CIMA - C2 Fundamentals of Financial Accounting
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360 24: Statements of cash flows ⏐ Part D Interpretation of accounts
COLBY CO
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2
20X1
$'000
$'000
$'000
$'000
Assets
Property, plant and equipment
Cost
1,596
1,560
Depreciation
318
224
1,278
1,336
Current assets
Inventory
24
20
Trade receivables
76
58
Bank
48
56
148
134
Total assets
1,426
1,470
Equity and liabilities
Capital and reserves
Share capital
360
340
Share premium
36
24
Retained earnings
686
490
1,082
854
Non-current liabilities
Non-current loans
200
500
Current liabilities
Trade payables
12
6
Taxation
102
86
Proposed dividend
30
24
144
116
1,426
1,470
During the year, the company paid $90,000 for a new piece of machinery.
Dividends paid and proposed for the year (before the reporting date) totalled $72,000.
Required
Prepare a statement of cash flows for Colby Co for the year ended 31 December 20X2 in accordance with the
requirements of IAS 7, using the indirect method.
Solution
Step 1
Set out the proforma statement of cash flows with the headings required by IAS 7. You should leave
plenty of space. Ideally, use three or more sheets of paper, one for the main statement, one for the notes
and one for your workings. It is obviously essential to know the formats very well.
Step 2
Begin with the reconciliation of profit before tax to net cash from operating activities as far as possible.
When preparing the statement from statements of financial position, you will usually have to calculate
such items as depreciation, loss on sale of non-current assets, profit for the year and tax paid (see Step
4). Note that you may not be given the tax charge in the income statement. You will then have to assume
that the tax paid in the year is last year's year-end provision and calculate the charge as the balancing
figure.
Step 3
Calculate the cash flow figures for dividends paid, purchase or sale of non-current assets, issue of shares
and repayment of loans if these are not already given to you (as they may be).
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Part D Interpretation of accounts ⏐ 24: Statements of cash flows 361
Step 4
If you are not given the profit figure, open up a working for the trading, income and expense account.
Using the opening and closing balances, the taxation charge and dividends paid and proposed, you will be
able to calculate profit for the year as the balancing figure to put in the net profit to net cash flow from
operating activities section.
Step 5
You will now be able to complete the statement by slotting in the figures given or calculated.
COLBY CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000
$'000
Net cash flow from operating activities
Profit before tax
392
Depreciation charges
118
Loss on sale of property, plant and equipment
18
Interest expense
28
Increase in inventories
(4)
Increase in receivables
(18)
Increase in payables
6
Cash generated from operations
540
Interest paid
(28)
Dividends paid (72 − 30 + 24)
(66)
Tax paid (86 + 124 – 102)
(108
)
Net cash flow from operating activities
338
Cash flows from investing activities
Payments to acquire property, plant and equipment
(90)
Receipts from sales property, plant and equipment
12
Net cash outflow from investing activities
(78)
Cash flows from financing activities
Issues of share capital (360 + 36 − 340 − 24)
32
Long-term loans repaid (500 − 200)
(300
)
Net cash flows from financing
(268
)
Decrease in cash and cash equivalents
(8)
Cash and cash equivalents at 1.1.X2
56
Cash and cash equivalents at 31.12.X2
48
Working: property, plant and equipment
COST
$'000
$'000
At 1.1.X2
1,560
At 31.12.X2
1,596
Purchases
90
Disposals (balance)
54
1,650
1,650
ACCUMULATED DEPRECIATION
$'000
$'000
At 31.1.X2
318
At 1.1.X2
224
Depreciation on disposals
Charge for year
118
(balance)
24
342
342
NBV of disposals
30
Net loss reported
(18
)
Proceeds of disposals
12
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362 24: Statements of cash flows ⏐ Part D Interpretation of accounts
Question
Statement of cash flows 2
Set out below are the financial statements of Shabnum Co. You are the financial controller, faced with the task of
implementing IAS 7 Statement of cash flows.
