Cash Flow Statement: Types, Preparation & Analysis

TAKEAWAYS:

• The cash flow statement reports cash inflows/outflows (not profits) in three categories: operating, investing, and financing activities.
• Operating activities focus on core business operations (e.g., cash from sales, payments to suppliers), while investing and financing activities track long-term assets and capital structure.
• The indirect method (adjusting net profit) is more common in Nepal due to its simplicity, but the direct method provides clearer cash flow insights.
• Non-cash transactions (e.g., depreciation, stock issuance) are excluded unless they affect cash indirectly (e.g., deferred tax).
• Analysis involves comparing cash flow trends, calculating ratios (e.g., operating cash flow to net income), and assessing liquidity/solvency.
• Exam focus: Link cash flow statements to trial balances, profit & loss accounts, and balance sheets using adjustments for non-cash items.

1. What is a Cash Flow Statement?

The cash flow statement is a financial statement that summarizes cash inflows (receipts) and outflows (payments) over a period (usually a year). Unlike the profit & loss (P&L) statement, which measures accrual-based income, the cash flow statement focuses only on actual cash movements.

Why is it important?

• Shows liquidity: Can the business pay its short-term debts?
• Reveals operational efficiency: Is cash generated from core activities?
• Helps predict future cash needs (e.g., for expansion or debt repayment).
• Required by Nepali accounting standards (NAS 7) and IFRS/IAS 7 for external reporting.

2. Types of Cash Flows

Cash flows are classified into three categories:

flowchart TD
    A["Cash Flow Statement"] --> B["1. Operating Activities"]
    A --> C["2. Investing Activities"]
    A --> D["3. Financing Activities"]
    B --> B1["Cash from sales to customers"]
    B --> B2["Cash paid to suppliers/employees"]
    C --> C1["Purchase/sale of long-term assets (e.g., machinery)"]
    C --> C2["Investments in securities"]
    D --> D1["Issuing shares/loans (inflows)"]
    D --> D2["Repaying loans/dividends (outflows)"]

Key Definitions

3. How to Prepare a Cash Flow Statement

There are two methods:

1. Direct Method: Lists individual cash receipts/payments (rare in Nepal due to complexity).
2. Indirect Method: Starts with net profit and adjusts for non-cash items (most common in TU/PU exams).

Step-by-Step Indirect Method

1. Start with Net Profit (from P&L statement).
2. Add back non-cash expenses (e.g., depreciation, amortization).
3. Adjust for working capital changes (e.g., increase in inventory = cash outflow).
4. Calculate net cash from operating activities.
5. Add investing and financing cash flows (from balance sheet changes).

4. Worked Example: Kathmandu Retail Shop (NPR)

Given Data (for 2079):

• Net Profit (P&L): Rs 500,000
• Depreciation: Rs 50,000
• Increase in Inventory: Rs 30,000
• Increase in Trade Receivables: Rs 20,000
• Purchase of New Shelves (Investing): Rs 100,000
• Bank Loan Taken (Financing): Rs 200,000

Cash Flow Statement (Indirect Method)

Interpretation:

• The shop generated Rs 500,000 from operations but spent Rs 100,000 on shelves.
• It raised Rs 200,000 via a loan, resulting in a net cash increase of Rs 600,000.

5. Real-World Applications in Nepal

Example 1: eSewa (Operating Cash Flow)

• Idea Used: Operating cash flow from digital transactions.
• How?
  • eSewa records cash inflows when users pay bills (e.g., electricity, phone).
  • Cash outflows occur when eSewa pays utility companies.
  • Net operating cash flow shows whether eSewa can cover its operational costs (e.g., salaries, server maintenance).

Example 2: Ncell (Investing Cash Flow)

• Idea Used: Investing in 5G infrastructure.
• How?
  • Ncell spends millions on new towers/base stations (investing outflow).
  • Future cash inflows come from higher data revenue.
  • The cash flow statement helps investors see if Ncell’s long-term investments are paying off.

