A cash flow statement is prepared according to the guidelines set by the International Accounting Standard 7 (IAS 7). This shows the effects of change in the values in the statement of financial performance and statement of financial position. It evaluates a business’ liquidity and solvency. It is less likely to be manipulated as figures are based on the amount of cash flows but the fact that historical data is considered can make it a bit limiting.
A cash flow statement can be prepared by using the direct method which uses costs of operating activties such as cash paid:
- from customers
- to suppliers
- for expenses
- for wages/salaries
Using this method can be quite difficult (and a bit more expensive) as the information needed to prepare a cash flow statement cannot be found elsewhere in the financial statements. The advantage of this is that it shows a good and honest picture of how cash flows from the company’s operations.
The indirect method first uses the profit before tax. This is taken from the statement of financial position and eventually adjusted for the interest and other non cash items (profit or loss on disposal of fixed assets, amortization of goodwill, etc.). Next, cash from operating activities figure is taken from making working capital changes, with increases in inventory and receivables are deducted while increase in the payable is added to the profit figure. Similaryly, a decrease in the receivables is added while a decrease in payables is added to the profit figure. To get net cash from operating activities, the amount of interest and income tax paid is deducted from cash from operating activities.
