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Cash Flow Analysis. SPACE-IOUS Cars Ltd. Mary Low Waikato Management School The University of Waikato. Importance of Cash. To explain the importance of cash, let us first look at this hint provided by Gitman (2000) in a Managerial Finance textbook. Remember that in finance*, cash is king.

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Presentation Transcript
slide1

Cash Flow Analysis

SPACE-IOUS Cars Ltd

Mary Low

Waikato Management School

The University of Waikato

© Mary Low

importance of cash
Importance of Cash
  • To explain the importance of cash, let us first look at this hint provided by Gitman (2000) in a Managerial Finance textbook.

Remember that in finance*, cash is king.

Income statement [Performance statement] profits are good, but they do not pay the bills nor do asset owners accept them in place of cash.

* Gitman defines finance as ‘the art and science of managing money’ (p. 2).

Profits do not represent cash in the business. Income (Performance) Statement profits are determined under GAAPs.

© Mary Low

why is cash important
Why is Cash important?
  • You could say that Cash is one of the most important assets in an organisation

Without cash, an organisation will not survive in the long term.

You might try and think of cash as petrol that you need for your car to go!

You car won’t go if your petrol gauge indicates ‘empty’.

Neither will the business ‘go’ if it doesn’t have cash!

  • A business without cash cannot:
  • pay for supplies, wages and other operating costs
  • buy assets to help it earn revenues,
  • repay debts or reward its owners

© Mary Low

how to evaluate an organisation s cash flows
How to evaluate an organisation’s cash flows?
  • To evaluate an organisation’s cash flows, we usually look at their Statement of Cash Flows

The statement of cash flows summarises how an organisation’s operating, investing and financing activities have affected cash during an accounting period.

Operating activities

Financing activities

Investing activities

© Mary Low

statement of cash flows operating activities

Cash Sales

Cash inflows

from customers

Accounts Receivables

Net cash flow

from operating

activities

Interest

Suppliers

Cash outflows to

suppliers, employees

and other expenses

Tax

Operating Expenses

Statement of Cash Flows– Operating Activities

Operating activities:

This category of activities show cash flows directly related to the production and sale of the organisation’s goods and services.

© Mary Low

statement of cash flows investing activities

Sale of investments

Cash

inflow

Net cash flow

from investing

activities

Sale of

Property, plant

and equipment assets

Purchase of

Property, plant

and equipment assets

Cash

outflow

Purchase of

investments

Statement of Cash Flows– Investing Activities

Investing activities:

This category of activities show cash flows related with the acquiring and selling of non-current assets like property, plant and equipment assets and investments.

© Mary Low

statement of cash flows financing activities

Capital contribution/

Issue of shares

Cash

inflow

Short-term /

long term borrowing

Net cash flow

from financing

activities

Cash Drawings by sole trader or

dividends paid to shareholders

Cash

outflow

Repayment of short-term /

long term borrowing

Statement of Cash Flows– Financing Activities

Financing activities:

This category of activities show cash flows related with equity capital contribution and rewards to owner(s) and debt borrowing and repayments.

© Mary Low

how to evaluate a statement of c ash f lows
How to evaluate a Statement of Cash Flows

We will look at SPACE-IOUS Cars Ltd, a fictitious example from 2 situations.

Situation 1 shows an overall favourable cash position for the SPACE-IOUS Cars Ltd business.

Situation 2 – You are to try this as a practice example.

What makes the cash position and cash flows favourable or unfavourable need to be examined.

© Mary Low

situation 1 analysis
Situation 1 - Analysis

The overall cash position in SPACE-IOUS Cars Ltd (Situation 1) is favourable because of the following reasons:

Net increase in cash in 2005 was $230,000. In 2006, the net increase in cash was $307,000 resulting in an overall cash closing balance of $662,000.

Net cash flow from operating activities is positive. In 2005, it was $373,000 and in 2006 it was $416,000. It is important to have positive operating net cash flows. Positive operating cash flows tells us that we should be able to pay for operating costs, have cash available for purchase of assets and investments as well as repay borrowings and rewarding the owner(s).

© Mary Low

situation 1 analysis continued
Situation 1 – Analysis continued

Net cash flow from investing activities is negative. In 2005, it was $95,000 and in 2006 it was $79,000. A negative cash flow under investing activities is not necessarily unfavourable. In this situation, the negative cash flows were due to the purchase of non-current assets. Purchase of such assets can signal growth or replacement of assets that are needed to improve revenue-earning potential.

Net cash flow from financing activities is negative. In 2005, it was $48,000 and in 2006 it was $30,000. Similar to investing activities, a negative cash flow here is not necessarily unfavourable. In this situation, the negative cash flow was due to the repayment of debt. Debt repayment is good as it may imply that the riskiness of the business is being reduced.

© Mary Low

situation 1 analysis continued12
Situation 1 – Analysis continued

Overall, SPACE-IOUS Cars Ltd has a very good cashposition as it is generating significant positive cash flows from its operating activities. This has allowed the business to purchase more assets, to repay debt and to increase its overall cash position.

