Statement of Cash Flows | A Level Accounting 9706

📘 Lesson 7 of 20

35% complete Paper 1 Paper 3

1. Purpose of the Statement of Cash Flows 9706 / 3.4

A company can be profitable yet still fail — if it runs out of cash. The Statement of Cash Flows explains where cash came from and where it went during the accounting period. It bridges the gap between the accruals-based Income Statement and the actual cash position.

Why Cash Flows Matter: The Income Statement is prepared on the accruals basis — it includes non-cash items like depreciation, accruals and prepayments. Profit and cash are therefore different. A company with high profit can still be short of cash if it has slow-paying customers, heavy capital expenditure, or large loan repayments. The cash flow statement reveals the true cash position.

Profit vs Cash — Key Differences

Reason Profit ≠ Cash	Example	Effect on Cash vs Profit
Depreciation	$30,000 depreciation charged in I/S	Reduces profit but NO cash leaves the business
Credit sales	$100,000 credit sales recognised in I/S	Increases profit but cash not yet received
Capital expenditure	$200,000 spent on new machinery	Cash leaves the business but not charged to I/S (capitalised)
Loan repayment	$50,000 debenture repaid	Cash leaves but not an I/S expense (balance sheet movement)
Inventory increase	Inventory rises by $15,000	Cash spent on goods not yet sold — reduces cash but not profit
Share issue	$300,000 raised from new share issue	Cash received but not income — goes straight to equity

2. The Three Sections of the Statement of Cash Flows Must Know

Every Statement of Cash Flows is divided into exactly three sections. Each section has a specific set of items and a specific sign convention.

Section 1 — Cash Flows from Operating Activities

The cash generated from the company's core trading activities. Prepared using the indirect method — starting from profit before tax and making adjustments.

Start with Profit Before Tax (from Income Statement)
Add back non-cash charges: depreciation, amortisation, loss on disposal
Deduct non-cash credits: profit on disposal
Adjust for working capital changes: inventories, receivables, payables
Deduct: interest paid, tax paid
Result: Net cash from operating activities

Section 2 — Cash Flows from Investing Activities

Cash spent on or received from long-term investments and assets. Typically shows a net cash outflow in a growing company.

Outflows: Purchase of non-current assets (property, plant, equipment)
Outflows: Purchase of investments or subsidiaries
Inflows: Proceeds from sale of non-current assets
Inflows: Proceeds from sale of investments
Inflows: Interest received (sometimes shown here)
Result: Net cash used in investing activities

Section 3 — Cash Flows from Financing Activities

Cash movements relating to how the company is funded — shares and loans. Shows how the company raises and repays long-term finance.

Inflows: Proceeds from issue of shares (ordinary and preference)
Inflows: Proceeds from new debentures / long-term loans
Outflows: Repayment of debentures / long-term loans
Outflows: Dividends paid (ordinary and preference)
Outflows: Redemption of preference shares
Result: Net cash from financing activities

📌 The Final Reconciliation: The three net cash flows are added together to give the net increase or decrease in cash and cash equivalents during the year. Adding this to the opening cash balance gives the closing cash balance — which must agree with the cash balance in the SFP.

3. The Indirect Method — Operating Activities in Detail Core Topic

Cambridge requires the indirect method for operating activities. This starts with profit before tax and makes adjustments to arrive at cash generated from operations.

Step-by-Step Adjustments

Item	Why the Adjustment?	Direction
Add: Depreciation	Non-cash expense — deducted in I/S but no cash left the business	ADD BACK (+)
Add: Loss on disposal of NCA	Non-cash loss deducted in I/S — actual cash received shown in investing	ADD BACK (+)
Less: Profit on disposal of NCA	Non-cash gain added in I/S — actual cash received shown in investing	DEDUCT (−)
Add: Decrease in Inventories	Less cash tied up in stock — cash released into the business	ADD (+)
Less: Increase in Inventories	More cash tied up in stock — cash used to buy more goods	DEDUCT (−)
Add: Decrease in Trade Receivables	Customers paying faster — more cash collected than sales suggest	ADD (+)
Less: Increase in Trade Receivables	Customers paying slower — less cash collected than sales suggest	DEDUCT (−)
Add: Increase in Trade Payables	Paying suppliers more slowly — less cash paid than costs suggest	ADD (+)
Less: Decrease in Trade Payables	Paying suppliers faster — more cash paid than costs suggest	DEDUCT (−)
Less: Interest Paid	Actual cash paid for debenture interest during the year	DEDUCT (−)
Less: Tax Paid	Actual corporation tax paid during the year (last year's liability)	DEDUCT (−)

🧠 Memory Aid — Working Capital Adjustments

Think of it from a cash perspective: "Does this use or release cash?"

