A profitable business can run out of cash, and a loss-making one can survive for a while if it has enough. Profit and cash are different things, so the financial statements include a third report, the statement of cash flows, which shows where the cash came from and where it went.
This topic covers the format required by International Accounting Standard (IAS) 7 and the Indirect method, which starts from profit before tax and adjusts it to arrive at the cash generated by operations.
The statement is built from the other statements rather than from the cash book: the movements between the opening and closing statements of financial position, plus items from the statement of profit or loss. If you can find the missing figure for each line, the rest is arithmetic. It follows the topic on IFRS 18, which changes where interest and dividends are shown.
The next topic covers the direct method, investing and financing. A full statement of cash flows is a 20-mark question in many diets.
In 30 seconds
The statement has three headings: Operating, Investing and Financing activities. Their total is the net increase or decrease in cash, which is added to opening cash to give closing cash. In the Indirect method, start with Profit before tax. Add back depreciation, losses on disposal and the interest charge. Deduct gains on disposal.
Then adjust for working capital: Increase in receivables or inventories is subtracted, an increase in payables is added, and the opposite for decreases. The result is cash generated from operations. Deduct Tax paid and Interest paid, each found as opening liability plus charge less closing liability.
Why profit and cash differ
A profit of ₦1,000 does not mean ₦1,000 more cash. Some costs in profit or loss are not cash flows, such as depreciation, amortisation and the gain or loss on disposal. Some cash flows are not in profit or loss at all, such as buying or selling non-current assets, issuing shares, taking or repaying loans and paying dividends.
The statement of cash flows shows what the cash flows were and helps assess what they might be in future.
The IAS 7 format
IAS 1 requires a statement of cash flows in a full set of statements, and IAS 7 sets the detailed rules. Cash flows are grouped into three headings: operating activities, investing activities and financing activities. The statement then shows the net increase or decrease in cash and cash equivalents and the opening and closing amounts. Cash is cash in hand and in the business bank account.
Cash equivalents are items that can be converted into cash very quickly without risk of loss, such as a deposit or savings account.
| illustration | ₦ |
|---|---|
| Net cash flow from operating activities | 75,300 |
| Acquisition of shares | (5,000) |
| Purchase of property, plant and machinery | (35,000) |
| Proceeds from sale of non-current assets | 6,000 |
| Interest and dividends received | 1,500 |
| Net cash used in investing activities | (32,500) |
| Proceeds from issue of shares | 30,000 |
| Proceeds from new loan | 10,000 |
| Repayment of loan | (17,000) |
| Dividends paid to shareholders | (25,000) |
| Net cash used in financing activities | (2,000) |
| Net increase in cash and cash equivalents | 40,800 |
| Cash and cash equivalents at the start of the year | 5,000 |
| Cash and cash equivalents at the end of the year | 45,800 |
IAS 7 permits two ways to reach operating cash flow, the direct method and the indirect method. It prefers the direct method, but you are expected to know both.
The indirect method step by step
The indirect method reconciles a profit figure to a cash figure. It starts with Profit before tax, which is operating profit after interest. It then removes the effect of non-cash items and accruals, and moves some items to other parts of the statement.
Non-cash items. Depreciation and amortisation are expenses but not payments, so they are Added back. A gain or loss on disposal is the difference between the cash received and the carrying amount. The gain is Deducted and a loss is Added back, and the actual cash proceeds go to investing activities. For example, equipment that cost ₦60,000 with accumulated depreciation of ₦32,000 has a carrying amount of ₦28,000.
Sold for ₦40,000, it gives a gain of ₦12,000. The ₦12,000 is deducted in operating activities and the ₦40,000 is a cash inflow in investing activities. If a vehicle that cost ₦50,000 with ₦20,000 of depreciation is sold at a loss of ₦8,000, the proceeds are 30,000 − 8,000 = ₦22,000 and the ₦8,000 loss is added back.
Interest. The interest charge in profit or loss is added back, and the interest actually paid is deducted lower down.
