Statements of cash flows

1. Chapter 5 Statements of cash flows

2. Objectives • By the end of this chapter, you should be able to: • prepare a statement of cash flows in accordance with IAS 7; • analyse a statement of cash flows; • critically discuss their strengths and weaknesses.

3. Cash Flow Statement • Cash Flow Statement is a summary of a business’s cash receipts and cash payments, over a certain period of time – usually one year. • It shows the cash that has come from and/or gone to sources external (outside) to the business.

4. Cash Flow Statement • The Cash Flow Statement classifies the sources of cash in terms of: • cash flows from operations (operating activities), • cash flows from investing activities, and • cash flows from financing activities. • The Cash Flow Statement has two main purposes: • measuring a business’s financial health, and • explaining the relationship between the Income Statement prepared under accrual accounting and the actual movement in cash from operations.

5. Cash Flow Statement • Why is it important? • Cash is the lifeblood of an entity. A business cannot survive without cash. • Cash, not reported profit, pays the bills. • A business’s ability to raise cash through financing activities is dependent upon its ability to generate cash from operations. • Creditors and shareholders are not keen to invest in a business that does not generate enough cash from operations to assure prompt payment of maturing liabilities, interest, and dividends.

6. Cash Flow Statement • The Cash Flow Statement is designed to assist stakeholders to assess: • the ability of a business to generate positive cash flows in future periods • both the cash and non-cash aspects of the business’s investing and financing transactions for the period • The Cash Flow Statement reports the business’s investments in such assets as plant and equipment. • ….. more

7. Cash Flow Statement • the business’s ability to meet its obligations and to pay dividends • Shareholders are interested in receiving dividends on their investment. Creditors (lenders and suppliers) want to receive their payments on time. • reasons for differences between the amount of profit for the period and the related net cash flow from operations • a business’s cash balance can decrease when its profit for the period is high (e.g. through large debt repayments), and cash can increase when profit for the period is low (e.g. through borrowing or sales of non-current assets).

8. Cash Flow Statement – information disclosed • Operational cash flow of Rubicon Ltd (in $millions) • 2012 2011 2010 2009 2008 • Net cash from operations (6) 3 10 41 25 • Net cash from investing (11) (6) (9) (16) (21) • Net cash from financing 14 4 (6) (19) (16) • Net increase (decrease) in cash held • (3) 1 (5) 5 (12) • Over this 5-year period, operational cash flows were insufficient (by $14,000,000), to fund investment in new plant and premises, and to service heavy borrowings and equity placements.

9. Cash Flow Statement • IAS 7 requires the cash flow information to be classified by its major sources and dispositions, namely its • operating , • investing and • financing • activities.

10. Cash Flow Statement • Operating activities • relate to the actual day-to-day trading or business activities of the business • include customer receipts, payments to suppliers, employees, interest, taxation. • Investing activities • support the business’s operational capacity • include the sale and purchase of non-current assets, and the sale and purchase of shares or debentures in other businesses. • Financing activities • involve the financial structure of a business • include borrowings from external sources and capital contributions from owners, and repayment of debt principal, and return of capital and distributions (such as dividends) to owners.

11. Cash Flow Statement

12. IAS 7 permitted methods Direct method: Developed from the firm’s cash book information 2. Indirect method: Developed from the firm’s accrual accounting records – using information contained in the income statement and balance sheet. Reconciles operating cash flow to net operating profit

13. Cash Flow Statement – indirect method • Reconciliation of net profit to cash flow from operations • Required by IAS 7 • Accrual accounting principles recognise income when the goods or services are provided – which, generally, is before cash is received/paid • Consequently, the Income Statement contains transactions that affect two accounting periods • It also contains items such as depreciation, taxation deferrals, and the effect of asset and liability revaluations that are not cash transactions.

14. Cash Flow Statement – indirect method • The calculations: • Cash receipts from customers • = sales – change in accounts receivable for the period • Cash payments to suppliers • = cost of goods sold + change in inventory for the period, • Or • = change in inventory + purchases – change in accounts payable for the period • Other expenses are assumed to be cash payments (except non-cash items such as depreciation, which must be subtracted) and must be added as operational cash payments.