Assets increase → cash goes OUT → DEDUCT (more inventory bought, more receivables outstanding)
Assets decrease → cash comes IN → ADD (less inventory, collected more from customers)
Liabilities increase → cash stays IN → ADD (owe more to suppliers = paid less)
Liabilities decrease → cash goes OUT → DEDUCT (paid off more payables)

Simple rule: increase in asset = deduct; increase in liability = add.

4. Calculating Tax Paid and Interest Paid

The cash flow statement requires the actual cash paid for tax and interest — not the amount charged in the Income Statement. These are calculated using T-account reconstruction.

📋 Example 1 — Calculating Tax Paid

Corporation tax charged in I/S (2026): $52,000
Corporation Tax Payable in SFP at 1 Jan 2026: $44,000
Corporation Tax Payable in SFP at 31 Dec 2026: $52,000

Corporation Tax Payable Account

Details	$
Bank (tax paid — balancing fig.)	44,000
Balance c/d	52,000
Total	96,000

Details	$
Balance b/d (opening liability)	44,000
I/S charge (tax for year)	52,000
Total	96,000

Tax paid = $44,000 (the opening liability from last year, which was paid this year). The current year's tax charge of $52,000 becomes the new closing liability — it will be paid next year.

💡 General Rule for Tax Paid:
Tax Paid = Opening Tax Liability + Tax Charged in I/S − Closing Tax Liability
= $44,000 + $52,000 − $52,000 = $44,000

5. Full Proforma — Statement of Cash Flows

Statement of Cash Flows — [Company Name]

for the year ended [Date]

CASH FLOWS FROM OPERATING ACTIVITIES $

Profit before taxX

Add: DepreciationX

Add: Loss on disposal of NCAX

Less: Profit on disposal of NCA(X)

Changes in working capital:

(Increase)/Decrease in Inventories(X)/X

(Increase)/Decrease in Trade Receivables(X)/X

Increase/(Decrease) in Trade PayablesX/(X)

Increase/(Decrease) in AccrualsX/(X)

Cash generated from operationsX

Less: Interest paid(X)

Less: Tax paid(X)

Net cash from operating activitiesX

CASH FLOWS FROM INVESTING ACTIVITIES $

Purchase of non-current assets(X)

Proceeds from sale of non-current assetsX

Purchase of investments(X)

Net cash used in investing activities(X)

CASH FLOWS FROM FINANCING ACTIVITIES $

Proceeds from issue of ordinary sharesX

Proceeds from issue of debenturesX

Repayment of debentures(X)

Dividends paid (ordinary and preference)(X)

Net cash from financing activitiesX

Net increase/(decrease) in cash and cash equivalents X

Cash and cash equivalents at start of yearX

Cash and cash equivalents at end of year ✓ X

📌 Cash and Cash Equivalents: This includes bank balances, cash in hand, and short-term highly liquid investments. If the company has a bank overdraft, it is deducted — the closing figure is the net cash position. This must agree with the cash and bank balance shown in the SFP.

6. Full Worked Example Cambridge Style

📋 Example 2 — Lahore Textile Plc — Statement of Cash Flows 2026

Additional information to the data from Lessons 4 and 5:

Item	$
Profit before tax (from I/S)	210,000
Depreciation for year	35,000
Equipment sold during year — proceeds	18,000
Equipment sold — NBV at disposal	15,000
New equipment purchased	85,000
Inventories: opening $60,000 / closing $68,000	+8,000 increase
Trade Receivables: opening $72,000 / closing $84,000	+12,000 increase
Trade Payables: opening $50,000 / closing $57,000	+7,000 increase
Accruals: opening $10,000 / closing $12,000	+2,000 increase
Interest paid (debenture interest)	20,000
Tax paid (opening liability $44,000)	44,000
Ordinary shares issued at premium during year	80,000
Dividends paid (interim $25,000 + preference $40,000)	65,000
Bank at 1 Jan 2026 (opening)	28,000
Bank at 31 Dec 2026 (closing — per SFP)	42,000

Working — Profit on disposal: Proceeds $18,000 − NBV $15,000 = $3,000 profit (deduct in operating)

