Paper F1 Finance Operations: The Secret to Answering Questions Requiring You to Produce Cash Flow Statements Is to Take a Methodical Approach to Taking out the Non-Cash Items

By Clarke, Richard | Financial Management (UK), January-February 2011 | Go to article overview

Paper F1 Finance Operations: The Secret to Answering Questions Requiring You to Produce Cash Flow Statements Is to Take a Methodical Approach to Taking out the Non-Cash Items


Clarke, Richard, Financial Management (UK)


All that a cash flow question actually asks you to do is to take the statement of comprehensive income and the statement of financial position (the balance sheet to you and me) and turn this into cash. That entails getting rid of the non-cash stuff- depreciation and receivables and so on. Here's a step-by-step guide to doing it.

Step one: take your operating profit figure and add back all non-cash items.

The first task is to add back all non-cash expenses to the operating profit (PBIT) and take off all noncash receipts. Magically, you'll be left with cash. There are seven non-cash items to consider: depreciation; amortisation; impairment; profit/loss on sale of non-current assets; increase/decrease in inventory; increase/decrease in receivables; and increase/decrease in payables. For the last three of these, if it's an increase in receivables or inventory, you take off from operating profit; if it's a decrease, you add back. The opposite applies to payables. All of this goes into the "Cash flow from operating activities" section of the cash flow statement.

Step two: continue down the income statement after PBIT: calculate the cash and put it into the cash flow statement.

Let's assume that the next item in the income statement is interest and that it says interest expense ($200). The question to consider is whether this $200 is all cash or not. Before we look at that, let me give you a scenario: at the start of year you owed me [pounds sterling]100. During the year you bought more things from me (on credit) worth [pounds sterling]40. At the end of the year you should owe me [pounds sterling]140, obviously. But, if I were to tell you that you owed me only [pounds sterling]120, what must have happened? You must have paid me [pounds sterling]20 in cash--and it's this cash that goes into the cash flow statement.

Let's use the principles of this scenario in a cash flow question. You need three figures:

* What you owe or are owed at the start of the year (opening receivable/payable): [pounds sterling]100.

* What was bought or sold in the year (income statement figure): [pounds sterling]40.

* What you owe or are owed at the end of the year (closing receivable/payable): [pounds sterling]120.

Using our scenario, we therefore have a cash paid of: [pounds sterling]100 + [pounds sterling]40--[pounds sterling]120 = [pounds sterling]20.

Let's get back to the question where I said that the interest figure in the income statement was $200. Now let me tell you that the interest payable at the start of the year was $1,000 and the payable at the end of the year was $900. How much interest cash has been paid out during the year? $1,000 + $200--$900 = $300. This figure goes into the "Cash flow from operating activities" section of the cash flow statement.

Let's assume that the income statement next shows a taxation expense of $400. There is an opening payable of $90 and a closing payable of $120. What is the tax cash paid that goes into the "Cash flow from operating activities" section of the cash flow statement? $90 + $400--$120 = $370.

Lastly, let's assume there are dividends in the statement of changes in equity of $300 and no dividends payable. As there's nothing payable, this is all cash and goes into the cash flow statement in the "Cash flow from financing activities" section.

You simply follow this procedure for all items in the income statement after operating profit, putting the cash amounts into the cash flow statement as you go along.

Step three: go down the statement of financial position (SFP), find the cash and put it into the cash flow statement.

The first item you will encounter is non-current assets. These can be tricky, so let's leave them until the end. Many of the SFP items we have already sorted out--payables, receivables etc--so let's look at four items we haven't yet dealt with:

* Shares. … 

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