Learning Objectives
By the end of this lesson, learners should be able to:
- Explain the purpose of the statement of cash flows.
- Identify the three categories of cash flows.
- Distinguish between cash flow and accounting profit.
- Explain operating, investing and financing cash flows.
- Understand the importance of cash-flow information to executives.
- Use cash-flow information to assess liquidity and financial sustainability.
1. Meaning of the Statement of Cash Flows
The statement of cash flows provides information about the changes in an entity’s cash and cash equivalents during a reporting period.
Under IAS 7 Statement of Cash Flows, cash flows are classified into:
- Operating activities.
- Investing activities.
- Financing activities.
The statement helps users understand how an entity generates and uses cash and cash equivalents.
2. Cash and Cash Equivalents
Cash
Cash includes:
- Cash on hand.
- Demand deposits.
Cash Equivalents
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value.
They are generally held to meet short-term cash commitments, rather than for investment or other purposes.
3. Operating Activities
Operating activities are the principal revenue-producing activities of the entity and other activities that are not investing or financing activities.
Examples include:
- Cash receipts from customers.
- Cash payments to suppliers.
- Cash payments to employees.
- Cash payments for operating expenses.
- Cash receipts and payments relating to certain operating items.
Operating cash flow is particularly important because it indicates whether the entity’s core operations are generating sufficient cash.
4. Investing Activities
Investing activities relate to the acquisition and disposal of long-term assets and other investments that are not considered cash equivalents.
Examples include:
- Purchase of property, plant and equipment.
- Sale of property, plant and equipment.
- Purchase of certain investments.
- Sale of certain investments.
- Cash advances and collections of certain loans made to other parties.
Investing cash flows help executives understand how much cash is being committed to future capacity and investment.
5. Financing Activities
Financing activities result in changes in the size and composition of the contributed equity and borrowings of an entity.
Examples include:
- Proceeds from issuing shares.
- Repayment of borrowings.
- Proceeds from obtaining loans.
- Payments to owners relating to distributions, subject to applicable classification requirements.
Financing cash flows help executives understand how the organization funds its activities and manages its capital structure.
6. The Three Categories
A simplified structure is:
Operating Activities → Cash generated or consumed by core operations
Investing Activities → Cash used for or generated from investments
Financing Activities → Cash raised from or returned to capital providers
Together, these explain movements in cash and cash equivalents.
7. Direct and Indirect Methods
IAS 7 permits the presentation of operating cash flows using either:
Direct Method
Shows major classes of gross cash receipts and gross cash payments.
For example:
- Cash received from customers.
- Cash paid to suppliers.
- Cash paid to employees.
Indirect Method
Starts with profit or loss and adjusts for items such as:
- Non-cash items.
- Changes in working capital.
- Items whose cash effects are investing or financing cash flows.
The indirect method is widely used in practice.
8. Cash Flow versus Profit
An important executive principle is:
Profit does not equal cash flow.
An entity may report a profit while experiencing cash pressure.
This can happen because of:
- Credit sales.
- Large inventory purchases.
- Delayed customer collections.
- Significant capital expenditure.
- Debt repayments.
Therefore, executives should examine both the income statement and statement of cash flows.
9. Free Cash Flow
Free cash flow is a commonly used financial management measure rather than an IFRS-defined subtotal.
A simplified calculation is:
Free Cash Flow = Operating Cash Flow − Capital Expenditure
It can provide an indication of the cash available after maintaining or expanding the entity’s asset base, depending on the definition used.
Executives may use free cash flow when evaluating:
- Investment capacity.
- Debt repayment.
- Acquisitions.
- Distributions to owners.
- Strategic expansion.
Because definitions vary, executives should clearly understand how an organization’s free cash flow measure has been calculated.
10. Cash Management and Liquidity
Liquidity refers broadly to an entity’s ability to meet its obligations as they fall due.
Executives monitor:
- Cash balances.
- Expected receipts.
- Expected payments.
- Working capital.
- Debt maturities.
- Short-term financing requirements.
Effective cash management helps prevent situations where an otherwise profitable entity cannot meet immediate obligations.
11. Cash Flow and Working Capital
Working capital includes items such as:
- Trade receivables.
- Inventory.
- Trade payables.
Changes in these items can significantly affect operating cash flow.
For example:
Increase in receivables → Cash may be tied up in amounts owed by customers.
Increase in inventory → Cash may be committed to unsold goods.
Increase in payables → Cash payments may be deferred, subject to contractual and business considerations.
Executives therefore need to monitor working-capital movements carefully.
12. Cash Flow Analysis for Executives
Executives should ask:
- Is operating cash flow consistently positive?
- Is the organization dependent on borrowing to fund operations?
- How much cash is being invested in long-term assets?
- Are debt repayments sustainable?
- Are working-capital requirements increasing?
- Is reported profit supported by operating cash generation?
These questions help executives evaluate the quality and sustainability of financial performance.
13. Practical Executive Example
An international services company reports:
- Operating cash flow: $12 million
- Investing cash flow: $(7 million)
- Financing cash flow: $(3 million)
The net movement in cash is:
$12m − $7m − $3m = $2 million increase
The company is generating cash from operations while using cash for investment and financing activities.
An executive would then investigate:
- Whether the operating cash flow is sustainable.
- What investments generated the $7 million outflow.
- Why $3 million was used in financing activities.
- Whether sufficient liquidity remains for future obligations.
Lesson Summary
The statement of cash flows provides information about changes in cash and cash equivalents during a reporting period.
Under IAS 7, cash flows are classified into:
- Operating activities
- Investing activities
- Financing activities
Cash-flow information is essential because profitability and cash generation are not the same thing.
Executives should use cash-flow information to assess:
- Liquidity.
- Operating strength.
- Investment requirements.
- Financing dependence.
- Working-capital management.
- Financial sustainability.
Key Principle
A financially strong organization must not only generate accounting profit but also manage sufficient cash and cash equivalents to meet its obligations and support its strategic objectives.
References
- IFRS Foundation — IAS 7 Statement of Cash Flows
IAS 7 — Statement of Cash Flows - IFRS Foundation — Conceptual Framework for Financial Reporting
Conceptual Framework for Financial Reporting - IFRS Foundation — IAS 1 Presentation of Financial Statements
IAS 1 — Presentation of Financial Statements - Atrill, P. Financial Management for Decision Makers. Pearson.
- Brigham, E. F., & Ehrhardt, M. C. Financial Management: Theory & Practice. Cengage.
Executive Review Questions
- What is the purpose of the statement of cash flows?
- What are the three categories of cash flows under IAS 7?
- What are cash equivalents?
- What are operating activities?
- What are investing activities?
- What are financing activities?
- What is the difference between the direct and indirect methods of presenting operating cash flows?
- Why can an entity report profit while experiencing cash-flow difficulties?
- What is free cash flow?
- Why is liquidity important to executives?
- How can working-capital movements affect operating cash flow?
- What questions should executives ask when evaluating cash-flow performance?