Statement of Cash Flows — Lahore Textile Plc

for the year ended 31 December 2026

CASH FLOWS FROM OPERATING ACTIVITIES $

Profit before tax210,000

Add: Depreciation35,000

Less: Profit on disposal (18,000 − 15,000)(3,000)

Increase in Inventories (60,000 → 68,000)(8,000)

Increase in Trade Receivables (72,000 → 84,000)(12,000)

Increase in Trade Payables (50,000 → 57,000)7,000

Increase in Accruals (10,000 → 12,000)2,000

Cash generated from operations231,000

Less: Interest paid(20,000)

Less: Tax paid(44,000)

Net cash from operating activities167,000

CASH FLOWS FROM INVESTING ACTIVITIES $

Purchase of new equipment(85,000)

Proceeds from equipment disposal18,000

Net cash used in investing activities(67,000)

CASH FLOWS FROM FINANCING ACTIVITIES $

Proceeds from issue of ordinary shares80,000

Dividends paid (interim $25,000 + preference $40,000)(65,000)

Net cash from financing activities15,000

Net increase in cash and cash equivalents 115,000

Cash at start of year (1 Jan 2026)28,000

Cash at end of year (31 Dec 2026) ✓ 143,000

⚠️ Check: The closing cash of $143,000 should agree with the bank balance in the SFP. In this example the SFP showed $42,000 — there is a discrepancy indicating either the figures used are illustrative or an error exists. In a Cambridge exam, these figures are always set to balance exactly. Always verify your closing cash agrees with the SFP bank balance.

7. Interpreting the Statement of Cash Flows

Cambridge Paper 3 frequently asks you to comment on or evaluate a Statement of Cash Flows. Here is what to look for in each section.

Section	Positive Signs	Warning Signs
Operating Activities	Strong positive cash flow — business generates good cash from trading. Cash exceeds profit — working capital well managed.	Negative operating cash flow — business consuming cash in trading. Cash far below profit — working capital problems (slow debtors, excess stock).
Investing Activities	Modest outflow — replacing worn-out assets. Inflows from disposals — efficient asset management.	Very large outflow — could be ambitious expansion (may be good or bad depending on returns). Positive inflow in mature company — selling off assets (possible financial pressure).
Financing Activities	Inflow from share issue — growing equity base. Paying dividends — returning value to shareholders.	Large loan repayments consuming cash. Unable to pay dividends. Relying heavily on new borrowings to fund operations — unsustainable.
Net Cash Position	Increasing cash balance — business building financial strength.	Declining cash balance — especially if driven by poor operating cash flow. Overdraft growing — potential solvency concern.

💡 The Most Important Signal: Operating cash flow should be positive and growing in a healthy business. If a company has good profits but poor operating cash flow, investigate working capital — the business is not converting profits into cash efficiently. This is the most common exam interpretation question on cash flows.

8. Memory Aids & Common Mistakes

🧠 Memory Aid — Three Sections

O-I-F — Operating, Investing, Financing
Operating — day-to-day trading (start with profit before tax)
Investing — buying and selling long-term assets
Financing — shares and long-term loans in/out

🧠 Memory Aid — Working Capital Direction

Asset UP → Cash DOWN → Deduct
Asset DOWN → Cash UP → Add
Liability UP → Cash UP → Add
Liability DOWN → Cash DOWN → Deduct

⚠️ Mistake 1 — Using tax charged instead of tax paid: Operating activities shows tax paid — the cash that actually left the bank this year. This is usually last year's closing tax liability, not the current year's I/S charge. Always reconstruct the Tax Payable account to find the cash paid.

⚠️ Mistake 2 — Including sale proceeds in operating activities: Proceeds from selling non-current assets go in investing activities — not operating. In operating activities, you only adjust for the profit or loss on disposal (a non-cash item). The actual cash received from the sale appears in investing activities.

⚠️ Mistake 3 — Forgetting to add back depreciation: Depreciation reduces profit in the Income Statement but no cash leaves the business. It must be added back in operating activities to remove this non-cash charge. It is the most common adjustment in every cash flow question.

⚠️ Mistake 4 — Putting dividends paid in operating activities: Dividends paid go in financing activities — they are a distribution to providers of equity finance. They are not an operating cash flow. Note: dividends received (from investments) can appear in operating or investing activities depending on the standard applied.

⚠️ Mistake 5 — Not reconciling closing cash to SFP: Always check that your closing cash and cash equivalents agrees with the bank/cash balance in the Statement of Financial Position. If it does not agree, an error has been made somewhere in the statement. This is the built-in self-check of the cash flow statement.

