Cash flow in practice or what it means and why we should compile it

23. March 2021
  • Jan Zvolský
  • Jan Tichý

1.  The aim of the Cash-Flow Statement

In this article, we will focus on the cash-flow statement (further in the text as “CF”), which gives an overview of financial and investment processes and their mutual connection, about the structure of own or external financial resources and their use and about the financial situation of the company or its change. Last but not least, the CF statement also deals with the liquidity of a company. In practice, it is used in engagements of the type of due diligence, acquisitions, corporate valuation compiled based on cash flow using an income-based approach, i.e. applying the DCF (Discounted Cash Flows) method.

The CF statement is beneficial not only for the management of the company, which compiles the given statement, but also for external users, especially creditors, who monitor the instalment capacity of the given company (bank, investor). They need to receive financial information, which they will not get from statements such as “the balance sheet” and the “profit and loss statement” (further in the text as “P&L”). These are compiled as of a certain date. From the balance sheet, users can find out the so-called stocks, such as assets (balance and structure of the assets), liabilities (sources of coverage) and from the P&L statement they will find out the so-called flows, such as the profit loss – it relates to the costs and revenues, from which the profit/loss results. It is also possible to find out the development of finance from the opening and the closing balance in the given period from the balance sheet. We do not see the reasons for these changes in the balance sheet, and the CF statement will thus serve us for these purposes.

The data gained from the Balance Sheet and from the P&L provide a different view of the development of financial resources. For these purposes, it is more suitable to use the more transparent indicators based on the CF statement. The CF statement maps the background of the changes in cash flow, provides users with direct information about credit and collection of financial resources, about whether or not the accounting entity is insolvent. The CF statement complements the above-mentioned statements and informs about the way, in which money was generated or how it was handled. In the CF statement, the effect of the accrual principle used in the accounting, i.e. the method of accounting, in which accounting transactions are recorded in the period, in which they actually occur, regardless of when they are paid, is removed. The CF statement further specifies the information from the P&L about the reality of profit and loss.

1.1.       Who compiles the CF

According to article 18 of act no. 563/1991 Coll., on accounting (hereinafter the “AA”), small and micro-size accounting entities are not obliged to compile a cash-flow statement (CF) and the statement of changes in equity.

Selected accounting units compile a cash flow statement (CF) and the statement of changes in equity always, if they meet both of the values stated in article 20 paragraph 1 letter c) point 1 and 2 of the AA, i.e. assets totalling CZK 40m, annual net turnover totalling CZK 80m as of balance sheet date and for the accounting period immediately preceding.

Medium and large accounting entities always compile a CF statement and the statement of changes in equity without the need for any conditions to be fulfilled.

The content of CF is defined in decree no. 500/2002 Coll., implementing some stipulations of the AA for accounting units that use double-entry accounting (hereinafter the “Decree”), in articles 40 to 43.

2.  The procedure of compiling CF

The information about the CF statement, not only the procedure of compiling it, can be found in the Decree, in articles 40 to 43. An example of a possible solution for compiling a CF statement using the indirect method is stated in the Czech Accounting Standard no. 023 (CAS). The CF statement is also treated in the International Financial Reporting Standards (IFRS) in standard IAS 7. If we compare treatment of the statement according to the CAS and the IFRS, they are basically compiled identically, the IAS being also based on the indirect method, while recommending and preferring the use of the direct method for partial lines such as income from sale of products and services, payments to employees, payments for material and payments for services. The formats of statements according to the CAS and the IAS 7 are also similar, only the IAS 7 enables further voluntary publications, such as analysis of cash flows according to operating segments.

2.1.       Methods

According to article 42 of the Decree, an accounting entity reports cash flow from operating activity using a direct or an indirect method.

In the case of the direct method, suitably selected and arranged groups of financial income and expenses are reported, linked for example the structuring in the profit and loss statement. The direct method may be further divided into the purely direct method, which finds out data from the sub-ledger bank accounts and cash count, i.e. from financial transactions, and the falsely direct (substitutive) method. The latter is based on the P&L and includes transformation of cost and revenue data to income and expenses data. Data from the P&L are adjusted for changes in balance sheet entries. Revenues include the revenues, which are not income, as well as income that do not create revenues. Costs are meanwhile represented by costs, which are not expenses, and expenses, which are not costs. This means cash flows.

The indirect method is called indirect, because it is not based on the costs and revenues, but on the achieved profit loss (“PL”) before taxation, which is subsequently adjusted. In other words, which is a transformation of PL into CF. The profit/loss of an accounting entity is adjusted mainly for non-monetary transactions, unpaid costs and revenues from past or future accounting periods, and by entries of income and expenses related to financial and investment activity. Non-monetary transactions are understood to mean costs, which are not expenses in the current period (depreciation, creation of reserves or provisioning, deferred taxes), revenues, which are not income in the current period (clearing of reserves and provisions) and finally changes in balance sheet entries, which are not related to cash flows.