SHABNUM CO
INCOME STATEMENT FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000
Revenue
2,553
Cost of sales
(1,814
)
Gross profit
739
Distribution costs
(125)
Administrative expenses
(264
)
350
Interest received
25
Interest paid
(75
)
Profit before taxation
300
Taxation
(140
)
Profit for the period
160
SHABNUM CO
STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER
20X2
20X1
Assets
$'000
$'000
Non-current assets
Property, plant and equipment
380
305
Intangible assets
250
200
Investments
–
25
Current assets
Inventories
150
102
Receivables
390
315
Short-term investments
50
–
Cash in hand
2
1
Total assets
1,222
948
Equity and liabilities
Equity
Share capital ($1 ordinary shares)
200
150
Share premium account
160
150
Revaluation reserve
100
91
Retained earnings
160
100
Non-current liabilities
Loan
170
50
Current liabilities
Trade payables
127
119
Bank overdraft
85
98
Taxation
120
110
Dividends proposed
100
80
Total equity and liabilities
1,222
948
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Part D Interpretation of accounts ⏐ 24: Statements of cash flows 363
The following information is available.
(a) The proceeds of the sale of non-current asset investments amounted to $30,000.
(b) Fixtures and fittings, with an original cost of $85,000 and a net book value of $45,000, were sold for $32,000
during the year.
(c) The following information relates to property, plant and equipment
31.12.20X2 31.12.20X1
$'000
$'000
Cost
720
595
Accumulated depreciation
340
290
Net book value
380
305
(d) 50,000 $1 ordinary shares were issued during the year at a premium of 20c per share.
(e) Dividends for 20X2 were declared before the reporting date. No payment has yet been made.
Required
Prepare a statement of cash flows for the year to 31 December 20X2 using the format laid out in IAS 7.
Answe
r
SHABNUM CO
STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 31 DECEMBER 20X2
$'000 $'000
Net cash flows from operating activities
Profit before tax 300
Depreciation charge (W1) 90
Interest expense 50
Loss on sale of property, plant and equipment (45 – 32) 13
Profit on sale of non-current asset investments (5)
(Increase)/decrease in inventories (48)
(Increase)/decrease in receivables (75)
Increase/(decrease) in payables
8
Cash generated from operating activities 333
Interest received 25
Interest paid (75)
Dividends paid (80)
Tax paid (110 + 140 – 120)
(130
)
Net cash flow from operating activities 73
Cash flows from investing activities
Payments to acquire property, plant and equipment (W2) (201)
Payments to acquire intangible non-current assets (50)
Receipts from sales of property, plant and equipment 32
Receipts from sale of non-current asset investments
30
Net cash flows from investing activities (189)
Cash flows from financing activities
Issue of share capital 60
Long-term loan
120
Net cash flows from financing
180
Increase in cash and cash equivalents (Note) 64
Cash and cash equivalents at 1.1 X2 (Note)
(97
)
Cash and cash equivalents at 31.12.X2 (Note)
(33
)
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364 24: Statements of cash flows ⏐ Part D Interpretation of accounts
NOTES TO THE STATEMENT OF CASH FLOWS
Note: analysis of the balances of cash and cash equivalents as shown in the statement of financial position
Change
20X2
20X1
in year
$'000
$'000
$'000
Cash in hand
2
1
1
Short term investments
50
–
50
Bank overdraft
(85
)
(98)
13
(33
)
(97)
64
Workings
1 Depreciation charge
$'000
$'000
Depreciation at 31 December 20X2
340
Depreciation 31 December 20X1
290
Depreciation on assets sold (85 − 45)
40
250
Charge for the year
90
2 Purchase of property, plant and equipment
PROPERTY, PLANT AND EQUIPMENT
$'000
$'000
1.1.X2 Balance b/d
595
Disposals
85
Revaluation (100 − 91)
9
Purchases (bal fig)
201
31.12.X2 Balance c/d
720
805
805
2.2 The advantages of cash flow accounting
The advantages of cash flow accounting are as follows.
(a) Survival in business depends on the ability to generate cash. Cash flow accounting directs attention
towards this critical issue.
(b) Cash flow is more comprehensive than 'profit' which is dependent on accounting conventions and
concepts.
(c) Lenders (long and short-term) are more interested in an enterprise's ability to repay them than in its
profitability. Whereas 'profits' might indicate that cash is likely to be available, cash flow accounting is
more direct with its message.
(d) Cash flow reporting provides a better means of comparing the results of different companies than
traditional profit reporting.