Example 3: Daraz (Financing Cash Flow)

• Idea Used: Debt repayment and equity issuance.
• How?
  • Daraz may take a loan from a bank (financing inflow) to expand warehouses.
  • Later, it repays part of the loan (financing outflow).
  • The statement shows whether Daraz is over-relying on debt or generating enough cash to sustain growth.

6. Direct vs. Indirect Method: Comparison

7. Common Adjustments in the Indirect Method

8. Linking Cash Flow to Other Statements

The cash flow statement connects to:

1. Profit & Loss (P&L): Net profit is the starting point (indirect method).
2. Balance Sheet:
   • Changes in assets/liabilities (e.g., inventory, loans) affect cash flow.
   • Example: If trade receivables increase, cash from sales decreases.

9. Analysis of Cash Flow Statement

Key ratios and trends to analyze:

1. Operating Cash Flow to Net Income Ratio

   • Formula: Operating Cash Flow / Net Income
   • Interpretation:
     • >1: Business generates more cash than reported profit (good).
     • <1: Profit includes non-cash items (e.g., high depreciation).

2. Free Cash Flow (FCF)

   • Formula: Operating Cash Flow – Capital Expenditures
   • Use: Shows cash available after maintaining assets (e.g., for dividends or expansion).

3. Cash Flow Trends

   • Growing operating cash flow: Business is sustainable.
   • Negative investing cash flow: Heavy spending on assets (e.g., NTC expanding fiber networks).

Exam Tip

1. Memorize the Three Categories: Always classify transactions correctly (operating, investing, financing).
2. Adjustments are Key: In the indirect method, add back depreciation and deduct increases in assets/liabilities.
3. Link to Balance Sheet: If inventory increases, cash flow from operations decreases (cash is tied up in stock).
4. Common Mistakes:
   • Forgetting to exclude non-cash items (e.g., stock issuance).
   • Misclassifying interest paid (operating in Nepal, but financing under IFRS).
5. Practice Questions:
   • Given a trial balance, prepare a cash flow statement using the indirect method.
   • Explain why net profit ≠ cash flow (e.g., credit sales not yet collected).
   • Calculate free cash flow for a given company.

10. Past Exam Question Solved

Question: "Preparation of cash flow statement includes cash flow from operating, investing, and financing activities. Explain with a suitable example."

Answer: The cash flow statement is divided into three sections, each showing different aspects of cash movement.

1. Operating Activities (Example: Kathmandu Supermarket)

   • Cash Inflow: Rs 2,000,000 from cash sales and Rs 500,000 from receipts from debtors.
   • Cash Outflow: Rs 1,200,000 paid to suppliers, Rs 300,000 to employees, and Rs 100,000 for utilities.
   • Net Operating Cash Flow: Rs 2,000,000 + Rs 500,000 – Rs 1,200,000 – Rs 300,000 – Rs 100,000 = Rs 800,000.

2. Investing Activities (Example: NTC)

   • Cash Outflow: Rs 500,000 spent on new fiber optic cables.
   • Net Investing Cash Flow: -Rs 500,000.

3. Financing Activities (Example: Global IME Bank Loan)

   • Cash Inflow: Rs 1,000,000 from bank loan.
   • Net Financing Cash Flow: +Rs 1,000,000.

Final Net Cash Flow: Rs 800,000 (operating) – Rs 500,000 (investing) + Rs 1,000,000 (financing) = Rs 1,300,000 increase in cash.

11. Quick Revision Checklist

Before exams, ensure you can: ✅ Define operating, investing, and financing activities. ✅ Prepare a cash flow statement using the indirect method. ✅ Identify non-cash items (e.g., depreciation, stock issuance). ✅ Calculate free cash flow and operating cash flow ratios. ✅ Link cash flow to balance sheet changes (e.g., inventory, loans).