Cash flow classification and overdraft treatment
Aldermoor Ltd's summarised statement of profit or loss for the year ended 31 December 20X4 shows profit before tax of £184,000 after charging depreciation of £42,000 and interest expense of £9,000, and after recording a gain on disposal of plant of £6,000. The plant had a carrying amount of £12,000 and was sold for £18,000. Inventories increased by £11,000, trade receivables decreased by £7,000 and trade payables decreased by £4,000. Interest payable increased by £1,000 during the year. Tax paid was £28,000. During the year the company bought property, plant and equipment for £95,000, issued 50,000 £1 ordinary shares at par for £50,000, paid dividends of £32,000 and repaid a £220,000 bank loan. The bank balance was £48,000 at 1 January 20X4 and an overdraft of £46,000 at 31 December 20X4. The overdraft is repayable on demand and forms part of cash and cash equivalents.
1. Calculate net cash from operating activities using the indirect method.
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| Operating cash flow | £ |
|---|---|
| Profit before tax | 184,000 |
| Add depreciation | 42,000 |
| Less gain on disposal | (6,000) |
| Add interest expense | 9,000 |
| Operating profit before working capital changes | 229,000 |
| Increase in inventories | (11,000) |
| Decrease in receivables | 7,000 |
| Decrease in payables | (4,000) |
| Cash generated from operations | 221,000 |
| Interest paid: £9,000 − £1,000 increase in payable | (8,000) |
| Tax paid | (28,000) |
| Net cash from operating activities | 185,000 |
The gain on disposal is deducted because it is an investing item, not an operating cash inflow. Depreciation is added back because it is a non-cash expense. The working capital movements follow the direction of the asset or liability: an increase in inventory uses cash, a decrease in receivables provides cash, and a decrease in payables uses cash. Interest paid is based on the expense adjusted for the unpaid amount.
2. Explain how the interest paid, dividends paid and bank overdraft should be classified in the statement of cash flows.
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Under FRS 102, interest paid may be classified as an operating cash flow or as a financing cash flow, provided the choice is applied consistently. Many companies treat it as operating because it arises from running the business; others treat it as financing because it is a cost of finance. The classification must be disclosed and not changed casually. Dividends paid are normally classified as financing because they are a return to the providers of equity finance. The bank overdraft is different: it is repayable on demand and is integral to the company's cash management, so it forms part of cash and cash equivalents. The movement from £48,000 cash to a £46,000 overdraft is therefore a movement within cash and cash equivalents, not a £46,000 financing inflow. Presenting the overdraft as a financing source would overstate financing cash flow and mislead users.
3. Reconcile the net cash flow to the movement in cash and cash equivalents and comment on the company's cash generation.
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| Reconciliation | £ |
|---|---|
| Net cash from operating activities | 185,000 |
| Purchase of PPE | (95,000) |
| Proceeds from disposal of plant | 18,000 |
| Issue of shares | 50,000 |
| Dividends paid | (32,000) |
| Repayment of bank loan | (220,000) |
| Net decrease in cash and cash equivalents | (94,000) |
| Cash and cash equivalents at 1 January 20X4 | 48,000 |
| Cash and cash equivalents at 31 December 20X4 (overdraft) | (46,000) |
The operating cash flow of £185,000 is strong enough to cover the £95,000 of capital expenditure and still leave £90,000 before financing. However, the company used most of its cash to repay a £220,000 loan and also paid £32,000 of dividends. That is why the overall cash position fell by £94,000 and moved into overdraft. The overdraft is part of cash and cash equivalents, so the reconciliation works. The key judgement is not simply that the overdraft exists, but that it reflects a deliberate use of cash for debt repayment and distributions rather than necessarily weak trading.