Harlow Engineering: Statement of Cash Flows Classification
Harlow Engineering Ltd has a 31 December 2024 year end. Extracts show profit before tax £186,000, depreciation £42,000, gain on disposal of plant £9,000, interest expense £12,000, increase in inventories £14,000, decrease in trade receivables £7,000, decrease in trade payables £11,000, tax paid £38,000, interest paid £12,000, purchase of plant £95,000, proceeds from disposal £23,000, issue of ordinary shares £40,000, repayment of bank loan £25,000 and dividends paid £30,000. Cash and cash equivalents at 1 January 2024 were £18,000. The finance director wants the statement prepared using the indirect method and wants interest paid classified as a financing cash flow. A colleague argues that depreciation should be ignored because it is not a cash flow. The company also has a bank overdraft that the treasurer wants to exclude from cash and cash equivalents.
1. Prepare the statement of cash flows for the year ended 31 December 2024 using the indirect method, with interest paid classified as financing. Show the net increase in cash and cash equivalents.
Read the worked answer
Cash flows from operating activities.
| Item | £ |
|---|---|
| Profit before tax | 186,000 |
| Depreciation | 42,000 |
| Gain on disposal | (9,000) |
| Interest expense added back | 12,000 |
| Operating profit before working capital changes | 231,000 |
| Increase in inventories | (14,000) |
| Decrease in receivables | 7,000 |
| Decrease in payables | (11,000) |
| Cash generated from operations | 213,000 |
| Tax paid | (38,000) |
| Net cash from operating activities | 175,000 |
Investing activities. Purchase of plant (95,000); proceeds from disposal 23,000; net cash used (72,000).
Financing activities. Issue of shares 40,000; repayment of bank loan (25,000); dividends paid (30,000); interest paid (12,000); net cash used (27,000).
Reconciliation. 175,000 − 72,000 − 27,000 = £76,000 net increase. Opening cash £18,000 + £76,000 = £94,000 closing cash and cash equivalents before considering the overdraft. The interest add-back is necessary because profit before tax is after charging interest; classifying interest paid as financing removes it from operating cash flow.
2. Recalculate net cash from operating activities if interest paid were classified as operating. Explain why the net increase in cash is unchanged and which classification is permitted by IAS 7.
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Operating classification. Do not add back interest expense. Start with profit before tax £186,000; add depreciation £42,000; deduct gain £9,000; working capital movement is still (14,000) + 7,000 − 11,000 = (18,000). Cash generated from operations before interest and tax = 186,000 + 42,000 − 9,000 − 18,000 = £201,000. Interest paid (12,000) and tax paid (38,000) give net cash from operating activities = £151,000? No - the £201,000 is already after deducting interest expense because profit before tax includes it. The correct operating figure is: 186,000 + 42,000 − 9,000 − 18,000 − 38,000 = £163,000. The interest cash paid is already reflected in profit before tax, so it is not deducted again.
Financing classification. If interest is operating, financing becomes 40,000 − 25,000 − 30,000 = (15,000). Net increase = 163,000 − 72,000 − 15,000 = £76,000. Under the financing classification, operating was £175,000 and financing was £27,000 used, also giving £76,000. The subtotals change by £12,000 but total cash does not.
IAS 7. Interest paid may be classified as operating or financing, consistently. It cannot be classified as investing. The choice must be disclosed and applied consistently.
3. A colleague argues that depreciation should be ignored in the cash flow statement because it is not a cash flow. Explain why it is added back and what would happen to net cash if it were omitted. Also assess the treasurer's wish to exclude the bank overdraft from cash and cash equivalents.
Read the worked answer
Depreciation. Depreciation is deducted in arriving at profit before tax but does not involve a cash outflow. The indirect method reconciles profit to cash, so non-cash expenses are added back. If depreciation of £42,000 were omitted, net cash from operating activities would be understated by £42,000 and the net increase would be £34,000 instead of £76,000. That would be wrong because the cash movement would not reconcile.
Gain on disposal. The gain is deducted because the cash proceeds are shown in investing activities. Leaving the gain in operating profit would double-count the disposal benefit.
Bank overdraft. IAS 7 treats bank overdrafts repayable on demand as a component of cash and cash equivalents where they form an integral part of cash management and fluctuate between positive and negative balances. Excluding an integral overdraft to show a more favourable cash balance is not acceptable. If the overdraft is not integral, it is a financing liability and its movement is shown in financing activities, with disclosure. The classification must reflect substance, not the treasurer's presentation preference.