Working capital. Each movement in working capital changes the cash from operations relative to profit.
| Balance | If it increased | If it decreased |
|---|---|---|
| Receivables (with prepayments) | Subtract | Add |
| Inventory | Subtract | Add |
| Payables (with accruals) | Add | Subtract |
The reason in each case is that cash differs from the accounting figure by the movement. If receivables rise from ₦6,000 to ₦9,000 while sales are ₦50,000 and purchases ₦30,000 are paid in cash, cash received is 6,000 + 50,000 − 9,000 = 47,000, so cash from operations is 47,000 − 30,000 = 17,000, which is the profit of 20,000 less the 3,000 increase. Accrued interest and tax payable are taken out of the payables figure, because they are dealt with separately.
Allowance for doubtful debts. You may use either approach. Adjust for the movement in the allowance as a non-cash item and use gross receivables, or ignore the allowance and use net receivables. Both give the same answer. For receivables of 5,000 and 7,100 with allowances of 500 and 600, profit of 10,000 gives 10,000 + 100 (allowance) − 2,100 (gross) = 8,000, and 10,000 − 2,000 (net: 6,500 − 4,500) = 8,000. If the question gives only totals, such as current assets, adjust with the totals you have.
Tax paid and interest paid
There is no adjustment for tax in the profit figure, because the starting point is profit before tax, but tax is a real cash flow. Tax paid, and interest paid, are found the same way: Opening liability + charge for the year − closing liability = cash paid.
| example (₦) | Tax | Interest |
|---|---|---|
| Liability at the start of the year | 53,000 | 4,000 |
| Charge for the year | 77,000 | 22,000 |
| Total | 130,000 | 26,000 |
| Liability at the end of the year | (61,000) | (3,000) |
| Cash paid | 69,000 | 23,000 |
Example in full. Profit before tax is ₦16,000, depreciation ₦15,000 and a gain on disposal ₦5,000. Receivables fall from ₦9,000 to ₦6,000, inventory rises from ₦3,000 to ₦5,000 and payables rise from ₦4,000 to ₦6,500. Tax paid is ₦4,800.
- Then 16,000 + 15,000 − 5,000 = 26,000.
- Add 3,000, subtract 2,000, add 2,500, giving cash generated from operations of ₦29,500 and net cash from operating activities of 29,500 − 4,800 = ₦24,700.
The ideas in more depth
Background (IFRS 18). Older illustrations place interest paid inside operating activities. Under the IFRS 18 amendments to IAS 7, interest paid and dividends paid are generally financing, and interest and dividends received are generally investing. The method for finding the amounts is the same. Check which treatment the question asks for. The tax paid stays in operating activities.
Other points. If the starting point is a loss, the same adjustments apply, so the loss is carried through. Depreciation and amortisation are added back, but impairment charges are also non-cash and are added back. Purchases of non-current assets are an investing outflow, found from the movement in cost or carrying amount plus depreciation and disposals, which the next topic explains.
Worked example: Ikeja Printers Ltd
Scenario. Ikeja Printers Ltd has a profit before tax of ₦120,000 after charging depreciation of ₦30,000, a loss on disposal of plant of ₦5,000 and interest of ₦12,000. Receivables rose from ₦60,000 to ₦75,000, inventory fell from ₦40,000 to ₦34,000, and trade payables and accruals, excluding interest and tax, rose from ₦35,000 to ₦42,000. Tax payable was ₦20,000 at the start of the year and ₦24,000 at the end, with a charge of ₦36,000.
Accrued interest was ₦2,000 at the start and ₦3,000 at the end. The plant sold had cost ₦40,000 and had accumulated depreciation of ₦22,000. Required: net cash from operating activities, and the proceeds from the disposal.
- Add back non-cash items.
120,000 + 30,000 + 5,000 (loss) + 12,000 (interest) = 167,000. - Working capital. Receivables increase (15,000). Inventory decrease 6,000. Payables increase 7,000. Net (2,000).
Cash generated from operations = 167,000 − 2,000 = 165,000. - Tax paid.
20,000 + 36,000 − 24,000 = 32,000. - Interest paid.
2,000 + 12,000 − 3,000 = 11,000. - Net cash from operating activities.
