Purchase) | XXX | By Profit & Loss A/c (Loss) | XXX | ||
| By Balance c/d (Closing) | XXX |
Sales Value: Book Value + Profit OR Book Value - Loss
Book Value (BV): Cost - Accumulated Depreciation
📊 Solution: Gems Investment Co. Ltd.
2021 April–May Q.No. 1 · Financial Analysis & Solutions
Comparative Balance Sheet
| Equities | 2075 | 2076 | Assets | 2075 | 2076 |
|---|---|---|---|---|---|
| Share capital | 500,000 | 800,000 | Land and building | 400,000 | 600,000 |
| Share premium | 50,000 | 90,000 | Furniture and fixture | 500,000 | 650,000 |
| 10% Debentures | 200,000 | 100,000 | Accumulated dep. | (200,000) | (210,000) |
| Bank loan | - | 50,000 | Stock | 50,000 | 80,000 |
| Sundry creditors | 40,000 | 80,000 | Sundry debtors | 50,000 | 70,000 |
| Provision for tax | 20,000 | 40,000 | Cash at bank | 20,000 | 70,000 |
| Provision for dividend | 10,000 | 20,000 | |||
| Retained earnings | - | 80,000 | |||
| Total | 820,000 | 1,260,000 | Total | 820,000 | 1,260,000 |
Income Statement for 2076
| Sales revenue | 800,000 | |
| Less: Cost of goods sold: | ||
| Beginning stock | 50,000 | |
| Add: Purchase | 300,000 | |
| Ending stock | (80,000) | |
| Wages | 210,000 | (480,000) |
| Gross profit | 320,000 | |
| Less: Operating expenses: | ||
| General expenses | 120,000 | |
| Depreciation | 50,000 | |
| Interest on debenture | 20,000 | |
| Premium on debenture redemption | 10,000 | |
| Provision for taxation | 40,000 | |
| Provision for dividend | 20,000 | (260,000) |
| Net income | 60,000 | |
| Add: Gain on sale of furniture and fixture (Book value Rs. 60,000) | 20,000 | |
| Retained earnings | 80,000 | |
Required:
- Cash flow from operating, investing and financing activities.
- Comment on operating, investing and financing activities.
- What strategies to be followed to achieve the competitive advantages and sustainable development of the company?
- Does the statement of cash flows have any managerial implication for decision making? Explain.
- Why preparation of cash flow statement is essential along with balance sheet?
- Do you think positive cash flow is healthy sign of a Co.? Justify your answer.
Solution 1: Cash Flow Statement for the year ended 2076
| Particulars | Rs. | Rs. |
|---|---|---|
| 1. Cash from operating activities: | ||
| a. Cash collection from customer / sales | ||
| Sales revenue | 800,000 | |
| Increase in sundry debtors | (20,000) | |
| Net cash collection from customer | 780,000 | |
| b. Cash collection from other income | Nil | |
| c. Cash paid to suppliers | ||
| Cost of goods sold | (270,000) | |
| Increase in stock or inventory | (30,000) | |
| Increase in sundry creditors | 40,000 | |
| Net cash paid to suppliers | (260,000) | |
| d. Cash paid to employees and expenses: | ||
| Wages expenses | (210,000) | |
| General expenses | (120,000) | |
| Net cash paid to employees and expenses | (330,000) | |
| e. Cash paid for interest expenses: | ||
| Interest on debentures | (20,000) | (20,000) |
| f. Cash paid for income tax: | ||
| Income tax expenses/provision | (40,000) | |
| Increase in provision for tax | 20,000 | |
| Net cash paid for income tax | (20,000) | |
| Net cash from operating activities (a+b+c+d+e+f) | 150,000 | |
| 2. Cash from investing activities: | ||
| Purchase of land and building | (200,000) | |
| Purchase of furniture and fixture | (250,000) | |
| Sold of furniture and fixture | 80,000 | |
| Net cash from investing activities | (370,000) | |
| 3. Cash from financing activities: | ||
| Issue of share capital | 300,000 | |
| Increase in share premium | 40,000 | |
| Redemption of debenture | (100,000) | |
| Premium on redemption of debenture | (10,000) | |
| Increase in bank loan | 50,000 | |
| Dividend paid | (10,000) | |
| Net cash from financing activities | 270,000 | |
| 4. Net cash increased (1 + 2 + 3) | 50,000 | |
| Add: Beginning cash balance and equivalent to cash | 20,000 | |
| Ending cash balance and equivalent to cash | 70,000 | |
Working Notes:
a. Calculation of depreciation of the sold part of furniture
Ending balance = Beginning balance + Depreciation for the year - Accumulated depreciation of sold part
- 210,000 = 200,000 + 50,000 - Accumulated depreciation on sold part
- Accumulated depreciation of sold part = Rs. 40,000
