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Cash from Business Operations

Funds from business operations under working capital concept are based on accrual accounting concept in that sales, whether credit or cash, are recognized as a source of working capital. Likewise, purchases whether credit or cash are considered as a use of working capital. But, under the cash concept of funds, obviously, the cash basis of accounting is to be used. Only cash sales and cash receipts from debtors against credit sales are recognized as a source of cash. Similarly, cash purchases and cash payments to suppliers for credit purchases are regarded as the use of cash. The same-holds true for other expenses and incomes. No consideration is given for outstanding and prepaid expenses and incomes.

Thus, every item in the profit and loss account is to be as per the cash approach. Some of the items of adjustment of the profit and loss account in the cash flow approach would be the same as in the funds statements, for instance, depreciation on plant and equipment, amortization of various deferred revenue expenses and so on. Since these items do not involve any corresponding outflow of funds (cash), they are added back to determine funds from operations in funds statements. The logic that is applied in the funds statement also applies in the cash flow statement, but the analysis is required to be extended further. Cash is only one of the current assets and is part of the net working capital. Therefore, the changes in all of the other current assets and in the current liabilities must be analysed in relation to their effect on cash. The rules for relating the changes in current assets and current liabilities to the profit and loss account in the computation of a flow of cash from operations are summarized below.

1. All the increases in current assets excluding cash and decreases in current liabilities which increase working capital decrease cash. The decrease in current liabilities takes place when they are paid in cash. For instance, decrease in creditors, bank overdrafts, bills payable and dividends payable will occur due to their payment. A word of explanation is necessary to show the negative impact of increase in current assets on cash. For instance, an increase in sundry debtors takes place when credit sales are greater than cash collections from them; inventories increase when the cost of goods purchased is more than the cost of goods sold. Increase in prepaid expenses involves payment of more cash than is required for their current services.

2. From the first follows the second rule--all decreases in current assets other than cash and increases in current liabilities which cause a decrease in working capital increase cash. Debtors would decrease because cash collections arc more than current credit sales, Inventories would decrease because cost of goods sold is more than cost of goods purchased, decrease in prepaid expenses reflects that the firm has paid less for service than are currently used. Exhibit shows the procedure for determining cash from business operations.

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