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CHAPTER 10Cash flow statements

ContentsIntroduction The cash flow statementUsefulness of cash flow informationCash flow cyclesFormat and structure of the cash flow statementCash flow from operating activitiesCash flows from investing and financing activitiesDirect and indirect method for operating cash flowsConstructing a cash flow statementDisposal of fixed assetsPresentational differences

Cash flow statementA cash flow statement presents information about the cash flows associated with the companys main operations and those associated with its investing and financing activities of the periodA cash flow statement functions in conjunction with both the income statement (performance dimension) and the balance sheet (financial position)IAS 7 Cash Flow Statements

Usefulness of cash flow informationAbility to generate adequate cash flows is a significant performance dimensionCash flow information clarifies the dynamics of short-term liquidity and long-term solvencyCash flow information is an essential input for economic decision models

Cash flow versus profitCash flow and profit are different economic phenomena But linked through the mechanisms of accrual accounting!Cash flows are factual details of incoming and outgoing flows of cash, while the balance sheet and income statement emanate from professional judgement and are not a direct projection of objective economic data

Liquidity/solvency and cash flows LiquidityRelates to nearness to cash of the structure of assetsDetermined by capacity to convert current assets into cash SolvencyRelates to future availability of cash in order to settle financial liabilities on due dateDetermined by timing and uncertainty of expected future cash payments and cash receiptsLiquidity and solvency ratios are determined on static financial position data, while cash flows reflect changes in financial position

Relationship with BS and IS Income statement

BS at start Cash flow BS at end

A cash flow statement reflects both profit related and non-profit related activities (investing and financing) with an impact on available cash over the period covered in the income statement

Related questionsFrom which sources did the company raise cash last year? How was this cash used? Were the normal operating activities capable of satisfying its need for cash during the year?If not, is the shortage of cash compensated by new borrowings, issuing new share capital or by selling fixed assets?Is a surplus of cash used for repayment of debt, for investments or for distribution of dividends?Why has the balance of cash available decreased, knowing that the companys operations have been profitable?

Cash conversion cyclesCash flows through the company continuously in a series of short-term and long-term conversion cyclesThe ST - cash conversion cycle (operating cycle) relates to the main business operations= OPERATING ACTIVITIES

Cash conversion cycles (cont.)The LT- cash conversion cycles relate to the acquisition, renewal and disposal of intangible and tangible infrastructure and the long-term sourcing of fundsProductive capacity acquired for cash and subsequently consumed during several ST-operating cyclesAcquisition and disposal of infrastructure = INVESTING ACTIVITIESExternal sourcing of funds = FINANCING ACTIVITIES

Fig. 10.1 Long-term and short-term cash flow cyclesInventoryWork in ProgressSalesReceiptsPaymentsProcurementCurrent payablesInventoryCurrent receivablesCash and cash equivalentsMain operationsExternal financingInvesting/ Productive infrastructure

Format and structure of the cash flow statement

Cash flows from operating activitiesOperating activities are primarily the revenue-generating activities of a companyOperating cash flow is conceptually most near to net profitMain differences:Non-cash expenses and non-cash revenues (f.i. depreciation expense)Non-operating items (f.i. gain on disposal of tangible fixed assets)Timing differences between net profit and underlying cash flow (f.i. changes in the level of inventories, receivables, creditors, etc.)

Operating cash flows: ExamplesReceipts from sale of goods and rendering of services (cashing in of receivables included)Receipts from taxes on sales and VATReceipts from royalties, fees, commissions,Payments to suppliers (payment of creditors included)Payments to employeesPayments of taxes, VAT, fines,

Operating cash flows Direct versus indirect method2 methods for identifying and presenting the operating cash flow:

Direct method: engenders the presentation of the most important categories of gross operating cash inflows and cash outflowsIndirect method: net operating cash flow is determined by adjusting the (net) profit figure for the 3 types of differences

Direct method - Example

Indirect method - Example

Cash flow proxy

Cash flow proxy (bis)

Cash flows from investing activitiesInvesting activities relate to the acquisition and disposal of long-term tangible and intangible assets and other investments Cash flows from investing activities are an indication of the expansion or downsizing of operating capacityExamples:Payments for newly acquired equipment Receipts from the disposal of a buildingPayments for new investments

Cash flows from financing activitiesFinancing activities relate to changes in the size and composition of contributed capital and financial debt of the companyExamples:Receipts from issuing new shares or bondsReceipts from new bank loanPayments for buy-back of shares Repayments of loansPayments of interest and dividend

Constructing a cash flow statementDetermine the net change in cashCompare beginning and ending balanceIdentify all transactions of the period leading to a change in cashDirect: analyze movements in the accounts of cash (equivalents) transaction by transactionIndirect: explain net change of cash by analyzing all other accounts, knowing that each transaction with an impact on cash also affects a non-cash accountUse the information (of step 1 and 2) to construct a cash flow statement according to the formal rules

