AC · Certificate Level
Statement of Cash Flows
IAS 7 Statement of Cash Flows: the purpose and importance of cash flow reporting, classification of cash flows into operating, investing, and financing activities, preparation of a statement of cash flows using the indirect method (reconciling profit to cash generated from operations), calculating investing and financing cash flows using balancing figures from comparative statements of financial position, a comprehensive worked example, and interpretation of cash flow patterns.
Learning Objectives
- •Explain the purpose and importance of the statement of cash flows and why it complements the accruals-based SoPL
- •Classify cash flows as operating, investing, or financing activities under IAS 7
- •Explain the classification flexibility permitted by IAS 7 for interest, dividends, and tax
- •Prepare the operating activities section using the indirect method, including all standard adjustments
- •Calculate cash flows for investing activities, including using balancing figures for PPE additions and disposal proceeds
- •Calculate cash flows for financing activities, including share issues, borrowings, and dividends paid
- •Prepare a complete statement of cash flows from comparative statements of financial position and a statement of profit or loss
- •Interpret cash flow patterns and assess an entity's financial health from its cash flow statement
Purpose and Importance of the Cash Flow Statement
IAS 7 requires entities to present a statement of cash flows as part of their complete set of financial statements. While the SoPL reports financial performance on the accruals basis, the cash flow statement shows the entity's actual cash receipts and payments during the period.
Why is a cash flow statement needed?
- Profit does not equal cash: A profitable entity can still fail if it runs out of cash. The SoPL includes non-cash items (depreciation, provisions, fair value changes) and timing differences (accruals, prepayments, credit sales not yet collected)
- Assessing liquidity and solvency: The SCF shows whether the entity can generate sufficient cash to meet its obligations, pay dividends, and fund investment
- Evaluating cash generation quality: Cash from operations is a more objective measure than profit — it is harder to manipulate through accounting policy choices
- Comparability: Cash flows remove the effects of different accounting policies (e.g., depreciation methods), making comparison between entities easier
- Forecasting: Historical cash flow patterns help users predict future cash flows
Cash and cash equivalents:
IAS 7 defines cash as cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments readily convertible to a known amount of cash, subject to an insignificant risk of changes in value — typically investments with a maturity of three months or less from the date of acquisition. Bank overdrafts repayable on demand that form an integral part of the entity's cash management may be included as a component of cash and cash equivalents.
Classification of Cash Flows
IAS 7 requires cash flows to be classified into three categories:
1. Operating activities
The principal revenue-producing activities of the entity and other activities that are not investing or financing. This is the most important section because it shows whether the entity's core business generates enough cash to sustain itself.
- Cash received from customers
- Cash paid to suppliers and employees
- Other operating cash payments (rent, utilities, etc.)
2. Investing activities
Cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
- Purchase of property, plant and equipment
- Proceeds from sale of PPE
- Purchase of investments / subsidiaries
- Proceeds from sale of investments / subsidiaries
- Loans made to other parties
- Repayment of loans by other parties
3. Financing activities
Cash flows that result in changes in the size and composition of the entity's equity capital and borrowings.
- Proceeds from issuing shares
- Cash paid to repurchase shares (treasury shares)
- Proceeds from borrowings (new loans, bonds)
- Repayment of borrowings
- Payment of lease liabilities (IFRS 16 — principal portion)
Classification flexibility under IAS 7:
Certain items may be classified in more than one way, provided the policy is applied consistently:
| Item | Permitted classifications | Most common in practice |
|---|---|---|
| Interest paid | Operating or Financing | Operating (UK), Financing (some jurisdictions) |
| Interest received | Operating or Investing | Operating or Investing |
| Dividends received | Operating or Investing | Investing (or Operating for financial institutions) |
| Dividends paid | Operating or Financing | Financing |
| Tax paid | Operating (unless specifically identifiable with investing/financing) | Operating |
Exam questions usually specify the classification policy or expect the most common treatment.
The Indirect Method — Operating Activities
The indirect method is the most commonly used method (and the one examined at certificate level). It starts with profit before tax and adjusts for non-cash items, non-operating items, and working capital changes to arrive at cash generated from operations.