165,000 − 32,000 − 11,000 = ₦122,000. - Disposal proceeds.
Carrying amount 40,000 − 22,000 = 18,000.
Loss 5,000, so proceeds = 18,000 − 5,000 = ₦13,000, shown as an investing inflow.
Common mistakes in the exam
- Starting from profit after tax instead of profit before tax.
- Adding a gain on disposal instead of deducting it, or deducting a loss.
- Getting the working capital signs wrong. An increase in an asset reduces cash. An increase in a liability increases cash.
- Including accrued interest and tax payable in the payables movement, and then deducting tax and interest again.
- Forgetting to add back the interest charge when interest paid is deducted below.
- Using the tax charge as the tax paid.
- Putting the whole carrying amount, instead of the cash proceeds, in investing activities.
- Not agreeing the closing figure to the cash and cash equivalents in the statement of financial position.
Quick revision
- Three headings: operating, investing, financing. Net change + opening = closing cash.
- Indirect: profit before tax + depreciation + interest + loss − gain ± working capital = cash generated from operations.
- Asset up = cash down. Liability up = cash up.
- Tax paid and interest paid = opening + charge − closing.
- Disposal proceeds belong in investing.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. The three activity headings of a statement of cash flows, in order, are:
- Operating, investing, financing
- Investing, operating, financing
- Financing, operating, investing
- Operating, direct, financing
Show the answer
A. The order is operating, investing and then financing.
Question 2. In the indirect method, depreciation is:
- Deducted from profit
- Ignored
- Deducted with tax
- Added back to profit
Show the answer
D. It is an expense that is not a cash flow.
Question 3. A gain on disposal of ₦12,000 is, in the indirect method:
- Added to profit
- Deducted from profit
- Ignored
- Shown in financing activities
Show the answer
B. The gain is not a cash flow, so it is deducted. The cash proceeds go to investing.
Question 4. Receivables increase by ₦3,000 during the year. The adjustment to profit is:
- Add 3,000
- Ignore it
- Subtract 3,000
- Show it in financing
Show the answer
C. More of the sales are unpaid, so cash is lower than profit.
Question 5. Trade payables increase during the year. The adjustment is to:
- Add the increase
- Subtract the increase
- Ignore it
- Show it in investing
Show the answer
A. The business has used credit, so cash paid is less than the cost.
Question 6. Tax payable was ₦53,000 at the start, the charge is ₦77,000 and tax payable is ₦61,000 at the end. Tax paid is:
- ₦130,000
- ₦61,000
- ₦69,000
- ₦77,000
Show the answer
C. 53,000 + 77,000 − 61,000 = 69,000.
Question 7. A vehicle cost ₦50,000 and had accumulated depreciation of ₦20,000. It is sold at a loss of ₦8,000. The investing cash inflow is:
- ₦8,000
- ₦30,000
- ₦50,000
- ₦22,000
Show the answer
D. Carrying amount 30,000 − loss 8,000 = proceeds of 22,000.
Question 8. Which statement is correct?
- Profit always equals cash flow
- Profit differs from cash flow because of non-cash items and accruals
- A statement of cash flows shows profit for the year
- Depreciation is a cash outflow
Show the answer
B. Non-cash items and timing differences separate profit from cash.
Question 9. Inventory decreases by ₦2,000. The adjustment to profit is to:
- Add 2,000
- Subtract 2,000
- Ignore it
- Show it in investing
Show the answer
A. Sales were partly met from stock, so purchases and cash paid were lower than cost of sales.
Question 10. Which of these is a cash equivalent?
- Inventory
- Trade receivables
- Land
- A deposit that can be converted into cash quickly without risk
Show the answer
D. Cash equivalents can be converted into cash very quickly without risk of loss.
Section B style: written questions
Question 11 (10 marks). (a) Explain why profit differs from cash flow. (4 marks) (b) State the three headings of the statement of cash flows and give one example of a cash flow under each. (6 marks)
Question 12 (20 marks). Bauchi Textiles Ltd has a profit before tax of ₦200,000 after charging depreciation of ₦40,000, interest of ₦15,000 and a gain on disposal of ₦6,000. Receivables rose from ₦80,000 to ₦95,000, inventory fell from ₦50,000 to ₦42,000, and trade payables rose from ₦60,000 to ₦72,000. Tax payable was ₦30,000 at the start of the year and ₦35,000 at the end, with a charge of ₦55,000. Accrued interest was ₦3,000 at the start and ₦4,000 at the end.