The indirect method is used more in practice due to being easier to compile. Its advantages compared to the direct method include especially being undemanding for inputs, gaining values in net value, publishing of a smaller amount of corporate information for competitors (absence of the structure and nature of cash flow). The shortcomings of the indirect method include the inclusion of non-monetary transactions in the CF statement, for which the cash flows need to be adjusted.

The CF statement is structured in such a way that it is possible to follow the cash flows in three activities, as described below in chapter 3.

3.  Structure of the CF statement

According to the Decree, more specifically article 41, points 2 to 4, the CF statement is structured according to the activity, in which cash flow was created, into the sections of cash flow from operating, investment and financial activity. The structuring enables assessing the weight of the individual activities with an impact on cash flows. The aim of the CF is thus also to structure cash flow into these three activities.

CF from operating activity includes the basic gainful activity of a company and other activities of the company, which are neither investment nor financial activities. These are mainly activities (including advance payments) such as sale of products, goods and services, sale of rights, licences, “know how”, meditator activity, acquisition of material, goods and services, wage costs, income tax payment, profit sharing, if it is not financial activity. It is important to realise that this definition is different from the P&L statement, where classification of the individual accounts is defined by a decree implementing the AA.

CF from investment activity includes acquisition and sale of non-current assets, or activities relating to the provision of loans, which are not operating activity for the given accounting entity. These are mainly activities of acquisition/sale – NTA (non-current tangible assets), NIA (non-current intangible assets), participating securities, option contracts, “forward”, “future”, provision of/income from instalments from loans to related parties.

CF from financial activity includes income and expenses for financing corporate activity. These operations are often related to a change in equity. This is mainly income/expenses – from issuing own shares/stock, bonds and warrants, from donations and subsidies in capital, from owners for covering losses, from accepted loans and loans for use “including interests”, from subsidies for NTA/NIA and profit sharing.

4.  Specific entries viewed from the perspective of Czech accounting rules for entrepreneurs

Selected cash flows in the CF are treated by the Czech accounting legislation. We mention these specifics further in the text. When compiling the CF statement, there may also be entries, which, with a different interpretation, may be included in operating or in investment or financial activity. The accounting methodology applicable in the Czech Republic requires that these entries be captured in separate uncompensated entries. Among such entries we include income from and expenses on an extraordinary event, interests on loans and loans for use accepted and paid, dividend accepted and paid, or profit sharing, payment on the income tax including paid additionally assessed tax for past taxable periods including tax prepayments paid for the current accounting period. Below we state some of them with a more detailed description.

4.1.       Extraordinary income and expenses

From extraordinary events, extraordinary income and expenses incur as well, entries in the CF are always classified according to their nature. For example, accepted payment based on an insurance event may be reflected based on factual relevance in operating activity, investment activity or financial activity. It is necessary to strictly separate costs and revenues stated in the P&L and the required income from and expenses on extraordinary events in the CF statement. Most of these accounting transactions are of non-monetary nature (accounting transfer) and will never affect cash and cash equivalents.

4.2.       Interests

From the perspective of the accounting entity of an entrepreneur, interests are mainly included in operating activity, but alternatively also in investment or financial activity. One of the reasons for including them in financial activity is that they are part of the entire relation to the banking sector, i.e. leverage (+), payment of liabilities (-), payment of financial costs – interests (-). The legislation (Czech as well as international) leaves a freedom of choice as to which part of the CF to include paid interest in.

4.3.       Profit sharing

Profit sharing (dividends) is primarily included in operating activity, but alternatively also in financial activity. In the case when a company only redistributes dividends among shareholders of a subsidiary, these transactions belong to operating CF.

In this article, we wanted to outline the basic aspects of the Cash Flow Statement for you, we pointed out the benefits of the cash flow statement both for the management of the company and for external users. We discussed the possible methods of compiling the CF statement, selected difference between the way it is treated in the CAS and the IFRS/IAS accounting frameworks and the rules of classification of some selected entries focusing on Czech accounting legislation.

Having read this article, it may occur to you that correct compilation of a CF statement is not an easy matter, because it combines various view of an entrepreneur’s accounting, i.e. it is necessary to include more information and documents in its compilation. We therefore recommend in this context that you turn to experts, who focus on this issue, and leave the worries relating to compilation of the cash flow statement to them, while you fully focus on your business. Our company has consultants among its staff, who will be glad to help you with either compiling the CF itself or with any questions you may have regarding this subject.

Author: Jan Zvolský, Jan Tichý