A Cash Flow Statement (CFS) is a fundamental financial statement that provides insights into all cash inflows and outflows of a business over a specific period, typically a quarter or a year. Unlike the Income Statement, which reports revenues and expenses on an accrual basis, or the Balance Sheet, which presents assets, liabilities, and equity at a specific point in time, the CFS focuses solely on the movement of cash. It serves as a crucial tool for assessing a company’s liquidity, solvency, and ability to generate future cash flows, enabling stakeholders like investors, creditors, and management to understand how a company generates and uses cash.

The primary objective of the Cash Flow Statement, as per accounting standards like AS-3 (Accounting Standard 3) issued by the Institute of Chartered Accountants of India (ICAI) or IAS 7 (International Accounting Standard 7), is to provide relevant information about the cash receipts and cash payments of an entity during a period. This information is critical for evaluating the entity’s ability to generate cash and cash equivalents, and the needs of the entity to utilise those cash flows. By classifying cash flows into operating, investing, and financing activities, the statement offers a structured view of the sources and applications of cash, differentiating between cash generated from core operations, cash used for long-term investments, and cash movements related to capital structure changes.

Cash and Cash Equivalents

Under AS-3, “cash” comprises cash on hand and demand deposits. “Cash equivalents” are defined as short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. The core characteristics distinguishing cash equivalents are their high liquidity and minimal risk.

To qualify as a cash equivalent, an investment must meet several stringent criteria:

  1. Short-Term Maturity: It must have a short maturity, generally three months or less from the date of acquisition. This short maturity period ensures that the investment is near its maturity date, making its conversion to cash highly probable and its market value less susceptible to interest rate fluctuations.
  2. Readily Convertible to Known Amounts of Cash: There must be an active market for the investment, allowing it to be sold quickly without significant loss of value. The amount of cash to be received upon conversion must be certain and not subject to significant variability.
  3. Insignificant Risk of Changes in Value: The investment must carry a very low risk of changes in its fair value due to market interest rate movements or other factors. This implies that the investment is stable and predictable in its valuation.

Examples of cash equivalents commonly include:

  • Treasury Bills (T-Bills): Short-term debt instruments issued by the government, typically with maturities of one year or less.
  • Commercial Paper: Unsecured, short-term debt instrument issued by corporations, usually for financing accounts receivable, inventories, and meeting short-term liabilities.
  • Money Market Funds: Open-ended mutual funds that invest in short-term debt securities such as T-bills, commercial paper, and certificates of deposit.
  • Short-Term Deposits with Banks: Bank deposits that are readily accessible and mature within three months.
  • Call Deposits/Overnight Deposits: Deposits that can be withdrawn by the depositor without prior notice or with very short notice.

It is important to note that not all short-term investments qualify as cash equivalents. For instance, an investment in equity shares, even if acquired for a short period, would generally not be considered a cash equivalent because of the inherent risk of significant changes in value. Similarly, investments held for strategic purposes or for long-term capital appreciation, even if they have a short maturity, might not fit the definition. Bank overdrafts, which are repayable on demand and form an integral part of an entity’s cash management, are generally included as a component of cash and cash equivalents. However, if they are not repayable on demand and represent long-term financing, they are classified as financing activities.

The aggregation of cash and cash equivalents is crucial because it provides a holistic view of the most liquid assets available to the company, enabling a clear reconciliation of the opening and closing balances of cash as presented in the Cash Flow Statement.

Classification of Cash Flows

AS-3 mandates the classification of cash flows into three primary categories to provide relevant information about the different types of activities undertaken by an entity:

1. Cash Flows from Operating Activities

Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities. Essentially, these are the cash flows generated from the day-to-day operations of the business. They represent the cash inflows and outflows that arise from the core business functions.

Examples of Cash Inflows from Operating Activities:

  • Cash receipts from the sale of goods and the rendering of services (e.g., cash sales, collection from debtors).
  • Cash receipts from royalties, fees, commissions, and other revenues.
  • Cash receipts from insurance claims, refunds of income taxes, etc., unless they are specifically identifiable with investing or financing activities.

Examples of Cash Outflows from Operating Activities:

  • Cash payments to suppliers for goods and services (e.g., cash purchases, payments to creditors).
  • Cash payments to employees and on behalf of employees (e.g., salaries, wages, employee benefits).
  • Cash payments of operating expenses (e.g., rent, utilities, advertising, maintenance).
  • Cash payments for income taxes, unless they are specifically identifiable with investing or financing activities.
  • Cash payments for insurance premiums.

