Preparing a Cash Flow Statement from Financial Statements

Understand Preparing Cash Flow Statement from Financial Statements

Key rules to remember

Net change in cash

Net increase or decrease = Operating cash flow + Investing cash flow + Financing cash flow

This must equal closing cash and cash equivalents minus opening cash and cash equivalents.

Reconciliation

Opening cash and cash equivalents + Net change = Closing cash and cash equivalents

Always show this at the foot of the statement. It is your proof of accuracy.

Net profit before tax (NPBT)

NPBT = Closing P&L balance − Opening P&L balance + Dividend and transfers to reserves + Tax charge for the year

Use this when the question gives only balance sheet balances. Add back any appropriations made out of profit.

Operating profit before working capital changes

NPBT + Depreciation + Finance costs + Loss on sale of assets − Profit on sale of assets − Interest and dividend income

Add non-cash charges and items shown in other sections. Remove non-operating gains.

Cash generated from operations

Operating profit before working capital changes − Increase in inventories and receivables + Increase in payables (reverse for decreases)

Tax paid is deducted after this line to get net cash from operating activities.

Fixed asset purchases (net block)

Purchases = Closing net block − Opening net block + Depreciation + Book value of assets sold

Book value of assets sold is the value at the date of sale. Sale proceeds = book value ± profit or loss.

Tax paid

Tax paid = Opening provision + Tax charge for the year − Closing provision

Use the same logic for any accrued item, such as outstanding expenses.

How to solve Preparing Cash Flow Statement from Financial Statements questions

1. 1Read the additional information first. Mark items like depreciation, sale of assets, dividend paid, tax paid, and interest. Note whether it asks for the direct or the indirect method.
2. 2Find the change in cash and cash equivalents from the two balance sheets. This is your target figure to prove at the end.
3. 3Find net profit before tax. Use the profit and loss account if given. Otherwise derive it from the change in the P&L balance by adding back dividend, transfers to reserves, and the tax charge.
4. 4Prepare working notes: fixed assets, investments, provision for tax, and any other account with hidden cash flows. Find purchases, sales, tax paid and dividend paid.
5. 5Write the operating section: NPBT, then adjustments for non-cash and non-operating items, then working capital changes, then tax paid.
6. 6Write the investing section (purchase and sale of assets and investments, interest and dividend received) and the financing section (shares, debentures, loans, interest and dividend paid).
7. 7Add the three totals, then reconcile with opening and closing cash. If the figures do not match, recheck your working notes and the sign of each working capital change.

Quickest way: Change-in-balance-sheet shortcut

Common mistakes in Preparing Cash Flow Statement from Financial Statements

• Starting from net profit after tax instead of net profit before tax.

  The closing P&L balance is the most visible figure, so students use it directly.

  Fix: Rebuild NPBT by adding back the tax charge, dividend and transfers to reserves. Show tax paid separately later.

• Getting the sign wrong on working capital changes.

  Students memorise a rule such as 'increase is plus' without thinking about cash.

  Fix: Ask whether cash was tied up or released. A rise in inventories or receivables ties up cash (deduct). A rise in payables releases cash (add).

• Treating depreciation as a cash outflow, or ignoring it in the fixed asset working.

  Depreciation appears in the P&L, so it looks like an expense paid.

  Fix: Add it back in the operating section. Use it in the net block working to find purchases.

• Using the profit or loss on sale instead of the sale proceeds in investing activities.

  The P&L shows only the gain or loss, and students stop there.

  Fix: Adjust the gain or loss in the operating section. Show the full sale proceeds in investing.

• Showing interest paid or dividend paid inside operating activities without stating a basis, or leaving them out of the statement.

  Both are in the P&L or appropriations, and students are unsure where they belong.

  Fix: Add back finance costs in operating and show interest paid in financing (state this as your policy where the question is silent). Show dividend paid in financing.

• Skipping the reconciliation, so a wrong figure goes unnoticed.

  Students run out of time or assume the working is right.

  Fix: Always write opening cash, net change and closing cash at the end. A mismatch tells you to recheck.

Worked examples