© Mary Low

situation 2 question 1
Situation 2: Question 1

The overall cash position in SPACE-IOUS Cars Ltd in Situation 2 is…

Favourable or Unfavourable?

Select the your answer by clicking on the appropriate box below.

Favourable

Unfavourable

© Mary Low

situation 2 question 1 favourable
Situation 2: Question 1 – Favourable?

The overall cash position in SPACE-IOUS Cars Ltd in Situation 2 is…

You chose “Favourable”

The overall cash position in SPACE-IOUS Cars Ltd is Unfavourable.

Look again at the Statement of Cash Flows.

(Click on the small image to get there.)

© Mary Low

situation 2 question 1 unf avourable
Situation 2: Question 1 – Unfavourable?

The overall cash position in SPACE-IOUS Cars Ltd in Situation 2 is…

Unfavourable.

Well done!

The overall cash position in SPACE-IOUS Cars Ltd is unfavourable.

© Mary Low

situation 2 question 2
Situation 2: Question 2

Q: What is the most important category of activity to look at in the evaluation of the cash position in Situation 2?

If you need to, look again at the Statement of Cash Flows.

(Click on the small image to get there, then come back to this slide, number 17.)

Select your answer by clicking on the appropriate box beside the activity.

Operating activity

Investing activity

Financing activity

© Mary Low

situation 2 question 2 investing activity
Situation 2: Question 2 – Investing activity?

You chose:

“Investing activity”

No, this is not the most important category to look at in this situation. You need to look at the operating activity category. Because the operating activity has not been generating positive cash flows, it can be argued that this has impacted on the investing activities by causing the sale of assets to help fund the running of the business.

Click on the green arrow to go back to the question.

© Mary Low

situation 2 question 2 financing activity
Situation 2: Question 2 – Financing activity?

You chose:

“Financing activity”

No, this is not the most important category to look at in this situation. You need to look at the operating activity category. Because the operating activity has not been generating positive cash flows, it can be argued that this has impacted on the financing activities by increasing debt borrowings and share issues to help fund the running of the business.

Click on the green arrow to go back to the question

© Mary Low

situation 2 question 2 operating activity
Situation 2: Question 2 – Operating activity?

You chose:

“Operating activity”

Well done!

This is the most important category of activity to look at in this situation. From the information available, SPACE-IOUS Cars Ltd have not generated any positive cash flows from operating activities for 2 (could be more) years. Negative cash flows from operating activities will impact on investing and financing activities and the overall solvency of the organisation.

© Mary Low

situation 2 question 3 evaluating investing activity
Situation 2: Question 3 – evaluating investing activity

Q: How would you evaluate the investing activity category in Situation 2?

Favourable or Unfavourable?

Select the your answer by clicking on the appropriate box below.

Favourable

Unfavourable

If you need to, look again at the Statement of Cash Flows

again. (Click on the small image to get there.)

© Mary Low

situation 2 question 3 evaluating investing activity favourable are you sure
Situation 2: Question 3 – evaluating investing activity – favourable? Are you sure?

Q: How would you evaluate the investing activity category in Situation 2?

Favourable or unfavourable?

You chose:

“Favourable”

Not really in this situation. Although it is generating positive investing cash flows, it can be argued that assets are being sold off to help the organisation generate cash for the running of the business.

Click on the green arrow to go back to the question

© Mary Low

situation 2 question 3 evaluating investing activity unfavourable well done
Situation 2: Question 3 – evaluating investing activity – unfavourable?? Well done!

Q: How would you evaluate the investing activity category in Situation 2?

Favourable or unfavourable?

You chose:

“Unfavourable…”

Yes, that is correct in this situation. Although it is generating positive cash flows, it can be argued that assets are being sold off to help the organisation generate cash for the running of the business.

© Mary Low

situation 2 question 4 evaluating financing activity
Situation 2: Question 4 – evaluating financing activity

Q: How would you evaluate the financing activity category in Situation 2?

Favourable or Unfavourable?

Select the your answer by clicking on the appropriate box below.

Favourable

Unfavourable

If you need to, look again at the Statement of Cash Flows

again. (Click on the small image to get there.)

© Mary Low

situation 2 question 4 evaluating financing activity favourable are you sure
Situation 2: Question 4 – evaluating financing activity – favourable?? Are you sure?

Q: How would you evaluate the financing activity category in Situation 2?

Favourable or unfavourable?

You chose:

“Favourable”

Not really in this situation. Although there are positive cash flows in this category, it can be argued that there is still significant loan (debt) borrowings to help fund the running of the business.

Click on the green arrow to go back to the question

© Mary Low

situation 2 question 4 evaluating financing activity unfavourable well done
Situation 2: Question 4 – evaluating financing activity – unfavourable? Well done!

Q: How would you evaluate the financing activity category in Situation 2?

Favourable or unfavourable?

You chose:

“Unfavourable….”

Yes, in this situation. Although there are positive cash flows in this category, it can be argued that there is still significant loan (debt) borrowings to help fund the running of the business. It is important that there is positive cash flows from operating activities otherwise the business will not be able to survive in the longer term. A business cannot continue to borrow or sell off assets to fund its operations.

© Mary Low