(a) Calculate the cash generated from operations. (10 marks) (b) Calculate the tax paid and the interest paid. (4 marks) (c) State the net cash from operating activities. (3 marks) (d) Explain how the gain on disposal is treated. (3 marks)
A further written question
Question 13 (10 marks). A company has profit before tax of ₦90,000. Gross trade receivables rose from ₦100,000 to ₦130,000, and the allowance for doubtful debts rose from ₦5,000 to ₦8,000. There are no other adjustments. (a) Calculate the cash from operations using gross receivables and the allowance. (4 marks) (b) Calculate it using net receivables. (4 marks) (c) Comment on the two results. (2 marks)
Model answers
Show the model answer to Question 11
(a) Profit is based on accruals, so it includes non-cash items such as depreciation and gains or losses on disposal. It also includes sales and costs that have not yet been received or paid. Cash flow includes items outside profit, such as the purchase and sale of non-current assets, share issues, loans and dividends. (b) Operating activities, such as cash received from customers.
Investing activities, such as the purchase of property, plant and equipment. Financing activities, such as the proceeds of a share issue or the repayment of a loan.
Show the model answer to Question 12
(a) Profit before tax 200,000, plus depreciation 40,000, less gain on disposal (6,000), plus interest 15,000 = 249,000. Receivables increase (15,000). Inventory decrease 8,000. Payables increase 12,000. Net working capital movement 5,000. Cash generated from operations ₦254,000.
(b)
- Tax paid.
30,000 + 55,000 − 35,000 = ₦50,000. - Interest paid.
3,000 + 15,000 − 4,000 = ₦14,000.
(c) Net cash from operating activities = 254,000 − 50,000 − 14,000 = ₦190,000.
(d) The gain is not a cash flow, so it is deducted from profit in operating activities. The cash received from the sale is shown as an inflow in investing activities.
Show the model answer to Question 13
(a) Profit 90,000, add the increase in the allowance 3,000, deduct the increase in gross receivables 30,000: 90,000 + 3,000 − 30,000 = ₦63,000.
(b)
- Net receivables: 95,000 at the start and 122,000 at the end, an increase of 27,000.
- 90,000 − 27,000 = ₦63,000.
(c) The two approaches give the same answer, because the allowance movement is already contained in the difference between gross and net receivables.
Pathfinder on Statement of cash flows (IAS 7): format and indirect method
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Asks you to define operating, investing and financing cash flows with two examples each (9 marks), and to prepare the statement of cash flows showing operating activities by the indirect method, with workings (11 marks).
Revise first: The IAS 7 format
From the previous syllabus. Gives the statements of financial position of a company for two years and asks for the statement of cash flows.
Revise first: The indirect method step by step
From the previous syllabus. Gives the financial statements of a company for two years and asks for the statement of cash flows by the indirect method.
Revise first: The indirect method step by step
From the previous syllabus. Gives the statements of a manufacturing company for two years and asks for the statement of cash flows by the indirect method.
Revise first: The indirect method step by step
From the previous syllabus. Gives the statement of profit or loss and financial position of a company and asks, in accordance with IAS 7, for the statement of cash flows by the indirect method.
Revise first: Tax paid and interest paid
From the previous syllabus. Gives the statements of a listed company with a plant sold at a loss, a share issue, part redemption of loan notes and a dividend, and asks for the statement of cash flows by the indirect method.
Revise first: The indirect method step by step
From the previous syllabus. Asks the order of the three activity groups, which item may not be classified as investing, and which information a statement of cash flows cannot reveal.
Revise first: The IAS 7 format
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2014, November Diet, 2016, November Diet, 2017, May Diet, 2018, November Diet, 2019, May Diet, 2019 and May Diet, 2023. All are on the previous syllabus. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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