In a given period, any of the following activities will generate cash:
- 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
Net Profit as a Source of Cash
Net profit is obviously the most apparent source of cash in any period.
To prepare a cash flow statement for a company, the starting point is net profit as disclosed by the profit and loss account (i.e., the profit before deducting any corporation tax for the year, any dividends for the year, or transfers to any reserves).
The reason for considering profit before tax and dividends is obvious: namely, 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, all profit is not earned in the form of cash. Therefore, the net profit figure disclosed by the profit and loss account 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 the company’s normal operational activities.