(e) Cash flow reporting satisfies the needs of all users better.
(i) For management, it provides the sort of information on which decisions should be taken: (in
management accounting, 'relevant costs' to a decision are future cash flows); traditional profit
accounting does not help with decision-making.
(ii) For shareholders and auditors, cash flow accounting can provide a satisfactory basis for
stewardship accounting.
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Part D Interpretation of accounts ⏐ 24: Statements of cash flows 365
(iii) As described previously, the information needs of lenders and employees will be better served by
cash flow accounting.
(f) Cash flow forecasts are easier to prepare, as well as more useful, than profit forecasts.
(g) They can in some respects be audited more easily than accounts based on the accruals concept.
(h) The accruals concept is confusing, and cash flows are more easily understood.
(i) Cash flow accounting should be both retrospective, and also include a forecast for the future. This is of
great information value to all users of accounting information.
(j) Forecasts can subsequently be monitored by the publication of variance statements which compare actual
cash flows against the forecast.
Question
Cash flow accounting
Can you think of some possible disadvantages of cash flow accounting?
Answer
The main disadvantages of cash accounting are essentially the advantages of accruals accounting (proper matching of
related items). There is also the practical problem that few businesses keep historical cash flow information in the form
needed to prepare a historical statement of cash flows and so extra record keeping is likely to be necessary.
2.3 Criticisms of IAS 7
The inclusion of cash equivalents has been criticised because it does not reflect the way in which businesses are
managed: in particular, the requirement that to be a cash equivalent an investment has to be within three months of
maturity is considered unrealistic.
The management of assets similar to cash (ie 'cash equivalents') is not distinguished from other investment decisions.
You could be asked to calculate the cash flow from any section.
Question
Operating cash flow
What is the cash flow from operating activities?
A Profit adjusted for non-cash items.
B Cash from selling non-current assets
C Cash from issuing long-term loans
D Cash from the issue of share capital
Answer
A. Cash flow from operating activities is the profit adjusted to remove non-cash items such as depreciation.
Assessment
focus point
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366 24: Statements of cash flows ⏐ Part D Interpretation of accounts
Chapter roundup
• Statements of cash flows are a useful addition to the financial statements of companies because it is recognised that
accounting profit is not the only indicator of a company's performance.
• Statements of cash flows concentrate on the sources and uses of cash and are a useful indicator of a company's
liquidity and solvency.
• You need to be aware of the format of the statement as laid out in IAS 7. Setting out the format is the first step. then
follow the step-by-step preparation procedure.
Quick quiz
1 What is the objective of IAS 7?
2 What are the benefits of cash flow information according to IAS 7?
3 Define cash and cash equivalents according to IAS 7.
4 Which of the following headings is not a classification of cash flows in IAS 7?
A Operating C Administration
B Investing D Financing
5 What is the 'indirect method' of preparing a statement of cash flows?
6 Set out the five steps required in preparing a statement of cash flows.
7 What are the advantages of cash flow accounting?
Answers to quick quiz
1 To provide information to users about the company's ability to generate cash and cash equivalents.
2 Further information is available about liquidation and solvency, of the change in net assets, the ability to adapt to
changing circumstances and comparability between enterprises.
3 See Para 1.5, Key Terms.
4 C. Administration costs are a classification in the income statement, not the statement of cash flows.
5 The operating cash flow is arrived at by adjusting net profits (or loss) for non-cash items and changes in inventories,
operating receivables and operating payables.
6 See Paragraph 2.1.
7 See Paragraph 2.2.
Now try the questions below from the Question Bank
Question numbers Page
115–119 412
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367
Topic list Syllabus references
1 Ratio analysis D (10)
2 Profit margin, asset turnover and return on capital employed D (10)
3 Working capital D (10)
4 Liquidity D (10)
5 Gearing D (10)
6 Items in company accounts formats D (10)
Interpreting company
accounts
Introduction
So far your studies have concentrated on the preparation of accounts. This chapter focuses
on interpretation primarily by means of ratio analysis.
The purpose of financial statement analysis is to aid decision-making. The financial statements help
interested persons decide on questions such as whether to lend a business money or invest in its
shares.
