FAC1502 · Financial Accounting · Study Unit 14
The Cash Flow Statement
Where money actually moved — and why it matters
Contents
01
Purpose & Overview
The Statement of Cash Flows (IAS 7) explains the change in a business’s cash and cash equivalents over a reporting period. While the income statement records profit on an accrual basis, the cash flow statement asks a simpler question: did cash actually move?
A business can be profitable on paper yet still run out of cash — think of a retailer with strong credit sales but slow-paying debtors. Conversely, a loss-making entity might generate strong operating cash flows. The cash flow statement bridges this gap between profit and liquidity.
Why IAS 7 Requires It
IAS 7 mandates the cash flow statement as a primary financial statement for all entities that prepare financial statements in accordance with IFRS. It must accompany the balance sheet, income statement, and statement of changes in equity.
The statement is structured around three activities: operating, investing, and financing. Together they must reconcile to the movement in cash and cash equivalents for the period.
02
The Three Activities
Every cash transaction in the business must be classified under one of three headings. Getting the classification right is the first skill to master.
Cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
− Purchase of investments
− Loans advanced
+ Proceeds from sale of PPE
+ Proceeds from investments
+ Loan repayments received
Cash flows that result in changes in the size and composition of the entity’s equity and borrowings.
+ Proceeds from borrowings
− Repayment of borrowings
− Dividends paid to owners
− Lease liability repayments
Interest and dividends can be classified in different sections depending on the entity’s accounting policy. For FAC1502, the typical treatment is: interest paid → operating or financing; interest received → operating or investing; dividends paid → financing; dividends received → operating or investing. Always follow the question’s instruction — or if silent, use the most common convention (interest paid and received = operating; dividends paid = financing; dividends received = operating).
Tax paid is generally classified as operating unless it can be specifically identified with financing or investing activities.
03
Direct vs Indirect Method
IAS 7 permits two approaches for presenting the operating activities section. The investing and financing sections are always presented the same way regardless of the method chosen.
Direct Method
Shows actual cash receipts and payments line by line: “Cash received from customers: R×××”, “Cash paid to suppliers: R×××”, etc. More transparent and intuitive — but requires detailed transaction records. IAS 7 encourages this method.
Indirect Method
Starts with net profit (or net loss) and works backwards — adjusting for non-cash items and working capital changes — to arrive at cash generated from operations. More commonly used in practice because it derives from existing financial statements without needing raw transaction data.
FAC1502 focuses almost exclusively on the indirect method.
Both methods produce the same total for cash generated from operating activities. The difference is only in presentation. Once you reach the operating subtotal, the rest of the statement (investing and financing) is identical under both methods.
04
The Indirect Method — Step by Step
The indirect method reconciles profit before tax to cash generated from operations. Think of it as un-doing the accrual adjustments the accountant made when preparing the income statement.
Take the net profit figure from the income statement, before income tax. This is your starting point.
Depreciation, amortisation, and impairment losses reduced profit but involved no cash outflow. Add them back.
Remove interest expense (will appear later, if paid), interest income, and profit/loss on disposal of assets (the cash proceeds appear in investing activities).
Adjust for changes in debtors, inventory, creditors, and other current items. These convert accrual-based operating profit into actual cash flows.
The subtotal after working capital adjustments. This is a key performance metric in its own right.
Subtract interest paid and income tax actually paid in cash during the period to arrive at net cash from operating activities.
05
Working Capital Adjustments — The Logic
Working capital adjustments are the trickiest part of the indirect method. The rule is simple once you understand the underlying logic: if cash came in, add; if cash went out, deduct.
The Underlying Principle
Accrual accounting records revenue when earned and expenses when incurred — regardless of when cash moves. Working capital adjustments convert these accrual figures back into their cash equivalents.
