Nature and sources of cash - Operating, investing, and finan...

Learning Outcomes

After completing this article, you will be able to identify the main categories of cash flows in financial statements, distinguish between operating, investing, and financing cash flows, and correctly classify typical transactions. You will be able to explain the exam-expected format of the statement of cash flows and understand its importance in analysing business performance and solvency.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand how cash flows are reported and why they matter when assessing a business’s health. This article covers:

• The differences between profit and cash flow, with exam focus on cash reporting
• The format and structure of the statement of cash flows in accordance with IAS 7
• Classifying cash flows under operating, investing, or financing activities
• Recognising typical transactions within each category
• The rationale for reporting cash flows separately in financial statements

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is classified as a cash flow from operating activities?
   1. Purchase of machinery
   2. Loan repayment to the bank
   3. Receipts from customers
   4. Proceeds from a share issue

2. A business pays annual interest on a bank loan and also issues new equity shares. Under IAS 7, how are these classified in the cash flow statement?

3. True or false? Depreciation of equipment is reported as an outflow in the statement of cash flows.

4. Briefly explain why a profitable company might still run out of cash.

Introduction

Successful businesses need both profit and cash flow to survive. Even if reported profit is high, companies can fail because of insufficient liquidity to pay suppliers, wages, or interest. The statement of cash flows, required by IAS 7, provides a summary of cash generated and used by a business in a period. This article explains the nature and sources of cash, focusing on recognising, classifying, and reporting cash flows as operating, investing, or financing activities.

Key Term: cash flow
The movement of cash and cash equivalents into and out of a business, reflecting actual receipts and payments rather than accrual-basis accounting profit.

Cash and Profit: What’s the Difference?

One of the first skills you need as an ACCA candidate is to distinguish between cash and profit. Profit is calculated using the accruals basis—matching income with the period it was earned and expenses to the period they were incurred. Cash flow, on the other hand, shows when money physically moves in and out of the business.

A business might earn profit by making credit sales, but if customers pay much later (or not at all), the company could be short of cash. Similarly, non-cash expenses such as depreciation reduce profit but do not reduce cash.

Key Term: accruals basis
Recognising income and expenses when they are earned or incurred, not necessarily when cash changes hands.

Key Term: cash equivalents
Short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant changes in value.

The Statement of Cash Flows

IAS 7 requires most companies to prepare a statement of cash flows as part of their annual financial statements. This statement groups cash movements into three categories:

• Operating activities
• Investing activities
• Financing activities

Let’s examine each in turn.

Operating Cash Flows

Operating activities are the main revenue-producing activities of the entity. This includes receipts from customers and payments to suppliers and employees. The operating section often starts with profit before tax and adjusts for non-cash items and changes in working capital.

Key Term: operating activities
The principal revenue-generating activities of an entity and other activities that are not investing or financing.

Common Operating Cash Flows

• Cash receipts from sales of goods or services
• Cash payments to suppliers and employees
• Receipts and payments of operating expenses and taxes
• Interest paid or received (policy may differ by entity)

Worked Example 1.1

Ajay’s company collects $100,000 from customers, pays $70,000 to suppliers and $20,000 to employees in the year, and owes $6,000 of interest, paid in cash. What is the net cash flow from operating activities, assuming no other transactions?

Answer:
Net cash from operating activities is $100,000 (inflow) – $70,000 (suppliers) – $20,000 (employees) – $6,000 (interest) = $4,000 inflow.

Investing Cash Flows

Investing activities involve the acquisition and disposal of long-term assets or investments, except for those considered cash equivalents. Investing cash flows usually do not occur as regularly as operating flows.

Key Term: investing activities
The acquisition and disposal of long-term assets and other investments not included in cash equivalents.

Common Investing Cash Flows

• Cash payments to acquire property, plant and equipment (PPE)
• Cash receipts from selling PPE
• Payments to acquire shares or debt instruments of other companies
• Receipts from the sale of shares, debt instruments, or investment property
• Loans advanced to other parties, and cash receipts from their repayment

Worked Example 1.2

A company spends $40,000 on new equipment, receives $5,000 from selling an old asset, and invests $10,000 in another business. What is the net cash flow from investing activities?

Answer:
Net investing flow = Outflow $40,000 (equipment) + Inflow $5,000 (asset sale) + Outflow $10,000 (investment) = $45,000 net outflow.

Financing Cash Flows

Financing activities result in changes to the amount and composition of the contributed equity and borrowings of the business.

Key Term: financing activities
Activities that result in changes in the size and composition of the entity’s equity capital and borrowings.

Common Financing Cash Flows

• Proceeds from issuing shares or other equity instruments
• Cash proceeds from new loans or borrowings
• Repayment of amounts borrowed (loan repayments)
• Dividends paid to shareholders
• Interest paid (if classified here by policy)

Worked Example 1.3

Khalid Ltd issues $50,000 of new shares, repays $20,000 of a bank loan, and pays dividends of $8,000. What is the net cash flow from financing activities?

Answer:
Net financing flow = Inflow $50,000 (shares) – Outflow $20,000 (loan) – Outflow $8,000 (dividends) = $22,000 net inflow.

Summary Table: Typical Cash Flow Classifications

How the Statement of Cash Flows Is Structured

The statement of cash flows typically starts with net cash generated from operating activities, adjusts for investing activities, and then financing activities. The sum of all three gives the net increase or decrease in cash and cash equivalents for the period.

Key Term: IAS 7
The International Accounting Standard that prescribes the requirements for preparing and presenting the statement of cash flows.

Indirect and Direct Methods

IAS 7 allows two methods for determining cash flows from operating activities:

• Direct method: Lists cash receipts and payments directly.
• Indirect method: Starts with profit before tax and adjusts for non-cash items (such as depreciation) and changes in operating working capital.

Most entities use the indirect method because it uses readily available financial statement figures.

Exam Warning

You may be asked to classify transactions or prepare parts of a cash flow statement under exam conditions. Carefully read whether interest and dividends paid are classified as operating or financing cash flows—entity policy on these must be followed consistently.

Why Is the Statement of Cash Flows Important?

• It reveals firm solvency and short-term financial health
• It shows whether a business is self-sustaining or reliant on external finance
• It helps predict future cash flows and spot possible trouble even when profit is reported

Key Point Checklist

This article has covered the following key knowledge points:

• Differences between profit and cash flow, and why cash flow matters
• The structure and required headings of the statement of cash flows
• Correct classification of typical transactions as operating, investing, or financing cash flows
• Recognition that operating activities relate to the main trading activities of the business
• Understanding that investing activities relate to asset and investment transactions, while financing activities affect the entity’s capital and borrowing

Key Terms and Concepts

• cash flow
• accruals basis
• cash equivalents
• operating activities
• investing activities
• financing activities
• IAS 7