IAS 7 is an international accounting standard that provides guidance on preparing and presenting a Statement of Cash Flows. This is a crucial financial statement that shows how cash and cash equivalents (such as bank balances) flow into and out of a business over a specific period. It helps understand where a company’s money comes from and how it’s spent.
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Why is the Statement of Cash Flows important?
While other financial statements like the income statement show profitability, the cash flow statement shows actual cash generated or used by the company. You can think of it like checking your bank account—it tells you exactly how much cash the business has on hand, regardless of what the income statement says.
Key Terms You Should Know:
- Cash: Money in hand or in bank accounts that the company can spend immediately.
- Cash equivalents: Short-term investments (like treasury bills or money market funds) that can easily be converted into cash.
- Cash inflows: Money coming into the business.
- Cash outflows: Money going out of the business.
3 Main Sections of the Statement of Cash Flows
IAS 7 requires that cash flows be classified into three main categories:
1. Operating Activities:
These are the cash flows that come from the company’s day-to-day operations—basically, what the company does to make money.
- Cash inflows: From selling goods or providing services.
Cash outflows: Payments for expenses like salaries, rent, and utilities.
Example: Imagine a retail store. The cash received from customers buying clothes is an inflow, while cash spent on inventory (clothes), salaries, and electricity bills are outflows.
Why this matters: Operating cash flows show whether the company’s core business is making or losing cash. Ideally, this section should have a positive cash flow, meaning the company is generating more cash than it’s spending in its normal operations.
2. Investing Activities:
These are cash flows related to buying or selling long-term assets, like property, machinery, or investments in other businesses.
- Cash inflows: Selling a building or investment.
Cash outflows: Buying equipment, machinery, or shares in another company.
Example: If the retail store buys a new delivery van, the money spent on the van is an outflow. If the store sells an old building, the cash from the sale is an inflow.
Why this matters: Investing cash flows give insight into how much the company is investing in its future. While negative cash flow here might look bad, it’s often a good sign that the company is investing in assets that will help it grow.
3. Financing Activities:
These cash flows are related to borrowing money or repaying loans, as well as issuing or buying back shares, and paying dividends to shareholders.
- Cash inflows: Borrowing from the bank or issuing shares.
Cash outflows: Repaying loans or paying dividends to shareholders.
Example: If the retail store takes out a loan to expand its operations, the loan is an inflow. If it repays part of the loan or pays dividends to shareholders, that’s an outflow.
Why this matters: Financing cash flows show how the company is funding its operations and investments. Positive inflows could indicate the company is raising capital to grow, while outflows may show it’s paying down debt or rewarding investors.
Two Methods of Presenting Cash Flows from Operating Activities:
IAS 7 allows two methods for presenting cash flows from operating activities:
1. Direct Method:
This method shows actual cash inflows and outflows, making it easy to see where the cash is coming from and where it’s going.
Example:
- Cash received from customers: ₦2,000,000
- Cash paid to suppliers: ₦1,200,000
- Cash paid for salaries: ₦300,000
Operating cash flow: ₦500,000 (₦2,000,000 - ₦1,200,000 - ₦300,000)
Why it's useful: It provides a clearer, more transparent view of cash transactions.
2. Indirect Method:
The indirect method starts with net profit from the income statement and adjusts for non-cash transactions (like depreciation) and changes in working capital (like inventory and receivables).
Example:
- Net profit: ₦600,000
- Add back depreciation: ₦100,000 (non-cash expense)
- Increase in receivables: ₦200,000 (cash not yet received)
Operating cash flow: ₦500,000 (₦600,000 + ₦100,000 - ₦200,000)
Why it's useful: This method is easier to prepare because it starts with net income, but it’s less transparent than the direct method.
Cash and Cash Equivalents
IAS 7 emphasizes the inclusion of cash equivalents, which are investments that are highly liquid, short-term, and easily convertible to cash with minimal risk of loss.
Example: Treasury bills or money market funds are typical cash equivalents because they can be quickly turned into cash.
Foreign Currency Cash Flows
If a company deals in foreign currencies, IAS 7 requires cash flows to be translated into the company’s reporting currency (e.g., naira) using the exchange rate at the time of the transaction.
Cash Flow and Liquidity
The statement of cash flows is a great indicator of liquidity—a company’s ability to meet short-term obligations. Even if a company shows a profit on its income statement, it could still be in trouble if it’s not generating enough cash.