Before we begin making a cash flow statement from balance sheet and income statement, take note of these tips, they are very important. I will list them and then explain more about them.
Examples would be given as each point is explained, after that, we take an example of a comparative balance sheet and an income statement and then use these financial statements to create a statement of cash flows.
Examples and calculations would be shown while explaining the above points; after that, we will pick 1 question and use it to make a cash flow statement from a balance sheet and income statement.
Cash and cash equivalents are the most important items of the cash flow statement because whatever you are calculating and recording in the statement of cash flows is simply the movements in the Cash and cash equivalents occurring during the fiscal year or during the reporting period.
Cash equivalents can be defined as assets that can easily be converted to cash within 6 months.
A good example of a cash equivalent is cash in the bank account. Other examples of cash equivalents include short-term investments such as short-term treasury bills or investments in buying shares of another company.
This shows that after preparing your cash flow statement using the balance sheet and income statement, the net change in Cash and cash equivalents for the current reporting period should be equal to the difference between the Cash and cash equivalents of the previous reporting period and the current reporting period; if they are not equal, then it shows you have prepared your cash flow statement wrongly.
Therefore, the Cash and cash equivalents help in the substantiation of the statement of cash flows to prove that it was prepared correctly.
Having known the importance of the Cash and cash equivalents, it is necessary to calculate the net increase or decrease in the Cash and cash equivalents even before building the cash flow statement from the balance sheet.
Below is an excerpt from a comparative balance sheet showing the cash and cash equivalents, use it to calculate the net increase or decrease in Cash and cash equivalents.
| 2019 | 2020 | |
|---|---|---|
| Short term investments | 10 | 40 |
| Cash in hand | 60 | 90 |
| Cash in the bank | 40 | 30 |
From the table above, the total Cash and cash equivalents for the fiscal year 2019 is 10+60+40 = 110 whereas the total Cash and cash equivalents for the fiscal year 2020 is 40+90+30 = 160
This example shows that as the company moves from one year to another, there is an increase in the cash and cash equivalents from 110 to 160. It means there is a net increase of +50 of the cash and cash equivalents. If there was a decrease in the cash and cash equivalents as we move to this current year, it means cash is being spent, this would have been negative. So it is important that you specify the negative and positive signs.
Below is an excerpt from a comparative balance sheet showing the cash and cash equivalents, use it to calculate the net increase or decrease in Cash and cash equivalents.
| Current Assets | 2019 | 2020 |
|---|---|---|
| Short term investments | 10 | 40 |
| Cash in hand | 40 | 30 |
| Cash in the bank | 60 | – |
| Current Liabilities | ||
| Trade Payables | – | – |
| Bank | – | 10 |
The above table has cash and cash equivalents listed under the liabilities section. What you will do when there is a cash and cash equivalent under the liability section is to subtract any liability that is a cash and cash equivalent from the current assets that are part of the cash and cash equivalents.
In the above example, the cash and cash equivalents is a bank draft of $10. This means our net change in cash and cash equivalents would be calculated as 10+40+60 = 110 – (40+30) – 10 (from the liability section); this gives net cash and cash equivalents of +30.
Once you know how to calculate the net increase or decrease of the cash and cash equivalents; you can begin calculating the values for all the 3 major sections of the cash flow statement (i.e, cash flows from operations, investing and financing).
The statement of cash flows prepared using the indirect method adjusts net income for the changes in balance sheet accounts to calculate the cash from operating activities. In other words, changes in asset and liability accounts that affect cash balances throughout the year are added to or subtracted from net income at the end of the period to arrive at the operating cash flow.
In order to build a cash flow statement from balance sheet and income statement, you will need the following: a copy of the company’s balance sheet for two accounting periods (previous year and current year) and a copy of the company’s income statement for the current accounting period. Additional information may have to be given to have a complete picture.
The balance sheet shows the financial position at a point in time, hence, you need the previous accounting date and the current accounting date in order to determine the changes that have occurred over this period (this means you need the comparative balance sheet of the previous fiscal year and the current fiscal year). Once you have these financial statements, you can begin building your cash flow statement from scratch.
The net profit is easy to find on the income statement, it is located at the bottom. In some cases, the examiner may not give you the net income directly; the profit after tax may just be what will be given.
If you are given profit after tax in a job interview question or in an exam, you must look for the tax expense from the income statement and add it back to the profit after tax in order to get the profit before tax. This is important due to the fact that tax expense is regarded as a non cash transaction because companies record the tax expense while preparing an income statement but that does not necessarily mean that the actual cash has been paid to the government agency in charge of tax (IRS); it may be paid at a later date, hence, tax expense is not regarded as a cash transaction in preparing a cash flow statement.
Please note that the statement of cash flows deals only with transactions that are paid with cash or cash equivalents. It doesn’t record transactions purchased on credit. This is important to note because whatever we are going to use from the balance sheet and income statement must be cash transactions. Any non-cash transaction from the income statement must be subtracted from the net income or added to the net income, depending on whether the non-cash transaction was an expense or gain.
