Classification of cash flows
IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements. A statement of cash flows classifies and presents cash flows under three headings:
(i) Operating activities;
(ii) Investing activities; and
(iii) Financing activities.
Operating activities can be presented in two different ways. The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and employees. The second is the indirect method which reconciles profit before tax to cash generated from operations. Under both of these methods the interest paid and taxation paid are then presented as cash outflows deducted from the cash generated from operations to give net cash from operating activities.
Investing activities cash flows are those that relate to non-current assets, including investments. Examples of cash flows from investing activities include the cash outflow on buying PPE, the sale proceeds on the disposal of non-current assets and any cash returns received arising from investments.
Financing activities cash flows relate to cash flows arising from the way the entity is financed. Entities are financed by a mixture of cash from borrowings (debt) and cash from shareholders (equity). Examples of cash flows from financing activities include the cash received from new borrowings or the cash repayment of debt. It also includes the cash flows related to shareholders in the form of cash receipts following a new share issue or the cash paid to them in the form of dividends.
Operating activities – the direct method and indirect method
As noted above, IAS 7 permits two different ways of reporting cash flows from operating activities – the direct method and the indirect method.
The direct method is intuitive as it means the statement of cash flow starts with the source of operating cash flows. This is the cash receipts from customers. The operating cash outflows are payments for wages, to suppliers and for other operating expenses which are deducted. Finally, the payments for interest and tax are deducted.
Alternatively, the indirect method starts with profit before tax rather than a cash receipt. The profit before tax is then reconciled to the cash that it has generated. This means that the figures at the start of the cash flow statement are not cash flows at all. In that initial reconciliation, the profit before tax is adjusted for income and expenses that have been recorded in the statement of profit or loss but are not cash inflows or outflows. For example, depreciation and losses on disposal of non-current assets, have to be added back, and non-cash income such as investment income and profits on disposal of non-current assets are deducted.
The changes in working capital (i.e. inventory, trade receivables and trade payables) do not impact on the profit but these changes will impact cash and so further adjustments are made. For example, an increase in the levels of inventory and receivables will not impact profit before tax but will have had an adverse impact on the cash flow of the business. Therefore, in the reconciliation process, the increases in inventory and trade receivables are deducted from profit before tax. Conversely, decreases in inventory and trade receivables are added back to the profit before tax. The opposite is applicable for trade payables.
For each movement in working capital, you must consider whether it has had a favourable or unfavourable cash flow impact on the business. If the impact is favourable, then the movement in the year should be added on to profit before tax as part of the reconciliation. If the impact is unfavourable, then it should be deducted.
Finally, the payments for interest and tax are presented.
The following example illustrates both the direct and indirect methods.
EXAMPLE 4 – The direct and indirect methods
Extracts from the financial statements are as follows