b. Calculation of purchase value of furniture
Ending balance = Beginning balance + Purchased - Sold value - Accumulated depreciation of sold part + Gain on sale
- 650,000 = 500,000 + Purchased - 80,000 - 40,000 + 20,000
- Purchased = 650,000 - 400,000 = Rs. 250,000
c. Calculation of dividend paid using provision for dividend account
Ending balance = Beginning balance + New provision - Dividend paid
- 20,000 = 10,000 + 20,000 - Dividend paid
- Dividend paid = Rs. 10,000
Detailed Theoretical Answers
2. Comments on Operating, Investing, and Financing Activities
- Operating Activities: Generates a positive cash flow of Rs. 150,000, indicating that the company's core operations are generating sufficient cash inflow to meet its operational payments.
- Investing Activities: Displays a negative cash flow of Rs. 370,000, driven by significant capital investment in long-term fixed assets (Land & Building: Rs. 200,000; Furniture & Fixtures: Rs. 250,000) to support future expansion.
- Financing Activities: Shows a positive cash flow of Rs. 270,000, raised via share capital issuance and bank loans to fulfill capital needs and fund asset acquisitions.
- Overall Performance: Overall business performance is satisfactory, with internal operating cash inflows supported by external equity/debt financing to fuel long-term asset growth.
3. Strategies for Competitive Advantages & Sustainable Development
- Core Cash Flow Optimization: Enhance focus on primary operating activities to maximize internal cash inflows and reduce dependency on external debt.
- Working Capital Management: Streamline collections from debtors and optimize inventory turnover to prevent unnecessary cash lockups.
- Cost Control Techniques: Implement systematic cost reduction measures across administration and manufacturing to boost operating margins.
- Strategic Resource Allocation: Reinvest operating surplus into high-yielding, modern economic resources to ensure long-term competitive expansion.
4. Managerial Implications of Statement of Cash Flows
The information in a Statement of Cash Flows assists management, investors, creditors and others in assessing the following:
Future Cash Generation
The enterprise's ability to generate positive future net cash flows.
Ability to Meet Obligations
The entity's ability to meet its obligations as they become due.
Ability to Pay Dividends
The enterprise's ability to pay dividends to its shareholders.
Need for External Financing
The enterprise's need for external financing when internally generated cash is insufficient.
Difference Between Profit and Cash
The reasons for differences between net income and the associated cash receipts and cash payments.
Effect on Financial Position
The effects on the enterprise's financial position of both its cash and non-cash investing and financing transactions during the period.
📝 Exam Reminder: The Statement of Cash Flows helps users assess future cash generation, obligation-paying capacity, dividend capacity, financing requirements, differences between profit and cash, and the effect of investing and financing transactions on financial position.
5. Necessity of Cash Flow Statement Alongside Balance Sheet
- Dynamic vs. Static Analysis: While the Balance Sheet presents a static picture of assets and liabilities, the Cash Flow Statement tracks dynamic movements of liquid cash over the period.
- Operational Efficiency Assessment: Evaluates how efficiently a company converts revenue into actual liquid cash to meet immediate operational obligations.
- Regulatory & Strategic Necessity: Serves as a mandatory financial reporting tool to assess liquidity health, dividend distribution capacity, and future capital requirements.
6. Is Positive Cash Flow Always a Healthy Sign?
- Operating Cash Flow: A positive cash flow here is a healthy sign, confirming viable and self-sustaining core business operations.
- Investing Cash Flow: A negative cash flow is often healthy and desirable, as it signifies active reinvestment into fixed assets for long-term growth.
- Financing Cash Flow: A high positive cash flow driven solely by excessive borrowing or equity dilution may indicate financial risk rather than business health.