The cash flow from operating activities is a key indicator of the extent to which the operations of the entity have generated sufficient cash flows to repay loans, maintain the operating capability of the entity, pay dividends, and make new investments without recourse to external financing.

2. Cash Flows from Investing Activities

Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents. These activities reflect the company’s decisions regarding its productive assets and long-term financial health.

Examples of Cash Inflows from Investing Activities:

  • Cash receipts from the sale of property, plant, and equipment (PPE) and intangible assets.
  • Cash receipts from the sale of shares or debt instruments of other entities (excluding cash equivalents).
  • Cash receipts from the repayment of advances and loans made to third parties (excluding advances and loans of a financial institution).
  • Interest received from investments (e.g., bonds, fixed deposits), unless specifically classified as operating for financial institutions.
  • Dividends received from investments in other entities, unless specifically classified as operating for financial institutions.

Examples of Cash Outflows from Investing Activities:

  • Cash payments to acquire property, plant, and equipment (PPE) and intangible assets.
  • Cash payments to acquire shares or debt instruments of other entities (excluding cash equivalents).
  • Cash payments for advances and loans made to third parties (excluding advances and loans of a financial institution).

Investing activities are crucial for understanding how a company is allocating its resources for future growth and profitability. They show whether the company is expanding its operational capacity or liquidating assets.

3. Cash Flows from Financing Activities

Financing activities are activities that result in changes in the size and composition of the owner’s capital (including preference share capital in the case of a company) and borrowings of the entity. These activities deal with how a company obtains and repays capital.

Examples of Cash Inflows from Financing Activities:

  • Cash receipts from issuing shares or other equity instruments.
  • Cash receipts from issuing debentures, loans, notes, bonds, and other short-term or long-term borrowings.

Examples of Cash Outflows from Financing Activities:

  • Cash payments to owners to redeem or acquire the entity’s shares (e.g., share buybacks).
  • Cash payments for the repayment of amounts borrowed (e.g., repayment of debentures, loans).
  • Cash payments of dividends to equity and preference shareholders.
  • Interest paid on borrowings, unless specifically classified as operating for financial institutions.

Financing activities provide insights into a company’s capital structure and its ability to raise and service debt and equity. This helps users assess the company’s financial leverage and its capacity to meet its financial obligations.

Calculation of Cash Flow in Each Activity as per AS-3

AS-3 outlines specific methods for calculating cash flows from each activity, with a particular emphasis on two approaches for operating activities: the direct method and the indirect method. While the question specifically asks for the direct method preparation, understanding how calculations are made for all categories is crucial.

Calculation of Cash Flow from Operating Activities

AS-3 permits two methods for reporting cash flows from operating activities: the direct method and the indirect method.

  1. Direct Method: This method presents major classes of gross cash receipts and gross cash payments. It involves directly identifying and listing the cash inflows and outflows related to operations.

    • Cash Receipts from Customers: This is calculated by adjusting sales revenue for changes in trade receivables and deferred revenue.
      • Cash Sales + Collection from Debtors (Opening Debtors + Credit Sales - Closing Debtors)
    • Cash Paid to Suppliers: This is derived by adjusting the cost of goods sold (or purchases) for changes in inventory and trade payables.
      • Cash Purchases + Payments to Creditors (Opening Creditors + Credit Purchases - Closing Creditors)
    • Cash Paid for Operating Expenses: This involves taking operating expenses from the income statement and adjusting them for non-cash items (like depreciation, amortization) and changes in related prepaid expenses and accrued liabilities.
    • Cash Paid for Income Taxes: This is determined by adjusting income tax expense for changes in current and deferred tax liabilities/assets.

  2. Indirect Method: This method starts with net profit or loss before tax and extraordinary items and adjusts it for the effects of non-cash transactions, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.

    • Start with Net Profit Before Tax and Extraordinary Items.
    • Add back non-cash expenses (e.g., depreciation, amortization, provisions).
    • Subtract non-cash incomes (e.g., profit on sale of assets).
    • Adjust for changes in current assets (excluding cash and cash equivalents) and current liabilities (excluding bank overdrafts and short-term borrowings used for financing activities).
    • Add/subtract items related to investing/financing activities that are included in profit/loss (e.g., interest income, dividend income, interest expense, profit/loss on sale of investments).
    • Subtract income tax paid.

Calculation of Cash Flow from Investing Activities

Cash flows from investing activities are calculated by analyzing changes in non-current assets (Property, Plant & Equipment, Investments, Intangible Assets, etc.) from the comparative balance sheets and relevant information from the income statement and notes to accounts.