Structure:
| Cash flows from operating activities (indirect method) | |
|---|---|
| Profit before tax | X |
| Adjustments for non-cash and non-operating items: | |
| Add: Depreciation and amortisation | X |
| Add: Impairment losses | X |
| Add: Loss on disposal of PPE / Subtract: Profit on disposal | X / (X) |
| Add: Finance costs (if classified as operating) | X |
| Subtract: Investment income (interest/dividends received) | (X) |
| Add/Subtract: Other non-cash items (e.g., share-based payments, provisions movement) | X / (X) |
| Working capital changes: | |
| Increase in inventories / Decrease in inventories | (X) / X |
| Increase in trade receivables / Decrease in trade receivables | (X) / X |
| Increase in trade payables / Decrease in trade payables | X / (X) |
| Cash generated from operations | X |
| Interest paid (if operating) | (X) |
| Tax paid | (X) |
| Net cash from operating activities | X |
Why Each Adjustment is Made
Depreciation and amortisation: Added back because they reduced profit but involved no cash outflow. They are non-cash charges.
Profit/loss on disposal: The profit or loss on disposal is removed from operating activities because: (a) it is not an operating cash flow — the actual cash proceeds appear in investing activities, and (b) leaving it would double-count the cash effect. A profit is subtracted; a loss is added back.
Finance costs and investment income: Removed from operating profit because they will be shown separately — interest paid in operating (or financing), interest/dividends received in operating (or investing). This avoids double-counting.
Working capital changes — the logic:
- Increase in current asset (inventory, receivables) → SUBTRACT: Cash has been absorbed (tied up in unsold goods or unpaid invoices). Think: receivables went up = customers haven't paid yet = less cash.
- Decrease in current asset → ADD: Cash has been released (goods sold, debts collected).
- Increase in current liability (payables) → ADD: Cash has been retained (the entity owes more but hasn't paid yet).
- Decrease in current liability → SUBTRACT: Cash has been paid out (debts settled).
Memory aid: For assets, movement direction is opposite to the cash effect. For liabilities, movement direction is the same as the cash effect.
Calculating Investing and Financing Cash Flows
The investing and financing sections are typically more straightforward than operating activities. Many figures come directly from information given in the question, but some must be calculated as balancing figures using comparative SoFP data.
PPE Additions and Disposal Proceeds (Balancing Figures)
When the question does not directly state the amount of PPE purchased or disposal proceeds, you reconstruct the PPE accounts:
PPE cost account:
Opening cost + Additions − Cost of disposals = Closing cost
Rearranged: Additions = Closing cost − Opening cost + Cost of disposals
Accumulated depreciation account:
Opening acc dep + Depreciation charge − Acc dep on disposals = Closing acc dep
Carrying amount of disposals:
CA of disposals = Cost of disposals − Acc dep on disposals
Disposal proceeds:
Proceeds = CA of disposals + Profit on disposal (or − Loss on disposal)
The additions figure (cash paid for new PPE) goes into investing activities as a cash outflow. The proceeds go as a cash inflow.
Tax Paid (Balancing Figure)
Tax paid during the year is usually not given directly. Use the tax payable account:
Opening tax payable + Tax charge for the year − Tax paid = Closing tax payable
Rearranged: Tax paid = Opening tax payable + Tax charge − Closing tax payable
Dividends Paid (Balancing Figure)
If not given directly, calculate from retained earnings:
Opening RE + Profit for the year − Dividends paid = Closing RE
Rearranged: Dividends paid = Opening RE + Profit − Closing RE
If there is a separate dividends payable account: Dividends paid = Opening payable + Dividends declared − Closing payable
Borrowings and Share Issues
Borrowings: Compare opening and closing loan balances. An increase = new borrowing (cash inflow in financing). A decrease = loan repayment (cash outflow in financing). If both new loans and repayments occurred, you may need additional information to separate them.
Share issues: Cash received from issuing shares = increase in share capital + increase in share premium. This is a financing inflow.
Interpreting Cash Flow Patterns
The overall pattern of positive (+) and negative (−) cash flows across the three activities reveals important information about the entity's lifecycle stage and financial health:
| Operating | Investing | Financing | Interpretation |
|---|---|---|---|
| + | − | − | Mature, healthy business. Generates cash from operations, invests in growth, and repays financing. This is the "ideal" pattern for an established entity. |
| + | − | + | Growing business. Operations generate cash but not enough to fund investment. Raising external finance to support expansion. |
| − | − | + | Start-up or rapid expansion. Operations not yet cash-positive. Heavy investment funded by external finance. Potentially high-risk if cash generation doesn't improve. |
| − | + | − | Distressed entity. Operations losing cash. Selling assets to repay debt. Possible going concern issue — the entity is consuming its asset base. |
| + | + | − | Restructuring. Selling assets and using operating cash to reduce debt/return capital. |
| − | + | + | Unusual/transitional. Poor operations, disposing of assets, raising finance — may indicate a major strategic shift or financial difficulty. |
Key analytical questions to consider:
- Is operating cash flow sufficient to cover capital expenditure? If not, the entity is reliant on external funding for investment.
