From a financial point of view, a firm basically generates cash and spends cash. It generates cash when it issues securities, raises a bank loan, sells a product, disposes an asset, so on and so forth. It spends cash when it redeems securities, pays interest and dividends, purchases materials acquires an asset, so on and so forth. The activities that generate cash are called sources of cash and the activities that absorb cash are called uses of cash.
To understand how a firm has obtained cash and how spent cash during a given period we need to look at the changes in each of the item in the balance sheet over that period. As an illustration, Exhibit shows the balance sheets of Horizon Limited as on 3.3.20X0 and 31.3.20X1. The change is various items of the balance sheet are noted in the last two columns of the statement.
Looking at the statement we find that a number of things have changed over the year. For example, terms loans increased by Rs 12 million and fixed assets (net) increased by Rs 8 million. Which of these changes represents a source of cash and which a use of cash? Our common sense tells us that a firm generates cash when it increases its liabilities (as well as owners’ equity); on the other hand it uses when it buys assets or reduces its liabilities. Thus, the following picture emerges.
Sources of Cash>
1) Increase in liabilities and owners’ equity
2) Decrease in assets (other than cash)
Uses of Cash>
1) Decrease in liabilities and owners’ equity
2) Increase in assets (other than cash).
Using the above framework we can summarize the sources and uses cash from the balance sheet data
Note that the net addition to cash is Rs 4 million and it tallies with the Rs 4 million change is shown on the balance sheet.
This simple statement tells us a lot about what happened during the year, but it does not convey the full story. For example, the increase in reserves and surplus is equal to profit after tax-dividends. If these are reported separately it would be more enlightening. Likewise, it would be more illuminating to know the break up of net fixed asset acquisition in terms of gross assets acquisition and depreciation charge.
To get these details, we have to draw on the profit and loss account of Horizon Limited shown In Exhibit. The amplified sources and uses of cash statement are given below:
Classified Cash flow Statement: The statement presented above lumped together all sources of cash and uses of cash. To understand better how cash flows have been influenced by various decisions, it is helpful to classify cash flows into three classes viz., cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities as shown.
Components of Cash flows>
Cash inflows from operations – Cash outflows from operations = Cash flow from operations
Cash inflows from investing activities – Cash outflows from investing activities = Cash flow from investing activities
Cash inflows from financing activities – Cash outflows from financing activities = Cash flow from financing activities.
Operating activities involve providing and selling goods and services. Cash inflows from operating activities include monies received from customers for sales of goods and services. Cash out flows from operating activities include payments to suppliers for materials, to employees for services, and to the government for taxes.
Investing activities involve acquiring and disposing fixed assets, buying and selling financial securities and disbursing and collecting loans. Cash inflows from investing activities include receipts from the sale of assets (real as well financial), recovery of loans, and collection of dividend and interest. Cash outflows from investing activities include payments for the purchase of assets (real and financial) and disbursement of loans.
Financing activities involve raising money from lenders and shareholders, paying interest and dividend and redeeming loans and share capital. Cash inflows from financing activities include receipts from issue of securities ad from loans and deposits. Cash outflows from financing activities include payment of interest on various forms of borrowings, payment of dividend, retirement of borrowings, and redemption of capital.
Exhibit shows that cash flow statement of Horizon Limited for the period 1.4.20X0 to 31.3.20X1 prepared in conformity with the format prescribed by the Accounting Principles Board of the Institute of Chartered Accountants of India.