  • Acquisition of Assets: If the balance of an asset (e.g., PPE) increases, it indicates a purchase, resulting in a cash outflow. To find the cash payment, one must consider any revaluations, disposals, or depreciation during the period.
    • Example: If opening PPE is ₹100, closing PPE is ₹150, and depreciation for the year is ₹20, then new assets purchased = ₹150 (closing) + ₹20 (depreciation) - ₹100 (opening) = ₹70 (cash outflow for purchase).
  • Sale of Assets: If an asset is sold, it results in a cash inflow. The cash received from the sale is the proceeds from disposal, not the book value or gain/loss.
    • Example: Proceeds from the sale of an old machine, sale of long-term investments.
  • Loans Made/Repaid: Cash paid for making loans to others (outflow) or cash received from their repayment (inflow).
  • Interest/Dividends Received: Directly identified and reported as cash inflows.

Calculation of Cash Flow from Financing Activities

Cash flows from financing activities are determined by examining changes in equity and non-current liabilities from the comparative balance sheets, along with information on dividends declared and interest paid.

  • Issuance of Shares/Debentures: An increase in share capital or debentures indicates issuance, resulting in a cash inflow.
    • Example: Proceeds from the issue of new equity shares or debentures.
  • Repurchase of Shares/Redemption of Debentures: A decrease in share capital (due to buybacks) or debentures indicates repayment, resulting in a cash outflow.
    • Example: Cash paid for buyback of shares, redemption of debentures.
  • Borrowings/Repayments: An increase in long-term loans indicates new borrowings (inflow), while a decrease indicates repayment (outflow).
  • Dividends Paid: This is a direct cash outflow and is often explicitly stated in the financial notes. It is crucial to differentiate between dividends declared (accrual) and dividends paid (cash).
  • Interest Paid: This is also a direct cash outflow related to borrowings. While for non-financial entities, interest paid is generally classified as a financing activity (or operating activity as per choice in AS-3), it is a cash outflow.

Preparation of Cash Flow Statement under Direct Method

The direct method for preparing the Cash Flow Statement involves presenting the major classes of gross cash receipts and gross cash payments from operating activities. This method is considered more informative by AS-3 and IAS 7 as it provides details about the actual cash transactions that generated or used cash in operations, making it easier for users to estimate future cash flows.

Here’s a step-by-step approach to prepare a Cash Flow Statement using the direct method:

Step 1: Identify and Calculate Cash Flows from Operating Activities

This is the most detailed part of the direct method. It requires analyzing the income statement and balance sheet accounts related to day-to-day operations.

  • Cash Received from Customers:
    • Start with Sales Revenue (from Income Statement).
    • Adjust for changes in Trade Receivables (Debtors): Decrease in receivables is added (cash collected more than sales), increase is subtracted (sales made on credit not yet collected).
    • Adjust for changes in Deferred Revenue/Unearned Revenue: Increase in deferred revenue is added (cash received in advance), decrease is subtracted (earned revenue for which cash was received earlier).
    • Formula: Sales Revenue + Decrease in Trade Receivables - Increase in Trade Receivables + Increase in Unearned Revenue - Decrease in Unearned Revenue.
  • Cash Paid to Suppliers:
    • Start with Cost of Goods Sold (from Income Statement).
    • Adjust for changes in Inventory: Increase in inventory is added (cash used to purchase more stock), decrease is subtracted (less cash spent as existing stock was used).
    • Adjust for changes in Trade Payables (Creditors): Decrease in payables is added (cash paid more than purchases), increase is subtracted (purchases made on credit not yet paid).
    • Formula: Cost of Goods Sold + Increase in Inventory - Decrease in Inventory - Increase in Trade Payables + Decrease in Trade Payables. (Note: For purchases, if COGS is given, adjust for inventory. If purchases figure is available, use that).
  • Cash Paid for Operating Expenses:
    • Take Operating Expenses (excluding non-cash items like depreciation, amortization, bad debts if they are not directly cash payments, etc.) from the Income Statement.
    • Adjust for changes in Prepaid Expenses: Increase in prepaid expenses is subtracted (cash paid for future benefits), decrease is added (expense incurred for which cash was paid earlier).
    • Adjust for changes in Accrued Expenses/Outstanding Expenses: Increase in accrued expenses is added (expense incurred but not yet paid), decrease is subtracted (cash paid for past accrued expenses).
    • Formula: Operating Expenses (excluding non-cash) + Increase in Prepaid Expenses - Decrease in Prepaid Expenses - Increase in Accrued Expenses + Decrease in Accrued Expenses.
  • Cash Paid for Income Taxes:
    • Start with Income Tax Expense (from Income Statement).
    • Adjust for changes in Income Tax Payable: Increase in payable is subtracted (expense incurred but not yet paid), decrease is added (cash paid more than current expense).
    • Adjust for Deferred Tax Assets/Liabilities: Changes in these generally do not involve cash flows in the current period.
    • Formula: Income Tax Expense - Increase in Income Tax Payable + Decrease in Income Tax Payable.

