Understanding Cash Flow Statement and its Activities

The article explains the three major activities of cash flow statement: operating, financing and investing activities. It also discusses the cash flows between a company and its stakeholders. Another solution includes calculations for payback period, return on investment and residual income.

Solution-1
The cash flow statement is a major financial statement which shows the movement of cash flows during
the period. These movements are in the form of cash inflows and cash outflows from various accounting
transactions. Broadly, the cash flow statement has three major activities classified on the basis of nature
of transactions. These are:
(a) Cash flow from operating activities – this activity records the inflows and outflows of cash from
the activities related to the business of the company useful in deriving the net income from the
business. This activity includes cash inflow from sale of product, cash outflow in payment to
vendors, employees, payment of taxes, purchase of inventory etc.
(b) Cash flow from financing activities – this activity records the flow of cash from financing
activities, meaning thereby the transactions involving borrowing of money to run the business. It
is generally associated with the long term liabilities and equity items. This activity mainly
consists of cash inflow from receipt of loan, cash outflow in repayment of loan and its interest,
issuance of stocks to the shareholders, dividend paid to them, etc.
(c) Cash flow from investing activities – this activity includes flow of cash from transactions related
to investment of money. It is related with long term assets of the company. This activity includes
cash flow from investing the money in purchase of shares, stocks, debentures, receiving interest
and dividends from investment, purchase or sale of fixed assets for business, purchasing or
disposal of other businesses and so on.
The company and the stakeholders are related to each other and the following are the cash flows between
a company and its stakeholder:
(a) Purchase of company’s shares by stakeholders by investing in stocks of the company – It is a cash
inflow from financing activities for company.
(b) Payment of dividend by company to its stakeholders – it is a cash outflow from financing
activities for the company.
(c) Buy back of shares by the company from its stakeholders – it is a cash outflow from a company
prospective.

Solution-2
Current Income Statement
Particulars Total Digital Watches Analog Watches
Sales revenue 850,000 500,000 350,000
Variable expenses (530,000) (250,000) (280,000)
Contribution margin 320,000 250,000 70,000
Fixed expenses (180,000) (90,000) (90,000)
Operating income (loss) 140,000 160,000 (20,000)
Revised Income Statement assuming Analog Watches line is dropped
Particulars Total Digital Watches Analog Watches
Sales revenue 500,000 500,000 -
Variable expenses (250,000) (250,000) -
Contribution margin 250,000 250,000 -
Fixed expenses (180,000) (90,000) (90,000)
Operating income (loss) 70,000 160,000 (90,000)
Hence, if the analog watch line is dropped than the net operating income will be $70,000 as compared to
$140,000 as of now, meaning thereby the net operating income will decrease by $70,000.
Hence, it is advised to not to drop the Analog watch line.

Solution-3
Calculation of Payback Period:
Year Cash Flow Cumulative Cash flows
0 (331,000) (331,000)
1 54,000 (277,000)
2 54,000 (223,000)
3 54,000 (169,000)
4 54,000 (115,000)
5 54,000 (61,000)
6 54,000 (7,000)
7 54,000 47,000
8 65,000 112,000
From the above table, it is evident that the cumulative cash flows are getting positive in the year 7. The
calculation of exact payback period is as below:
Payback Period = 6 + (7000/54000)
Payback Period = 6.130
Hence, the payback period is 6.13 years.

Solution-4
Calculation of return on investment (ROI)
Return on investment = Net Operating Income / Average Operating Assets
Return on investment = 2,006,400/6,000,000
Return on investment = 33.44%
Hence, the division's return on investment (ROI) is 33.44%.

Solution-5
Calculation of residual income
Residual Income = Net operating income - (average operating assets X minimum required rate of
return)
Residual Income = 86,000 - (410,000 X 19%)
Residual Income = 8,100
Hence, the Games Division's residual income in June is $8,100.