Lecture 6c - Measuring & Reporting Cash Flows

Given the financial information derive the company´s net cash flow from operating activities

The answer is in the bottom of the photo

In what part of the 2 other statements was cash historically represented?

Under assets in the balance sheet, as "cash". The company´s most liquid asset.

SUMMARY What is the importance of the statement of cash flows?

● Cash is important because no business can operate without it. ● The statement of cash flows is specifically designed to reveal movements in cash over a period. ● Cash movements cannot be readily detected from the income statement, which focuses on revenue and expenses rather than on cash receipts and cash payments. ● Profit (or loss) and cash generated for the period are rarely equal. ● The statement of cash flows is a primary financial statement, along with the income statement and the statement of financial position.

SUMMARY Problems with IAS 7

● IAS 7 has been criticised for being too permissive in the description and classification of important items and for allowing businesses to adopt the indirect method for determining net cash from operating activities. ● There have also been calls for movements in net debt to be reconciled with cash flows.

SUMMARY What is the structure of the cash flow statement?

● The layout of the statement contains three categories of cash movement: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. ● The total of the cash movements under these three categories will provide the net increase or decrease in cash and cash equivalents for the period. ● A reconciliation can be undertaken to check that the opening balance of cash and cash equivalents plus the net increase (or decrease) for the period equals the closing balance.

SUMMARY: How is the cash generated from operations calculated?

● The net cash flows from operating activities can be derived by either the direct method or the indirect method. ● The direct method is based on an analysis of the cash records for the period, whereas the indirect method uses information contained within the income statement and statements of financial position of the business. ● The indirect method takes the net operating profit for the period, adds back any depreciation charge and then

SUMMARY Interpreting the statement of cash flows

● The statement of cash flows shows the main sources and uses of cash. ● Tracking the cash movements over several periods may reveal financing and investing patterns and may help predict future management action.

To calculate the net flow of cash for INVESTING activities, what items are looked at in the opening and closing balance sheet?

Payments to acquire tangible non-current assets Interest recieved (from loans to others) Profit (loss) on disposal of non-current assets Didividens recieved *** Under IAS 7, interest recieved and dividends recevied could be classidied under "cash flows form operating activities" as they appear in the calculation of profit.

Why is cash so important?

- Because others expect payment in the form of cash (suppliers, workers, lenders etc.) - Cash generation is therefore VITAL FOR BUSINESSES TO SURVIVE and to be able to take advantage of commercial opportunities. - During an economic downturn, the ability to generate cash takes on even greater importance. Banks become more cautious in their lending and businesses with weak cash flows often find it difficult to obtain finance.

Define cash and "cash equivalents" according to IAS.

- CASH = notes and coins in hand and deposits in banks and similar institutions that are accesible to the business ON DEMAND. - CASH EQUIVALENTS = short-term, highly liquid investments that can be readily convertible to known amounts of cash.

Explain the statement "Cash is King"

- Cash is the most important asset in keeping a company afloat. - You can have a profit, but if you do not have cash to repay your liabilities, it will kill you. - You can survive on cash with no profits for an extended period of time. ** We want to do business with a company that is self-sustaingin. One that can organically grow rather than having continously to ask for funding. Cash direction (indirect method) gives insight into whether the business is self-sustaining.

What does the cash statement tell users?

- How the business has generated cash during the period and where that cash has gone. This is potentially very useful, an useful in making predictions of future behaviour of the business. - Relate the cash flow to the other statements, what is the bigger picture they reveal? - Relate the cash flow to ratios, previous years and competitiors.

What are is IAS 7, and the problems with it?

- IAS is the international standard, defining cash flow and its compoenents CRITICS: - Arguably the difinition/standard is too permissive in the description and classification of important items in the cash statement. e.g. dividends and interest, both paid and recieved, can be classified in an alternative way. >> Under net cash flow from operating activities and investing activitives. - Would generate greater confidence if it insisted only the DIRECT method be used. In the direct method, no acrual-based adjustments are made, which means that it is LESS SUSCPETIBLE TO MANIPULATION than the indirect appriach.

What does the indirect method of generating the net cash flow for operating activities depend on?

