4 Cash Flows Flashcards
What is meant by cash?
Cash comprises of cash on hand and demand deposits.
How do we recognise on the cash flow statement?
Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.
e.g. short term government bonds, marketable securities, commercial papers etc.
What are the two ways of approaching cash flow statements?
Direct and indirect.
What is the direct approach to cash flows?
Shows major classes of gross cash receipts and payments
What is the indirect approach to cashflows?
Starts with profit or loss before tax and adjusts for non-operating items, non-cash items and changes in working capital. Provides useful information about management of working capital.
Consideration that must be made for the direct method
If the direct method is chosen, reconciliation of profit/loss before tax to cash flows from operating activities is disclosed.
Working capital formula
Working Capital = current assets - cash - (current liabilities - short term debt)
Indirect method approach to inventory
An increase in inventory represents an outflow of cash as more money will have been spent on acquiring this additional inventory.
Indirect method approach to receivables
An increase in receivables means additional sales have been recognised in the income statement, but cash has not been received from this additional income.
Indirect method approach to trade payables
An increase in trade payables means you have not spent money on paying your suppliers.
Direct method approaches to all cash flows
Categorise them into: operating, investing, and financing.
How are cash flow statements prepared?
Constructed at the end of the period using the cash account in the ledger.
Cash is an asset
Thus, each transaction is either an increase (source of cash) or a decrease (use of cash)
Identify each increase or decrease as either operating, investing or financing → re-arrange to obtain the direct method statement.
Accurals: cash flow vs. economic effects
Accruals record economic effects of transactions:
- Recording cash flows that have related cash flows in the future
- Balance sheet and income statements reflect the effects of those accruals
But… accrual accounting focuses on the economic meaning of the transaction rather than its cash effects.
What does de-accural mean?
- Adds increases in liabilities
- Decrease in assets
- Subtract decreases in liabilities and increases in assets
- Add non-cash expenses and subtract non-cash revenues.
De-accural in practice
(6)
+ Depreciation and amortisation expense
- Change in Accounts Receivable
- Change in Inventories
and
+ Change in Accounts Payable
- Change in Prepaid expenses
+ Change in other payables
= Net cash provided by operating activities.
What are operating cash flows?
Operating cash flows - result of trading activities. For example, cash received from customers, or cash paid to supplier or employees.
What might a positive operating cash flow indicate?
A positive operating cash flow is a good sign - indicating that the cash received from business activity exceeds the cash expended on business operation.
What are investing cash flows?
Investing cash flows - long-term assets. The purchase of land, equipment and buildings is an investing cash flow.
What might a negative (and positive) investing cash flow indicate?
A negative investing cash flow is indicative of business expansion as more long-term assets are bought, a positive flow indicates the reverse.
What are financing cash flows?
Financing cash flows - long-term finance. For example, cash received from issuing new shares or cash paid out to redeem a bank loan.
What might a positive financing cash flow indicate?
Positive: finance in. Negative: finance out.
Interpreting this cash flow is never unambiguous. The reason for which finance is being taken out or paid for is not shown on the cash flow and thus cannot indicate the nature of financial decisions.
Operating cash flows compared to the rest
Operating cash flows involve changes in wealth, whereas investing and financial cash flows can be viewed as wealth-neutral.
What should we consider when analysing cash flow statements?
Follow the cash flow.
Take into context (industry and life stage)
What might financial statement users be looking for?
Define depreciation
An accounting method of allocating the cost of a tangible asset over its useful life to account for declines in value over time
Define amortisation
An accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time
