21 Cashflow Statements

Question 1

What is the importance of cashflow statements

Answer 1

• Statements of cash flows are a useful addition to the financial statements because profit is not the only indicator of an entity’s performance.
• IAS 7 was introduced to assist users wanting to evaluate an entity’s ability to generate cash and to see how it spends its cash

Question 2

What are the objectives of IAS 7

Answer 2

To provide information to the users of the financial statements about the entity’s:
* Ability to generate Cash and Cash Equivalents (CCE)
* Indicate the cash needs of the entity
* Classify cash flows

Question 3

How can cashflows be classified

Answer 3

• Operating activities
• Investing activities
• Financing activities

Question 4

What is cash

Answer 4

Cash on hand and demand deposits

Question 5

What are cash equivalents

Answer 5

• Short-term (less than 3 months)
• Highly liquid investments that are readily convertible to known amounts of cash.
• Not equity shares.

Question 6

What are cashflows

Answer 6

Cash flows = in/outflows of CCE

Question 7

What are operating activities

Answer 7

• The principal revenue-producing activities of the entity.
• What they are known for

Question 8

What are investing activities

Answer 8

Purchase/sale of non-current assets and other investments not included in CCE

Question 9

What are financing activities

Answer 9

• Change the size/composition of the entity’s equity capital and borrowings.
• Therefore affect gearing
  Share issues, dividend payments

Question 10

What are the two methods under IAS 7

Answer 10

Direct method:
* Disclose major classes of gross cash receipts and payments
Indirect method:
* Adjust net profit for non-cash transactions

Question 11

What is the direct method

Answer 11

• 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.
• Provides more information about sources/uses of cash than indirect method.
• Shows operating cash receipts and payments.
• Possibly more useful in assessing future cash flows than indirect method

Question 12

What is the indirect method

Answer 12

• 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.
• Easier to prepare than direct method.
• Able to estimate future cash flow and adjust for accruals
• Explains how profit can be made but have no cash as there are many nonfinancial transactions that can make profit but not generate cash

Question 13

How can you evaluate the cash generated from operations

Answer 13

• Interest cover
• Cash debt coverage
• Cash dividend coverage
  o Do we have enough money to pay interest and dividends?
  o Must pay interest, dividends are optional

Question 14

How can you evaluate the investing activities cash flows

Answer 14

• Acquisitions
  o Replacing
  o Expanding
• Can you afford to expand / can you afford not to expand

Question 15

What does positive and negative cash flows from investing show

Answer 15

• Having a negative from investing activities is not always a bad thing as it shows investing in the future
• A positive for investing could suggest not investing enough in new assets

Question 16

How can you evaluate the financing cash flows

Answer 16

• Extent to which investment has been financed.
• Does not assess the financing policy of the company.
• Does not assess whether the company would have done better to provide finance by improved control over its assets, e.g. working capital reduction

Question 17

What does positive and negative cash flows from financing show

Answer 17

• For positive figure is not always good as need to break it down to understand if it has call come from issuing debt
  o Which needs to be serviced
• For negative not always bad as could be paying debtors or making dividend payments

Question 18

What are the advantages of cash flow accounting

Answer 18

• The ability to generate cash is crucial to an entity’s survival – cash flow accounting directs attention to this.
  o Nothing will kill a business faster than a lack of cash
• Cash flow is more comprehensive than profit which is dependent on accounting conventions and concepts.
  o Profit can be manipulated but cash is cash
• Payables are more interested in an entity’s ability to pay them than profitability.
• Cash flow reporting provides a better means of comparing entities.
• Cash flow statements are easier to audit than accruals-based FS and more difficult to manipulate as they are not affected by accounting policies.
• Cash flows are more easily understood (particularly by non-accountants who do not understand the accruals concept).

Question 19

What are the disadvantages of cash flow accounting

Answer 19

• Basically, the advantages of accruals accounting (income/expense matching) are the disadvantages of cash accounting.
  o When buying a buying accrual accounting would expense it over its useful life where in cash it just goes through the statement
• In practice, few businesses keep information in the form needed to prepare a cash flow statement and so this is the reason the indirect method (pulling from the FS) tends to be used rather than the direct method.
• The figures required for the direct method may not be readily available and so it would require additional record keeping.

Question 20

What is the step method to preparing a statement of cash flows

Answer 20

Need to be able to run over the 4 steps and look at seminars for details