The net income used in building the cash flow statement from the balance sheet is gotten from the income statement, but you have to understand that such net income is derived by calculating the difference between the Total Revenues and the Total Expenses (i.e Total Revenues – Total Expenses). This means the total revenue also includes both cash and non-cash revenues; the same applies to the total expenses – it also includes both cash and non-cash expenses.
Since the statement of cash flows is only concerned with the cash movements, it means starting the cash flow statement with the net income will require you to remove the effects or impact of the non-cash transactions associated with the net income. I will give some examples of how you can make these non-cash adjustments to the net income below.
If a non cash transaction was added when calculating the net income on the income statement, then it will be subtracted from the net income on the cash flow statement when using the indirect method. But if a non cash transaction was subtracted when calculating the net income on the income statement, then it will be added to the net income on the cash flow statement when using the indirect method. These 2 rules are very important when preparing a cash flow statement from a balance sheet and income statement.
First, we add back the depreciation. Please note that you will only add back depreciation if it was used to calculate the net profit of the income statement.
For example, you purchased a machine for $600; we need to calculate the depreciation. Before calculating the depreciation, you have to give it an estimated useful life.
So let’s assume you gave it an estimated useful life of 10 years. Your depreciation would now be calculated using the formula: (purchased price/estimated useful life); this gives a depreciation of 600/10 = $60. What this means is that every year, you will deduct $60 from the Selling, General and Administrative (SGA) expenses section of the balance sheet.
Assuming you used the machine for 4 years, at the end of the fourth year, the accumulated depreciation would be 4X60 = $240. This means your net book value at the end of the 4th year would be 600 – 240 = $360; that means the net book value is the value of an asset that remains after it has been depreciated.
You have to remember that our net book value was calculated from an estimated useful life, which means at the end of the 4th year, the true value of our machine may be more than the net book value, it may be less, or equal.
Now, since you used the estimated useful life in calculating the depreciation and also deducting the depreciation in order to arrive at the net income; what this means is that you didn’t actually pay any cash as depreciation, it was just an estimate; and because it is an estimate, the IAS 7 guideline for preparing a statement of cash flows does not permit it to be included in the cash flow statement; therefore, its effect has to be canceled and because you deducted it in order to arrive at the net income, we have to add it back to the net income when using the indirect method of preparing a cash flow statement from the balance sheet and income statement.
Still on the machine, assuming you sell it at the end of the 4th year for $400, it means you have made a profit of 400 – 360 = $40 (that is, selling price – estimated value). You see, this $40 cannot be recorded in the cash flow statement because it was derived using an estimate from a non cash transaction.
Other non-cash transactions are adjusted in the same way that depreciation is adjusted when building a cash flow statement using the indirect method. That means if one noncash transaction was added to the items on the balance sheet in order to arrive at the net income, such a transaction must be subtracted from the net income when preparing a cash flow statement using the indirect method.
If another noncash transaction was subtracted from the items on the profit and loss statement in order to arrive at the net income, the transaction must be added to the net income when preparing a cash flow statement (this is done in order the cancel the effects of the non cash transactions.
If there is a profit on the sale of a noncurrent asset that has been added to “Other income” and therefore used in arriving at the net income, then you have to subtract it from the net income while preparing your cash flow statement using the indirect method.
But, if there is a loss on the sale of a non-current asset that has been subtracted from “Other income” and therefore used in arriving at the net income on the income statement, then you have to add it back to the net income on your cash flow statement while preparing it using the indirect method.
Remember, these adjustments are made because we are only interested in cash transactions in a statement of cash flows.
The working capital includes transactions affecting inventories, cash receivables, and cash payables. Cash and cash equivalents are part of the working capital, but since the whole essence of a cash flow statement is to show the inflow and outflow of cash and cash equivalents, it is not included under this section of the cash flow statement.
Negative and positive signs before the values in your cash flow statement are very important because they show the movement of cash. An outflow of cash is a reduction in your cash whereas an inflow of cash is an increase of cash. This rule is very important in recording your transactions.
Please note also that the cash flow statement does not care about the ITEMS being transacted but ONLY the CASH; so always ask yourself in any transaction whether it is causing a reduction in cash (outflow) or an increase in cash (inflow) and then use the appropriate sign needed. Examples of the use of these cash movements and the positive and negative signs are shown in calculating the working capital changes below.
Inventories are found on the balance sheet. To calculate the changes in the inventories, you check if there is an increase or decrease in inventories from the previous reporting period to this current reporting period.
An increase in inventories as you move from the previous accounting period to the current accounting period means you spent more cash in order to add the inventories; this means your cash is reduced (outflow of cash) in order to buy more inventories. On your cash flow statement, it is indicated as “Increase in inventories” with a negative sign.
A decrease in inventories as you move from the previous accounting period to the current accounting period means you sold out your products, leading to a reduction in the inventories; this means your cash is increased (inflow of cash). On your cash flow statement, it is indicated as “Decrease in inventories” with a positive sign.
| January 2022 | January 2023 | |
|---|---|---|
| Inventories | $40 | $60 |
From the table above, we can see that there is an increase in inventories from $40 to $60. This means there is an outflow of cash (that is, cash is spent in order to buy more inventories). The cash flow statement would look like the sample below:
