In any given period cash will be generated by any of the following activities:
- Net profit made in the period.
- Increase in share capital during the year.
- Increase in any liability during the year
- Decrease in any asset during the year
Let us consider each of the above sources in some detail.
Net Profit as a source of cash
Net profit is obviously the most apparent source of cash in any period. For the purpose of preparing a Cash Flow Statement of a company, the starting point is Net Profit as disclosed by Profit and Loss Account, i.e. the profit before deduction of any corporation tax for the year, any dividends for the year or any transfers to any reserves.
The reason for taking the Profit before Tax and Dividends is obvious: taxes and dividends are paid after the end of the financial year and hence do not form part of the cash outflows for the year.
However, as seen in earlier paragraphs all profit is not earned in the form of cash. Therefore the net profit figure as disclosed by the Profit and Loss Account of a company needs to be adjusted in some respects to arrive at the amount of cash generated through normal trading or operational activities. These adjustments account for non-cash expenses and non-cash incomes as well as items that do not fall within the definition of normal operational activities of the company