Applying step 2Information for operating cash flow is primarily derived from balances in the IS, while information for the two other principal categories comes from the Balance Sheet (and details in the Notes)Movements in the accounts indicate a change in financial position and further examination is needed to determine if they had a cash impactCheck if balances have been impacted by accrual-based adjustments or other non-cash activities

Fig. 10.2 Classifying balance sheet movements as inflows or outflows of cash

AssetsEquity/liabilitiesIncreaseOutflowInflowDecreaseInflowOutflow

Illustration - Constructing a CFS (1)

X2

X1

Outflow

Inflow

Assets

Fixed assets (at cost)

980

740

240

240

Acc. depreciation

-350

-265

85

85

Inventories

180

171

9

9

Trade receivables

115

98

17

17

Cash

92

110

18

18

1017

854

Financing

Equity

Share capital

600

600

__

Reserves

90

90

__

X2 profit

50

__

50

50

Liabilities

Trade payables

62

59

3

3

LT debt

215

105

110

110

1017

854

266

266

Illustration - Constructing a CFS (2)

Operating activities

Net profit after tax

50

Add back depreciation

85

135

Changes in non-cash working capital

23

Net cash flow from operations (A)

112

Investing activities

Purchase of fixed assets (B)

240

Financing activities

New LT debt (C)

110

Net change in cash (A+B+C)

18

Cash balances

At beginning of year

110

At balance sheet date

92

Difference

18

Disposal of fixed assets - ExampleDisposal of equipment:Acquisition cost 275Accum. depreciation- 200Net carrying value = 115 Sale at 135

Result (gain) on disposal = 135 - 115= 20

Incoming cash flow = 135, composed of a decrease in net carrying value of equipment in the BS (115) and gain on disposal in the IS (20)

Disposal of fixed assets

Incoming cash flows

Outgoing cash flows

Presentational choicesInterest paid can be classified under either operating or financing activitiesInterest and dividends received can be included in either operating or investing cash flowsStarting from net profit or operating profit under the indirect method (with implications for the adjustments to be made)

IAS 7 - Direct Method (Extract) Source: IAS 7 Cash Flow Statements, Appendices

20X2

Cash flows from operating activities

Cash receipts from customers

30,150

Cash paid to suppliers and employees

(27,600)

Cash generated from operations

2,550

Interest paid

(270)

Income taxes paid

(900)

Net cash from operating activities

1,380

Cash flows from investing activities

Acquisition of subsidiary X, net of cash acquired

(550)

Purchase of property, plant and equipment

(350)

Proceeds from sale of equipment

20

Interest received

200

Dividends received

200

Net cash used in investing activities

(480)

Cash flows from financing activities

Proceeds from issue of share capital

250

Proceeds from long-term borrowings

250

Payment of finance lease liabilities

(90)

Dividends paid*

(1,200)

Net cash used in financing activities

(790)

Net increase in cash and cash equivalents

110

Cash and cash equivalents at beginning of period

120

Cash and cash equivalents at end of period

230

* This could also be shown as an operating cash flow.

IAS 7 - Direct Method (Extract) Source: IAS 7 Cash Flow Statements, Appendices

20X2


Cash receipts from customers

30,150

Cash paid to suppliers and employees

(27,600)


2,550

Interest paid

(270)

Income taxes paid

(900)


1,380


Acquisition of subsidiary X, net of cash acquired

(550)


(350)


20

Interest received

200

Dividends received

200


(480)

IAS 7 - Direct Method (Extract- cont.) Source: IAS 7 Cash Flow Statements, Appendices



250


250


(90)

Dividends paid*

(1,200)


(790)


110


120


230


IAS 7 - Indirect Method (Extract) Source: IAS 7 Cash Flow Statements, Appendices

20X2


Profit before taxation

3,350

Adjustments for:

Depreciation

450

Foreign exchange loss

40

Investment income

(500)

Interest expense

400

3,740

Increase in trade and other receivables

(500)

Decrease in inventories

1,050

Decrease in trade payables

(1,740)


2,550

Interest paid

(270)

Income taxes paid

(900)


1,380


Acquisition of subsidiary X net of cash acquired

(550)


(350)


20

Interest received

200

Dividends received

200


(480)



250


250


(90)

Dividends paid*

(1,200)


(790)


110


120


230


IAS 7 - Indirect Method (Extract) Source: IAS 7 Cash Flow Statements, Appendices

20X2


Profit before taxation

3,350

Adjustments for:

Depreciation

450

Foreign exchange loss

40

Investment income

(500)

Interest expense

400

3,740

Increase in trade and other receivables

(500)

Decrease in inventories

1,050

Decrease in trade payables

(1,740)


2,550

Interest paid

(270)

Income taxes paid

(900)


1,380

IAS 7 - Indirect Method (Extract cont.) Source: IAS 7 Cash Flow Statements, Appendices

20X2


Acquisition of subsidiary X net of cash acquired

(550)


(350)


20

Interest received

200

Dividends received

200


(480)



250


250


(90)

Dividends paid*

(1,200)


(790)


110


120


230


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