300 Accounting: Business Reporting for Decision Making
Summary of learning objectives
7.1 Assess the purpose and usefulness of a statement of cash flows.
The purpose of a statement of cash flows is to show the cash flows of an entity over a set period, in
order to assess an entity’s ability to generate cash and to meet future obligations. The heightened
awareness of the management of earnings in the statement of profit or loss has elevated the impor-
tance of reviewing the statement of cash flows in conjunction with the statement of profit or loss.7.2 Outline the format and the classification of cash flows in the statement of cash flows.
The statement of cash flows presents the beginning and ending cash balances and the cash inflows
and outflows of a reporting period. The cash inflows and outflows are classified into operating,
investing and financing activities. A reconciliation of cash from operating activities with the profit in
the statement of profit or loss is presented in a note to the accounts.7.3 Produce a statement of cash flows using the direct method and a reconciliation using the
indirect method.
Cash flows from operating activities are determined by examining the income and expenses in the
statement of profit or loss and the non-current assets and non-current liabilities in the balance sheet.
Cash flows from investing activities are determined from changes in balance sheet items dealing
with non-current assets. Cash flows from financing activities are determined from changes in bal-
ance sheet items associated with non-current liabilities and equity.
7.4 Evaluate an entity’s performance using a statement of cash flows.
The interpretation of the statement of cash flows requires a general evaluation, as well as the use
of trend and ratio analysis. Cash flow warning signals can also indicate a cash flow problem. Cash-
based ratios include the cash adequacy ratio, the cash flow ratio, the debt coverage ratio, the cash
flow to sales ratio, and free cash flow. Despite the complexity of transactions, the basic purpose of a
statement of cash flows is to report what cash came in and how it was spent.Key terms
Cash Cash and cash equivalents.
Cash adequacy ratio Cash from operating activities divided by capital expenditure plus dividends
paid.
Cash equivalents Highly liquid investments and short-term borrowings.
Cash flow ratio Measure of liquidity calculated as cash from operating activities divided by current
liabilities.
Cash flow to sales ratio Measure of profitability calculated as cash from operating activities divided
by net sales revenue.
Cash flows Cash movements resulting from transactions with parties external to the entity.
Cash inflows Cash movements into the entity resulting from transactions with an external party.
Cash on hand Notes and coins, and deposits at call with a financial institution.
Cash outflows Cash movements out of the entity resulting from transactions with an external party.
Debt coverage ratio Capital structure ratio calculated as non-current liabilities divided by cash from
operating activities.
Direct method Method of preparing a statement of cash flows that discloses major classes of gross
cash receipts and gross cash payments.
Financing activities Those activities that change the size and/or composition of the financial structure
of the entity (including equity), and borrowings not falling within the definition of cash.
Free cash flow The cash from operating activities less the amount spent on capital expenditure to
maintain the existing level of operations.