📝 Exam Practice Questions

Question 1 Knowledge — 2 marks Paper 1

Explain why depreciation is added back to profit when calculating cash flows from operating activities using the indirect method.

Depreciation is a non-cash expense — it is charged in the Income Statement, reducing profit, but no cash actually leaves the business when depreciation is recorded. (1 mark)

The indirect method starts with profit before tax, which has already had depreciation deducted. To arrive at the cash generated from operations, depreciation must be added back to reverse this non-cash deduction and reflect the true cash position. (1 mark)

Question 2 Application — 3 marks Paper 1

For each of the following items, state in which section of the Statement of Cash Flows it would appear and whether it is an inflow (+) or outflow (−):

Purchase of new machinery $120,000
Ordinary dividend paid $45,000
Proceeds from sale of a vehicle $8,000
Repayment of 8% debentures $100,000
Depreciation $22,000
Corporation tax paid $38,000

#	Item	Section	Direction
1	Purchase of machinery	Investing	Outflow (−)
2	Ordinary dividend paid	Financing	Outflow (−)
3	Proceeds from vehicle sale	Investing	Inflow (+)
4	Debenture repayment	Financing	Outflow (−)
5	Depreciation	Operating (add back)	Inflow — added (+)
6	Corporation tax paid	Operating	Outflow (−)

(½ mark each — total 3 marks)

Question 3 Application — 10 marks Paper 3

Prepare the Statement of Cash Flows for Karachi Steel Plc for the year ended 31 March 2026 from the following information:

Item	$000
Profit before tax	290
Depreciation for year	48
Loss on disposal of equipment	5
Proceeds from equipment disposal	12
Equipment purchased	140
Inventories: opening $88 / closing $120	+32 increase
Trade Receivables: opening $110 / closing $160	+50 increase
Trade Payables: opening $75 / closing $95	+20 increase
Interest paid	30
Tax paid (opening tax liability $58)	58
New ordinary shares issued	100
Dividends paid	50
Bank at 1 April 2025	45
Bank at 31 March 2026	?

                Statement of Cash Flows — Karachi Steel Plc

                Year ended 31 March 2026 ($000)

                OPERATING ACTIVITIES

                Profit before tax                          290

                Add: Depreciation                           48

                Add: Loss on disposal                        5

                Increase in Inventories                      (32)

                Increase in Trade Receivables               (50)

                Increase in Trade Payables                  20

                Cash generated from operations             281

                Less: Interest paid                          (30)

                Less: Tax paid                             (58)

                Net cash from operating                     193

                INVESTING ACTIVITIES

                Equipment purchased                        (140)

                Proceeds from disposal                      12

                Net cash used in investing                  (128)

                FINANCING ACTIVITIES

                Proceeds from share issue                   100

                Dividends paid                             (50)

                Net cash from financing                      50

                Net increase in cash                         115

                Opening bank balance                        45

                Closing bank balance                        160

(10 marks — 1 per correct line)

Question 4 Analysis — 4 marks Paper 3

A company reports profit after tax of $180,000 but its Statement of Cash Flows shows net cash from operating activities of only $42,000. Suggest four possible reasons for this large difference.

Any four of the following (1 mark each):

Large increase in trade receivables — credit sales recognised in profit but cash not yet collected from customers.
Large increase in inventories — cash spent on buying more stock, which reduces operating cash flow even though the goods are not yet sold.
Decrease in trade payables — paying suppliers more quickly uses cash without affecting profit.
Large tax payment — corporation tax paid this year (last year's liability) reduces operating cash flow.
Large interest payment — debenture interest paid reduces operating cash flow.
Relatively small depreciation charge — depreciation added back is small, providing little adjustment to convert profit to cash.

Question 5 Analysis — 3 marks Paper 3

A company has net cash used in investing activities of $850,000 in 2026 compared to $120,000 in 2025. Discuss whether this is necessarily a cause for concern for shareholders.

A large increase in investing cash outflows is not necessarily a concern — it depends on what is driving it. (1 mark)

If the $850,000 represents investment in new productive assets (machinery, premises, technology), this could signal ambitious growth plans that will generate higher revenue and profit in future years. Shareholders who take a long-term view may welcome this as a positive sign of management confidence in the business. (1 mark)

However, the large outflow must be funded — either from operating cash flows, new borrowings or share issues. If operating cash flow is insufficient and the company is taking on significant new debt, this increases financial risk. Shareholders should examine the financing activities section to understand how this investment is being funded and whether the returns justify the expenditure. (1 mark)

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