Cash Flow Statements and Interpretation of Financial Statements
What the domain tests
You must prepare a cash flow statement under operating, investing and financing headings, and calculate and interpret profitability, liquidity, efficiency and gearing ratios. The exam tests both mechanics and the story the ratios tell.
Cash flow rules
Operating activities may be presented indirectly: profit before tax + depreciation + loss on disposal − profit on disposal − increase in receivables + decrease in receivables + increase in payables − decrease in payables. Interest and tax paid are then deducted if classified as operating. Investing activities include purchase and sale of non-current assets and interest or dividends received. Financing activities include share issues, loans raised or repaid, and dividends paid.
Cash and cash equivalents include cash, bank balances and short-term highly liquid investments. A bank overdraft is included only where it forms part of cash management and is repayable on demand.
Ratio analysis
- Profitability: gross margin, net margin, return on capital employed.
- Liquidity: current ratio, quick ratio.
- Efficiency: inventory turnover, receivable days, payable days.
- Gearing: debt ÷ equity or debt ÷ (debt + equity).
Worked example
Profit before tax is 10,000,000; depreciation 2,000,000; receivables increased by 1,500,000; payables decreased by 500,000; interest paid 800,000; tax paid 1,200,000; equipment purchased 3,000,000; loan received 2,000,000; dividends paid 1,000,000.
- Operating cash before interest and tax = 10,000,000 + 2,000,000 − 1,500,000 − 500,000 = 10,000,000.
- Net operating cash = 10,000,000 − 800,000 − 1,200,000 = 8,000,000.
- Investing = −3,000,000. Financing = 2,000,000 − 1,000,000 = 1,000,000.
- Net increase in cash = 8,000,000 − 3,000,000 + 1,000,000 = 6,000,000.
Traps
Depreciation is added back, but profit on disposal is deducted and loss on disposal is added back. An increase in receivables reduces cash; an increase in payables increases cash. Dividends paid are financing, not operating. Do not compare ratios across firms without considering accounting policies. A high current ratio may hide slow-moving inventory.