Cash and Cash Equivalents
Cash and Cash Equivalents are crucial components of the Cash Flow Statement, reflecting a company's liquidity and short-term financial stability. Here’s a detailed explanation of these terms:
1. Cash
- Definition: Cash refers to currency on hand and demand deposits with banks. It includes all forms of cash readily available for immediate use.
- Examples: Coins, banknotes, checking accounts, and funds in bank accounts that are immediately accessible.
2. Cash Equivalents
- Definition: Cash equivalents are short-term, highly liquid investments that are easily convertible into known amounts of cash and are subject to an insignificant risk of changes in value.
- Criteria: To qualify as a cash equivalent, an investment must have a short maturity period, typically three months or less from the acquisition date.
- Examples: Treasury bills, commercial paper, and money market funds.
Classification of Cash Flows
According to Accounting Standard 3 (AS-3), cash flows are classified into three main categories: Operating Activities, Investing Activities, and Financing Activities. Each category provides insights into different aspects of a company's cash management and financial health.
1. Operating Activities
Definition: Operating activities are the principal revenue-producing activities of the company and other activities that are not investing or financing activities. They include transactions and events that affect net income.
• Cash Inflows from Operating Activities:
o Receipts from sales of goods and services.
o Receipts from royalties, fees, commissions, and other income.
o Receipts from the collection of interest and dividends.
• Cash Outflows from Operating Activities:
o Payments to suppliers for goods and services.
o Payments to and on behalf of employees (salaries, wages).
o Payments of interest on borrowings.
o Payments of income taxes (unless specifically investing or financing).
Calculation: Under the indirect method, operating cash flow is derived from net income by adjusting for changes in working capital accounts and non-cash items. Under the direct method, it is calculated by directly adjusting cash inflows and outflows from operating activities.
2. Investing Activities
Definition: Investing activities involve the acquisition and disposal of long-term assets and other investments not included in cash equivalents. They reflect changes in the company's investment portfolio and capital assets.
• Cash Inflows from Investing Activities:
o Proceeds from the sale of property, plant, and equipment.
o Proceeds from the sale of investments (such as stocks and bonds).
o Receipts from the collection of loans made to others.
• Cash Outflows from Investing Activities:
o Payments for the purchase of property, plant, and equipment.
o Payments for the purchase of investments.
o Payments for loans made to others.
Calculation: Investing cash flows are calculated based on the cash transactions involving the acquisition or disposal of long-term assets and investments.
3. Financing Activities
Definition: Financing activities relate to changes in the size and composition of the company’s capital structure. They involve transactions with the company’s owners and creditors.
• Cash Inflows from Financing Activities:
o Proceeds from issuing shares or other equity instruments.
o Proceeds from issuing debt (bonds, loans).
• Cash Outflows from Financing Activities:
o Payments to repay borrowings (principal payments on loans and bonds).
o Payments for repurchasing shares (buybacks).
o Payments of dividends to shareholders.
Calculation: Financing cash flows are calculated based on cash transactions related to the company’s capital structure, including raising and repaying capital.
Preparing Cash Flow Statement under Direct Method
The Direct Method of preparing the Cash Flow Statement involves reporting cash flows from operating activities by directly listing all major types of cash receipts and payments. This method provides a clear view of cash flows by showing the specific cash inflows and outflows, making it more intuitive for users.
Here’s how the Cash Flow Statement is prepared under the Direct Method:
1. Operating Activities
• Cash Receipts:
o Cash from Customers: Total receipts from customers, calculated by adjusting net sales for changes in accounts receivable.
o Interest and Dividends Received: Cash received from investments and interest-bearing accounts.
• Cash Payments:
o Payments to Suppliers: Total cash paid to suppliers, which is calculated by adjusting purchases for changes in accounts payable.
o Payments to Employees: Total cash paid as salaries and wages, adjusted for changes in accrued expenses.
o Interest Paid: Total cash paid for interest on borrowings.
o Income Taxes Paid: Total cash paid for income taxes.
Formula for Cash Flows from Operating Activities (Direct Method):
Cash Flows from Operating Activities=Cash Receipts from Customers−Cash Payments to Suppliers and Employees−Interest Paid−Income Taxes Paid
2. Investing Activities
• Cash Inflows:
o Proceeds from Sale of Assets: Cash received from the sale of property, plant, and equipment.
o Proceeds from Sale of Investments: Cash received from selling investment securities.
o Collections on Loans: Cash received from the repayment of loans made to others.
• Cash Outflows:
o Purchase of Assets: Cash paid for acquiring property, plant, and equipment.
o Purchase of Investments: Cash paid for purchasing investment securities.
o Loans Made: Cash used for issuing loans to other parties.
Formula for Cash Flows from Investing Activities:
Cash Flows from Investing Activities=Proceeds from Sale of Assets−Cash Payments for Acquisitions + Collections on Loans−Loans Made
3. Financing Activities
• Cash Inflows:
o Proceeds from Issuance of Shares: Cash received from issuing equity shares.
o Proceeds from Borrowings: Cash received from taking on new debt.
• Cash Outflows:
o Repayment of Borrowings: Cash used to repay principal amounts of loans and bonds.
o Repurchase of Shares: Cash used to buy back the company's own shares.
o Dividends Paid: Cash paid to shareholders as dividends.
Formula for Cash Flows from Financing Activities:
Cash Flows from Financing Activities=Proceeds from Issuance of Shares + Proceeds from Borrowings−Repayment of Borrowings−Repurchase of Shares−Dividends Paid
Example of Direct Method Cash Flow Statement
Let’s consider a simplified example:
Operating Activities:
- Cash received from customers: $500,000
- Cash paid to suppliers: $200,000
- Cash paid to employees: $100,000
- Interest paid: $10,000
- Income taxes paid: $20,000
Investing Activities:
- Proceeds from sale of equipment: $50,000
- Purchase of new equipment: $70,000
Financing Activities:
- Proceeds from issuance of shares: $100,000
- Repayment of loans: $30,000
- Dividends paid: $20,000
Cash Flow Statement under Direct Method:
Operating Activities:
Net Cash Flow from Operating Activities=$500,000−$200,000−$100,000−$10,000−$20,000=$170,000
Investing Activities:
Net Cash Flow from Investing Activities=$50,000−$70,000=−$20,000
Financing Activities:
Net Cash Flow from Financing Activities=$100,000−$30,000−$20,000=$50,000
Net Increase in Cash:
Net Increase in Cash=$170,000−$20,000+$50,000=$200,000
In summary, cash and cash equivalents include cash on hand and short-term, highly liquid investments. Cash flows are classified into operating, investing, and financing activities according to AS-3, reflecting various aspects of financial management. The direct method for preparing the Cash Flow Statement involves reporting specific cash receipts and payments, offering a detailed view of cash movements in the operating, investing, and financing activities. This method provides clarity on the company's cash generation and usage, essential for financial analysis and decision-making.
Subscribe on YouTube - NotesWorld
For PDF copy of Solved Assignment
Any University Assignment Solution
.webp)