- It relies on the fact that, sooner or later, sales revenue gives rise to cash inflows and expenses give rise to cash outflows. - This means that the figure for PROFIT FOR THE YEAR will be linked to the NET CASH FLOWS from OPERTAING ACTIVITIES. ** Important to recognize that income statement takes into account revenue generated, which is NOT neccesarily equivalent to cash flow of the period, esp. if revenue is generated near the end of the financial period in the form of credit.

When was the cash flow sheet developed? Why?

- Last of the 3 to be developed. - At one time, companies were only required to publish an income statement and statement of financial position. >> The view was that all the financial information needed by user groups would be contained within these 2 statements. Based partly on the ASSUMPTION that is a business was profitable it would also have plenty of cash. - While in the long run this is likely to be true, it is not necessarily true in the short to medium term.

How do you calculate the net cash flow form the 3 categories of cash flow movement? How does this relate to the balance sheet?

- Sum the net cash flow in the 3 categories - Add opening cash balance for the year This should give you the closing cash balance for the year (which is provided in the balance sheet under assets)

What does the sum of the cash flows from operating, investing and financing activities give?

- The final total shown on the cash statement = NET increase or decrease in cash and cash equivalents over the period.

Define cash flows from investing activities What make up the cash inflows and outflows?

- These include cash outflows to acquire NON-current assets and cash inflows from their DISPOSAL, AND cash inflows from financial investments (loans to others and dividends from shares in other companies). *** Under IAS 7, interest recieved and dividends recevied could be classidied under "cash flows form operating activities" as they appear in the calculation of profit.

Define cash flows from financing activities What make up the cash inflows and outflows?

- These represent cash inflows and outflows relating to the long-term financing of the business. Cash inflows = long-term bank loan, share capital injection, loan notee, issue of new shares Cash outflows = cost of issuing shares, interest and dividends paid by the business could appear under this heading (instead of cash from operating activities), repaying loans, buying back shares

Define cash flows from operating activities What make up the cash inflows and outflows?

- These represent the cash inflows and outflows arising from normal day-to-day trading activities, after taking account of the tax paid and financing costs (equity and borrowings) relating to those activities. CASH INFLOWS: for the period are the amounts received from trade receivables and from cash sales for the period. CASH OUTFLOW: for the period are the amounts paid for inventories, operating expenses (such as rent and wages), tax, interest and dividends. (many companeis pay tax on their annual profits in 4 equal instalments. 2 of these are paid during the year concerned and the other 2 are paid during the following year - thus at the end of the year, hafl of the tax will have been paid and the remaining half will be outstanding (accruals) to be paid during the following year). ** NOTE it is the cash inflows and outdlows during a period that appear in the statement of cash flows, not revenu and expenses (different from income statement that is governed by matching principle) >>> They are flows of cash that ACTUALLY HAPPENED.

Which of the two methods of generating the net cash flow for operating activities is most commonly used?

- When a computer is used, the direct method is simpler, but hardly any businesses adopt the direct method. - The indirect method is very much the popular method.

Solution

1 This is simply taken from the income statement for the year. 2 Since there were no disposals, the depreciation charges must be the difference between the start and end of the year's plant and machinery (non-current assets) values, adjusted by the cost of any additions. 3 Interest receivable must be taken away to work towards the profit before crediting it, because it is not part of operations but of investing activities. The cash inflow from this source appears under the 'Cash flows from investing activities' heading. 4 Interest payable expense must be taken out, by adding it back to the profit figure. We subsequently deduct the cash paid for interest payable during the year. In this case the two figures are identical. 5 Taxation is paid by companies 50 per cent during their accounting year and 50 per cent in the following year. As a result the 2010 payment would have been half the tax on the 2009 profit (that is, the figure that would have appeared in the current liabilities at the end of 2008), plus half of the 2010 taxation charge (that is, 16 + ( 1-2 × 46) = 39). 6 It has been assumed that the loan notes were redeemed for the value shown on the statement of financial position. This is not, however, always the case. 7 The share issue raised £90 million, of which £50 million went into the share capital total on the statement of financial position and £40 million into share premium. 8 There were no 'cash equivalents', just cash (though negative).

What are the 3 categories into which the statement of cash flow is divided ACCORDING TO REGULATION?