Step 2: Calculate Cash Flows from Investing Activities

This involves looking at the changes in non-current assets from the comparative balance sheets and related information.

  • Purchase of Property, Plant & Equipment (PPE) and Intangible Assets: Cash Outflow. Derived from increase in net block, considering depreciation and disposals.
  • Sale of Property, Plant & Equipment (PPE) and Intangible Assets: Cash Inflow. This is the actual cash proceeds from sale.
  • Purchase of Investments (long-term): Cash Outflow.
  • Sale of Investments (long-term): Cash Inflow.
  • Loans Made to Others: Cash Outflow.
  • Collection of Loans from Others: Cash Inflow.
  • Interest Received: Cash Inflow.
  • Dividends Received: Cash Inflow.

Step 3: Calculate Cash Flows from Financing Activities

This involves analyzing changes in equity and long-term liabilities from the comparative balance sheets.

  • Proceeds from Issue of Shares/Debentures: Cash Inflow.
  • Repayment of Loans/Debentures: Cash Outflow.
  • Buyback of Shares/Redemption of Preference Shares: Cash Outflow.
  • Dividends Paid: Cash Outflow.
  • Interest Paid on Borrowings: Cash Outflow.

Step 4: Consolidate and Reconcile

  • Sum up the net cash flow from Operating Activities, Investing Activities, and Financing Activities.
  • This sum represents the “Net Increase (or Decrease) in Cash and Cash Equivalents” during the period.
  • Add the “Cash and Cash Equivalents at the Beginning of the Period” to this net change.
  • The result should precisely match the “Cash and Cash Equivalents at the End of the Period” as reported on the Balance Sheet.

Typical Format of a Cash Flow Statement (Direct Method):

Cash Flow Statement for the Year Ended [Date]

A. Cash Flows from Operating Activities: Cash Receipts from Customers Less: Cash Paid to Suppliers Less: Cash Paid for Operating Expenses Less: Cash Paid for Income Tax Net Cash from Operating Activities (A)

B. Cash Flows from Investing Activities: Proceeds from Sale of Property, Plant & Equipment Purchase of Property, Plant & Equipment Proceeds from Sale of Investments Purchase of Investments Interest Received Dividends Received Net Cash from Investing Activities (B)

C. Cash Flows from Financing Activities: Proceeds from Issue of Share Capital Proceeds from Issue of Debentures/Long-term Loans Repayment of Long-term Loans/Debentures Dividends Paid Interest Paid Net Cash from Financing Activities (C)

D. Net Increase/(Decrease) in Cash and Cash Equivalents (A + B + C)

E. Cash and Cash Equivalents at the Beginning of the Period

F. Cash and Cash Equivalents at the End of the Period (D + E)

The direct method, while requiring more data and effort in preparation, offers a clearer picture of the actual cash generated and used by the company’s core operations. It is particularly useful for forecasting future cash flows and assessing a company’s ability to cover its operational expenses directly from its cash collections.

The Cash Flow Statement, irrespective of the method used for operating activities, consolidates critical financial information into a concise report. It highlights the definition of “cash and cash equivalents” as the liquid bedrock of an entity’s financial stability, encompassing readily convertible, low-risk assets. The rigorous classification of cash movements into operating, investing, and financing activities, as mandated by AS-3, offers unparalleled clarity into how a company generates, deploys, and raises funds. This categorical breakdown allows stakeholders to discern the operational efficiency, strategic investment choices, and financial structuring decisions that drive a company’s liquidity.

The granular detail provided by the direct method for operating activities, specifically, reveals the precise sources of cash receipts from customers and the actual cash payments to suppliers and employees, alongside other core expenses. This transparency is invaluable for assessing the sustainability of an entity’s core business model and its capacity to fund future operations without relying excessively on external financing or asset sales. By reconciling the net change in cash and cash equivalents with the opening and closing balances, the Cash Flow Statement serves as a vital bridge between the accrual-based income statement and the point-in-time balance sheet, offering a dynamic view of an entity’s financial health and its ability to manage its most liquid asset.