Cash flows and financial interpretation
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: under the classroom convention here, operating profit before interest and tax + depreciation + loss on disposal − profit on disposal − increase in inventory + decrease in inventory − increase in receivables + decrease in receivables + increase in operating payables − decrease in operating payables. Interest and tax paid are then deducted if classified as operating. In the supplied convention, investing includes purchase and sale of non-current assets and financing includes ordinary-share issues, principal borrowings and repayments, and ordinary dividends paid. Interest/dividend classifications depend on the framework, version and entity circumstances; do not transfer one classroom choice as a universal current rule.
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
Operating profit before interest and 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. The worked example explicitly classifies ordinary dividends paid as financing; verify the convention required by the actual framework and reporting period. Do not compare ratios across firms without considering accounting policies. A high current ratio may hide slow-moving inventory.