1. CASH FLOW FROM OPERATING ACTVITIES 2. CASH FLOW FROM INVESTING ACTIVITIES 3. CASH FLOW FROM FINANCING ACTIVITIES 1 +/- 2 +/- 3 = NET INCREASE (or decrease) in CASH and CASH EQUIVALENTS OVER THE PERIOD.

How are the 3 financial statments inter-related? What is the relationship between them?

BALANCE SHEET = shows various assets (including cash) and claims (including shareholders equity) of the business at a PARTICULAR POINT IN TIME (photograph) CASH STATEMENT + INCOME STATMENT= explain the changes over a period to two of the items in the statment of financial position. CASH = explains changes to cash over time INCOME = explains changes to equity, arising from trading operations.

How is the net cash flow from financing and investing activities determined using the indirect method?

Both of the above may be ascertained through an examination of the opening and closing balance sheets and the Income Statement.

To calculate the net flow of cash for FINANCING activities, what items are looked at in the opening and closing balance sheet?

Cash inflows = long-term bank loan, share capital injection, loan notee, issue of new shares Cash outflows = cost of issuing shares, interest and dividends paid by the business could appear under this heading (instead of cash from operating activities), repaying loans, buying back shares

What is the normal direction of cash flows?

OPERTAING ACTIVITIES: - Provide positive cash flows and therefore increase the businesses cash resources. - For most UK business, cash generated from day-to-day trading after deducint tax, interests and dividends is by far the MOST IMPORTANT source of new finance. INVESTING ACTIVITIES: - Typically provide cause net negative cash flows. This is because many non-current assets either wear out or become obsolete and NEED TO BE REPLACED. Businesses may also expand their asset base. >> Non-current assets may of course also be sold which would give rise to positive cash flows. ** Normally cash spent on new assets far outweights that recieved from the sale of old ones. FINANCING ACTVITIES: - Can go either direction, depending on the FINANCING STRATEGY at the time. - Since businesses seek to expand, there is a general tendency for this area to lead to cash coming into the business rather than leaving it.

What is the process (template) for deducing the net cash flow from operating activities using the indirect method? EXAM QUESTION (VERY LIKELY)

Profit before tax = net profit Determining the net cash flows from operating activities involves: adding back the depreciation and the interest expense to the Net Profit before Tax for the period. adjustment is made for any increases or decreases in Inventories (stock), Receivables (debtors), Prepayments, and Payables (creditors). Cash payments for interest, tax and dividends * are deducted. * Note that dividends could alternatively be included under the heading 'Cash flows from financing activities'. Not both headings. ** Before "interest paid" add an item called "cash generated from operation" = sum of all the previous categories, from which interest paid, taxation paid and dividend paid are deduced to give "net cash from operating activities"

The sales revenue figure for a business for the year was £34 million. The trade receivables totalled £4 million at the beginning of the year, but had increased to £5 million by the end of the year. What is the cash flow from operating activities for the year?

Sales = 34M Trade recievables increased by 1M Therefore only 33M of sales were recieved in cash. Therefore net cash flow (ceteris paribus) equals 33M.

Determine the net cash flow for the year of the given company, given the balance sheet and income statement

Solution given in next slide

Why do we add back an amount for interst at the start of the derivation of cash flow from operating activities only to deduct an amount for interst further down?

The reason is that the first is the interst EXPENSE for the reporting period (expense incured to generate profit - matching profit), where as the second is the amount of CASH PAID OUT for interst during that period. You can figure out the difference by looking at accruals in the balance sheet***

How can we deduce the cash inflows from sales using the income statement and statement of financial position for the business?

The statement of financial position will tell us how much was owed in respect of credit sales at the beginning and end of the year (trade receivables). The income statement tells us the sales revenue figure. If we adjust the sales revenue figure by the increase or decrease in trade receivables over the year, we deduce the cash from sales for the year.

What is a company´s tax payment PAID during the year usually equal to?

The tax payment during a year is normally eual to hald of the previous year´s tax change and half of that of the current year.

What are the 2 broad methods from which the cash flow from operating activities can be derived?

There are two methods... DIRECT INDIRECT 1. DIRECT: The direct method is used within your own company where you already have available all the cash receipts and payments details. 2. INDIRECT: The indirect method is used where you are looking at another company's details and have only the opening and closing balance sheets for the latest year and the income statement for the latest year (work backwards from balance sheet and income statement).