How do you reconstruct where a company's cash came from and went, and why can a profitable company still run short of cash?
Prepare a statement of cash flows for a limited company in accordance with IAS 7, classifying cash flows into operating, investing and financing activities, reconciling profit before tax to cash generated from operations, and interpreting the result.
A focused answer to the SQA Advanced Higher Accounting statement of cash flows, covering the IAS 7 classification into operating, investing and financing activities, the reconciliation of profit before tax to cash from operations, the treatment of working-capital changes, and interpreting why profit and cash differ.
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What this dot point is asking
The SQA wants you to reconstruct a company's cash movements over the year and present them in the IAS 7 format, then explain what they reveal. A company can report a profit and still be running out of cash, and the statement of cash flows is the tool that exposes the difference. This is a regular extended-response question worth a substantial block of marks.
The three sections of IAS 7
IAS 7 forces every cash movement into one of three buckets, and the order is fixed.
The logic is that users want to know not just whether cash rose or fell, but why. Cash generated from healthy trading is sustainable; cash raised by selling assets or borrowing is not. Separating the three sections lets a reader judge the quality of the cash flow.
Reconciling profit to cash from operations
The operating section is the part candidates find hardest because profit is calculated on the accruals basis, not the cash basis. The reconciliation strips the accruals adjustments back out.
The single rule that prevents most errors is: an increase in an asset uses cash, an increase in a liability provides cash. Apply that consistently and the working-capital signs follow automatically.
Investing and financing activities
The other two sections are mostly a matter of sorting movements correctly and getting the signs right.
Investing activities record cash spent buying non-current assets (an outflow) and cash received from selling them (an inflow). The figure for assets purchased is often found by reconstructing the non-current asset account: opening cost plus additions minus disposals equals closing cost. Financing activities record cash from issuing shares (inflow), new loans raised (inflow), loans repaid (outflow) and dividends paid (outflow).
Interpreting the statement
The numbers are only half the question. The SQA usually asks you to comment on liquidity and the quality of the cash flow. Strong, positive net cash from operations is the healthiest sign. Heavy reliance on selling assets or new borrowing to fund the business is a warning. A profitable company with falling cash has usually either invested heavily, repaid debt, paid large dividends, or let working capital balloon.
Why this matters later
The statement of cash flows complements the ratio analysis in the interpretation topic: profitability ratios can look strong while cash is draining away, and only the cash flow statement reveals it. It also connects to the management accounting area, where the cash budget projects the same operating, investing and financing flows forward rather than reporting them after the fact. In the project, a real company's cash flow statement is a key piece of evidence about its financial health.
Try this
Q1. Profit before tax is GBP 90,000, depreciation is GBP 20,000, inventories fell by GBP 6,000 and payables fell by GBP 4,000. Find cash generated from operations. [4 marks]
- Cue. (inventory fall adds cash, payables fall uses cash).
Q2. A company sold equipment for GBP 12,000 and bought new equipment for GBP 70,000. State the net cash flow from investing activities. [2 marks]
- Cue. .
Exam-style practice questions
Practice questions written in the style of SQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AH style: cash from operations7 marksProfit before tax is GBP 120,000. Depreciation for the year was GBP 30,000. Inventories rose by GBP 12,000, trade receivables fell by GBP 8,000 and trade payables rose by GBP 5,000. Calculate the cash generated from operations.Show worked answer →
Start from profit before tax GBP 120,000 and add back the non-cash depreciation: (2 marks).
Adjust for working capital. A rise in inventories uses cash, so subtract GBP 12,000. A fall in receivables releases cash, so add GBP 8,000. A rise in payables delays cash going out, so add GBP 5,000 (3 marks for the correct signs).
Cash generated from operations is (2 marks). Markers reward adding back depreciation, applying the correct direction to each working-capital change, and a labelled subtotal.
AH style: interpretation4 marksA company reports a healthy profit but its cash position has fallen sharply over the year. Suggest two reasons consistent with a statement of cash flows, and one action to improve the cash position.Show worked answer →
Two reasons might be heavy investing outflows (for example buying non-current assets) or large financing outflows (repaying a loan or paying dividends), or a build-up of working capital such as rising inventories and receivables tying up cash (2 marks for two valid, distinct reasons).
An action could be to tighten credit control to collect receivables faster, reduce slow-moving inventory, delay non-essential capital expenditure, or arrange financing (1 mark for a sensible action, 1 mark for linking it to the reason given). Markers reward reasons that a cash flow statement would actually reveal and an action that addresses them.
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