- Is operating cash flow sufficient to cover dividends? If dividends exceed operating cash flow, the entity may be borrowing to pay dividends — unsustainable long-term.
- How does operating cash flow compare to profit? A persistent gap may indicate aggressive revenue recognition, growing receivables, or inventory build-up.
- What is the free cash flow? (Operating cash flow minus capital expenditure) — this is the cash available for discretionary uses (dividends, debt reduction, acquisitions).
- Is the entity a net borrower or net repayer? Increasing debt may signal growth or may signal distress.
Examiner Focus
Common Pitfall
Study Tip
Watch Out
Examiner Focus
Common Pitfall
Key Definitions
Cash
Cash on hand and demand deposits (money in bank accounts that can be withdrawn without notice).
Cash equivalents
Short-term, highly liquid investments readily convertible to known amounts of cash and subject to an insignificant risk of changes in value. Typically investments maturing within three months of acquisition.
Operating activities
The principal revenue-generating activities of the entity and other activities that are not investing or financing. Includes cash from customers, payments to suppliers and employees.
Investing activities
Cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
Financing activities
Cash flows that result in changes in the size and composition of the contributed equity and borrowings of the entity.
Indirect method
A method of presenting operating cash flows that starts with profit before tax and adjusts for non-cash items, non-operating items, and working capital changes to reconcile to cash generated from operations.
Direct method
An alternative method (permitted but rarely used in practice) that shows actual cash receipts from customers and cash payments to suppliers and employees. IAS 7 encourages but does not require the direct method.
Free cash flow
Operating cash flow minus capital expenditure. Represents cash available for discretionary purposes such as dividends, debt reduction, or acquisitions. Not defined by IAS 7 but widely used in analysis.
Key Formulas
Worked Examples
Related Topics
Key Takeaways
- ✓The SCF shows actual cash movements, complementing the accruals-based SoPL. Cash and cash equivalents include cash on hand, demand deposits, and short-term liquid investments maturing within 3 months.
- ✓Cash flows are classified into: operating (core business), investing (long-term assets), and financing (equity and borrowings).
- ✓IAS 7 allows classification flexibility for interest paid/received, dividends paid/received, and tax paid — the chosen policy must be applied consistently.
- ✓The indirect method starts with profit before tax and adjusts: add back depreciation and losses on disposal; subtract profits on disposal and investment income; add back finance costs.
- ✓Working capital adjustments: increase in current assets → subtract (cash absorbed); decrease in current assets → add (cash released); increase in current liabilities → add (cash retained); decrease in liabilities → subtract (cash paid).
- ✓PPE additions and disposal proceeds are often balancing figures — reconstruct the PPE cost and accumulated depreciation accounts.
- ✓Tax paid and dividends paid are also often balancing figures — reconstruct the relevant liability/equity accounts.
- ✓Cash flow patterns indicate lifecycle stage: the ideal mature pattern is +Operating, −Investing, −Financing.
- ✓The key analytical question: is operating cash flow sufficient to cover capital expenditure and dividends without relying on external financing?
Practice Questions
Question 1 of 8
In the indirect method, depreciation of £25,000 is:
Question 2 of 8
Trade receivables increased from £40,000 to £48,000 during the year. In the operating section of the SCF, this is shown as:
Question 3 of 8
Equipment costing £50,000 with accumulated depreciation of £35,000 was sold for £18,000. The profit on disposal and its treatment in the SCF are:
Question 4 of 8
PPE cost was £200,000 at the start and £250,000 at the end. During the year, equipment with a cost of £40,000 was disposed of. PPE additions during the year were:
Question 5 of 8
Tax payable was £18,000 at the start and £22,000 at the end. The tax charge for the year was £30,000. Tax paid during the year was:
Question 6 of 8
Which of the following cash flows is classified as a financing activity?
Question 7 of 8
Under IAS 7, dividends paid can be classified as:
Question 8 of 8
An entity has operating cash flow of +£200,000, investing cash flow of −£180,000, and financing cash flow of −£30,000. This pattern most likely indicates:
Source and Version
Syllabus: ICAEW ACA Certificate Level 2026 · Reviewed: 2026-05-04