15. Cash Flow Statement – indirect method • Operating cash flows: • Cash from customers (cash inflow) • Sales XXX,XXX • Less: Accounts receivable XXX • XXX,XXX • Payments to suppliers (cash outflow) • Opening inventory plus Purchases XX,XXX • Expenses XX,XXX • XXX,XXX • Less: Accounts payable (X,XXX) • Depreciation (X,XXX) • XXX,XXX • The difference between cash inflow and cash outflow gives cash flow from operations.

16. Cash Flow Statement – indirect method • Reconciliation between the movement in cash flow from operations, and the reported profit or loss after taxation: • Profit (loss) for period XXX,XXX • Adjust for non-cash items: • + Depreciation X,XXX • XXX,XXX • Working capital changes: • (Increase) decrease in inventory (X,XXX) • (Increase) decrease in accounts receivable (X,XXX) • Increase (decrease) in accounts payable X,XXX • Cash flow from operations XXX,XXX

17. Cash Flow Statement – indirect method • Other requirements of IAS 7 • Certain cash movements, such as interest and dividends, and income tax to be separately disclosed. • A company may show the following abbreviated operational cash flows: • The cash flow is positive, and the amount is known, but little else.

18. Cash Flow Statement – indirect method • Assume that the company has decided to discontinue part of its business, and undertook a restructuring during the reporting period, IAS 7 will require the result to be shown thus:

19. Step approach to preparation of a statement of cash flows – indirect method Step 1: Calculate differences in the Balance Sheets and note whether to treat under Operating activities, Investing activities, Financing activities or as a cash equivalent.

20. Steps 2 and 3 Step 2: Identify any items in the income statement for the year after earnings before interest and tax (EBIT) (also known as profit before interest and tax (PBIT)), to be entered under operating, investing or financing activities. Step 3: Refer to the PPE schedule to identify any acquisitions, disposals and depreciation charges that affect the cash flows.

21. IAS 7 format – indirect method • Cash flow from operating activities • Cash generated from operations • Cash flows from investing activities • Cash flows from financing activities • Net increase in cash and cash equivalents.

22. Illustration – see pp. 110-112

23. Illustration (Continued)

24. Methods of presenting cash flows from operating activities Direct method Indirect method.

25. The direct method Reports cash inflows and outflows directly Starts with the major categories of gross cash receipts and payments Cash flows such as receipts from customers and payments to suppliers are stated separately within the operating activities.

26. Indirect method Starts with profit before tax Highlights differences between operating profit and net cash flow from operating activities Indicates quality of earnings Able to estimate future cash flows and adjust for accruals.

27. IAS 7: cash generated from operations

28. IAS 7: net cash from operating activities

29. IAS 7: net cash from investing activities

30. Direct method Starts with gross cash receipts and payments Provides more information about sources/uses of cash Shows operating cash receipts and payments Possibly more useful in assessing future cash flows Useful in failure prediction models.

31. Analysing a cash flow statement Interest cover Impact of working capital movements Need for additional information Evaluating investing activities Relate expenditure to depreciation charge. Evaluating financing cash flows Extent to which investing has been financed.

32. Discussion Do you agree or disagree with the following statements: The cash flow statement is the link between profitability and viability All companies should be required to report using the indirect format.

33. Discussion (Continued) Do you agree or disagree with the following statements: The format of the cash flow statement should be left to the discretion of management The requirement to standardise the CFS format indicates a lack of trust in management.

34. Review questions 1. Explain the information that a user can obtain from a cash flow statement that cannot be obtained from the current or comparative statements of financial position. 4. Many people preferred the direct method for cash flow preparation, but IAS 7 did not require it. Discuss possible reasons for allowing choice and the effectiveness of the IASC’s encouragement to companies to use the direct method. 7. A negative free cash flow is always a sign of a company in trouble. Discuss.