An increase in debtors means the business recognised revenue but has not yet received the cash — so subtract it. A decrease in debtors means cash was collected from sales recorded previously — so add it back.
| Balance Sheet Item | Movement | Cash Flow Effect | Adjustment |
|---|---|---|---|
| CURRENT ASSETS (Debtors, Inventory, Prepayments) | |||
| Trade debtors / Inventory | Increase ↑ | Cash tied up — less cash received than revenue/COGS suggests | (Deduct) |
| Trade debtors / Inventory | Decrease ↓ | Cash freed up — more cash received/saved than accrual shows | Add |
| CURRENT LIABILITIES (Creditors, Accruals) | |||
| Trade creditors / Accruals | Increase ↑ | Less cash paid than expenses suggest — creditors absorbing costs | Add |
| Trade creditors / Accruals | Decrease ↓ | More cash paid than expenses suggest — settling old payables | (Deduct) |
Assets and liabilities move in opposite directions: an asset increase = deduct; a liability increase = add. Think of it this way — when an asset grows, your business used cash to fund it (bad for cash); when a liability grows, your business deferred cash payment (good for cash).
Calculating Tax Paid
The income statement shows tax expense, not tax paid. To find actual cash paid:
The same logic applies to calculating interest paid when only the expense and an accrued interest balance are given.
06
Investing Activities
The investing section records actual cash movements relating to the purchase and disposal of long-term assets. This section is prepared by analysing the relevant asset accounts in the ledger.
PPE Ledger Analysis
For each class of fixed asset, reconstruct the ledger account to find the cash paid for new assets and the cash received from disposals:
In the investing section, record the actual cash proceeds received on disposal, not the book value. The difference between cash proceeds and carrying amount is the profit/loss on disposal — which was already removed in the operating section reconciliation.
- 01Cash paid for PPE → always a cash outflow in investing activities.
- 02Cash received on disposal of PPE → always a cash inflow in investing activities.
- 03If PPE was acquired on credit or hire purchase, only the cash portion appears in investing. The finance element appears in financing.
- 04Loans granted to third parties → outflow; Loan repayments received → inflow.
07
Financing Activities
Financing activities reflect changes in the entity’s capital structure — how it raised and repaid funds from owners and lenders. These are typically the easiest to identify because they involve share capital, long-term borrowings, and dividends.
Calculating Dividends Paid
A bonus share issue (capitalisation issue) is not a cash flow — it increases share capital and decreases retained earnings but involves no money changing hands. Exclude it from the cash flow statement entirely. Only cash received from new share issues appears in financing activities.
08
Full Worked Example
The following information relates to Mara Traders (Pty) Ltd for the year ended 28 February 2025. Prepare the Statement of Cash Flows using the indirect method.
Given Information
| Item | 28 Feb 2025 | 28 Feb 2024 |
|---|---|---|
| PPE (carrying amount) | 480 000 | 360 000 |
| Inventory | 95 000 | 80 000 |
| Trade debtors | 62 000 | 75 000 |
| Cash & bank | 28 000 | 15 000 |
| Trade creditors | 48 000 | 40 000 |
| Income tax payable | 18 000 | 14 000 |
| Long-term loan | 200 000 | 150 000 |
| Share capital | 300 000 | 250 000 |
| Retained earnings | 99 000 | 46 000 |
| Item | Amount (R) |
|---|---|
| Net profit before tax | 120 000 |
| Depreciation | 45 000 |
| Interest expense | 22 000 |
| Profit on disposal of PPE | 8 000 |
| Income tax expense | 36 000 |
| Dividends declared | 31 000 |
Additional: PPE with a carrying amount of R20 000 was sold during the year. New PPE was purchased for cash. Interest payable: nil opening and closing (assume all paid). No dividends payable at year end (nil opening).
Preliminary Calculations
Statement of Cash Flows
| Description | R | R |
|---|---|---|
| OPERATING ACTIVITIES | ||
| Profit before tax | 120 000 | |
| Adjustments for non-cash items: | ||
| Depreciation | 45 000 | |
| Profit on disposal of PPE | (8 000) | |
| Interest expense | 22 000 | |
| Working capital changes: | ||
| Decrease in trade debtors (75k → 62k) | 13 000 | |
| Increase in inventory (80k → 95k) | (15 000) | |
| Increase in trade creditors (40k → 48k) | 8 000 | |
| Cash generated from operations | 185 000 | |
| Interest paid | (22 000) | |
| Income tax paid | (32 000) | |
| Net cash from operating activities | 131 000 | |
| INVESTING ACTIVITIES | ||
| Purchase of PPE | (185 000) | |
| Proceeds from disposal of PPE | 28 000 | |
| Net cash used in investing activities | (157 000) | |
| FINANCING ACTIVITIES | ||
| Proceeds from issue of shares | 50 000 | |
| Proceeds from long-term loan | 50 000 | |
| Dividends paid | (31 000) | |
| Net cash from financing activities | 69 000 | |
| NET MOVEMENT IN CASH | ||
| Net increase in cash and cash equivalents | 43 000 | |
| Cash at beginning of year | 15 000 | |
| Cash at end of year | 28 000 ✓ | |
The closing cash of R28 000 matches the balance sheet. Always verify this — it is your built-in proof that the statement is complete and balanced.