It has already been mentioned (in Chapter 1) that the users of financial statements extend
beyond present and potential shareholders and payables and include such groups as
employees, government bodies and society at large. We will not attempt to deal with the
possible decision needs of each class of user - such a discussion would require a book of its
own. Instead we will concentrate on three aspects relevant to all groups of users, namely its
profitability, liquidity and gearing. The topics will be discussed in terms of limited companies,
but it should be realised that most of the points will be relevant when examining the accounts
of other business entities.
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368 25: Interpreting company accounts ⏐ Part D Interpretation of accounts
1 Ratio analysis
Ratio analysis is the calculation of ratios (eg profit margin) from a set of financial statements which is used for
comparison with either earlier years or similar businesses to provide information for decision-making.
1.1 Comparing different businesses
When ratio analysis is used to assess the relative strength of a particular business, by comparing its profitability and
financial stability with another business, the two businesses should be largely similar.
• In size
• In their line of activities
If the businesses are not broadly similar in size or in what they do, then differences revealed by ratio analysis might
merely arise as a natural consequence of the size difference, or the varying lines of business they operate in. We do not
need ratios to tell us that one business is larger, or that two businesses operate in entirely different industries!
2 Profit margin, asset turnover and return on capital employed
2.1 Profit margin
Profit margin. This is the ratio of profit to sales, and may also be called 'profit percentage' or 'profit to turnover ratio'. It
is calculated as
Net or gross profit
100%
Sales
×
For example, if a company makes a profit of $20,000 on sales of $100,000 its profit percentage or profit margin is 20%.
This also means that its costs are 80% of sales. A high profit margin indicates.
(a)
Either costs are being kept well under control because if the ratio of costs:sales goes down, the profit
margin will automatically go up. For example, if the costs:sales ratio changes from 80% to 75%, the profit
margin will go up from 20% to 25%.
(b)
Or sales prices are high. For example, if a company sells goods for $100,000 and makes a profit of $16,000
costs would be $84,000 and the profit margin is 16%. Now if the company can raise selling prices by 20% to
$120,000 without affecting the volume of goods sold or their costs, profits would rise by the amount of
revenue increase ($20,000) to $36,000 and the profit margin would also rise (from 16% to 30%).
2.2 Asset turnover
Asset turnover. This is the ratio of sales in a year to the amount of net assets (capital) employed. It is calculated as
Sales
Net assets or capital employed
For example, if a company has sales in 20X4 of $720,000 and has assets of $360,000, the asset turnover will be
000,360$
000,720$
= 2 times.
Key term
Key term
FA
S
T F
O
RWAR
D
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 369
This means that for every $1 of assets employed, the company can generate sales turnover of $2 per annum. To utilise
assets more efficiently, managers should try to create a higher volume of sales and so a higher asset turnover ratio. For
example, suppose that our firm with assets of $360,000 can increase its sales turnover from $720,000 to $900,000 per
annum. The asset turnover would improve to
000,360$
000,900$
= 2.5 times.
The significance of this improvement is that if a business can create more sales turnover from the same amount of assets it
should make larger profits (because of the increase in sales) without having to increase the size of its investment.
2.3 Return on Capital Employed
Return on capital employed (ROCE) is the amount of profit as a percentage of capital employed. It is calculated as
Profit
100%
Capital employed or net assets
×
Return in an investing sense means a reward for investing in a business.
If a company makes a profit of $30,000, we do not know how good or bad this profit is until we look at the amount of
capital which has been invested to achieve the profit. $30,000 might be a good-sized profit for a small firm, but it would
not be good enough for a
'giant' firm such as Marks and Spencer.
For this reason, it is helpful to measure performance by relating profits to the amount of capital employed, and because
this seems to be the
only satisfactory ratio or percentage which judges profits in relation to the size of the business, it is
sometimes called the
primary ratio in financial analysis.
Question
Ratios
A business has the following results
Sales $450,000
Profit $100,000
Net assets $400,000
Calculate:
(a) The profit margin
(b) Asset turnover
(c) Return on capital employed
Answer
(a)
%22.22%100
000,450$
000,100$
=×
(b)
times1.125
$400,000
$450,000
=
(c)
400,000
100,000
× 100% = 25%
Key term
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