09
Practice Exercises
For each of the following changes, state whether the adjustment to profit under the indirect method is an addition or a deduction:
- Trade debtors increased from R40 000 to R55 000
- Inventory decreased from R90 000 to R70 000
- Trade creditors decreased from R30 000 to R22 000
- Accrued expenses increased from R5 000 to R9 000
- Prepaid expenses decreased from R12 000 to R8 000
- Debtors ↑ R15 000 → Deduct R15 000 — cash not yet received
- Inventory ↓ R20 000 → Add R20 000 — goods sold, cash saved on purchases
- Creditors ↓ R8 000 → Deduct R8 000 — more cash paid than expenses suggest
- Accruals ↑ R4 000 → Add R4 000 — expense recognised but not yet paid in cash
- Prepayments ↓ R4 000 → Add R4 000 — prior cash payment now expensed, restoring cash position
Classify each item as Operating (O), Investing (I), or Financing (F), and state whether it is an inflow (+) or outflow (−):
- Cash received from credit customers
- Purchase of a new delivery truck for cash
- Dividends paid to shareholders
- Proceeds from selling a piece of land
- Repayment of a long-term bank loan
- Cash paid to employees (salaries)
- New shares issued for cash
- Income tax paid to SARS
- O (+) — Cash collected from customers is core operating revenue
- I (−) — Acquisition of a long-term asset
- F (−) — Return of capital to equity holders
- I (+) — Disposal of a long-term asset
- F (−) — Capital repayment on borrowing
- O (−) — Core business cash payment
- F (+) — Raising equity capital
- O (−) — Tax is classified as operating (general rule)
The PPE account (at cost) had a balance of R620 000 at the start of the year and R780 000 at year end. During the year, an asset that originally cost R60 000 was sold. Depreciation for the year was R95 000 (use accumulated depreciation below).
Accumulated depreciation: opening R180 000; closing R220 000. The sold asset had accumulated depreciation of R35 000 at the date of sale.
Calculate: (a) the carrying amount of the disposed asset, (b) the cash paid to purchase new PPE.
(a) Carrying amount of disposed asset:
Cost R60 000 − Accumulated depreciation R35 000 = R25 000
(b) PPE purchases (cost account):
Verify accumulated depreciation account:
Opening R180 000 + Charge R95 000 − Disposed R35 000 = Closing R240 000… but closing given is R220 000.
Check: 180 + 95 − 35 = 240 ≠ 220 → the depreciation charge must be R75 000 (not R95 000) for the numbers to balance, or there is a rounding/typo in the question. In exam conditions, always check your accumulated depreciation account as a cross-check — if it doesn’t balance, revisit the depreciation figure.
Study Unit 14 — Key Takeaways
1. Three sections: Operating, Investing, Financing. Every cash transaction belongs in exactly one.
2. Indirect method starts with profit before tax and works backwards by removing non-cash and non-operating items, then adjusting for working capital changes.
3. Working capital rule: current asset ↑ = deduct; current asset ↓ = add; current liability ↑ = add; current liability ↓ = deduct.
4. PPE purchases are calculated by reconstructing the asset account: Opening + Purchases − Disposals (cost) − Depreciation = Closing.
5. Tax paid, dividends paid, and interest paid are all calculated via their respective ledger/payable accounts using the same Opening + Charge − Closing = Paid formula.
6. Verify by confirming that opening cash + net movement = closing cash per the balance sheet. If it doesn’t balance, find the error before submitting.