L5 - Cash Flow Statements Flashcards
What is cash?
Essentially cash is anything of a short term, highly liquid nature e.g. cash in the tills, petty cash, money in the bank account, short term certificates of deposit (which may pay short term interest - not like nowadays)
- a firm may have several bank accounts and any overdraft(s) (negative cash) are netted off against other positive balances and against other ‘equivalents’
what is the definition of cash and cash equivalents?
A Cash equivalent must:
- be investments for short term
- readily convertible to cash
- an significant risk of changes in value
why is cash so important?
- On the one hand cash is just another asset that the business needs to enable it to function - hence, it is no different from inventories or non-current assets
- The importance of cash lies in the fact that people will only normally accept cash in settlement of their claims
- If a business wants to employ people, it must pay them in cash, if it wants to buy a new non-current asset, it must normally pay the seller in cash (perhaps after a short period of credit)
- When businesses fail , it is the lack of cash to pay amounts owed that really pushes them under
- Cash generation is vital for businesses to survive and to be able to take advantage of commercial opportunities
- These are the things that make cash the pre-eminent business asset
- there are many firms who make large profits and own lots of valuable assets but which, nevertheless, get into difficulties and even become bankrupt because they have insufficient cash in the business to meet heir daily commitments, in which case, we say that they are ‘illiquid’
- During an economic downturn, the ability to generate cash takes on even greater importance
- Banks become more cautious in their lending and businesses with weak cash flows often find it difficult to obtain finance
- this could lead to insolvency and creditors can apply to the courts to have the business declared bankrupt and end up in administration
What is the difference between cash and profit?
- in the Income Statements we saw how profit is derived after charges in which no cash leaves the company for example depreciation and accrued expense
- Conversely, cash is spent on assets (non current e.g. equipment and current e.g. inventory) but such spending does not immediately have an effect on the Income Statement
- Thus, the cash flowing in to and out of the bank account is said independent of the Income Statement
- In, the long term, the cumulative profit (or loss) retained in the firm will equate to the cash accumulated over its lifetime, This becomes apparent in the event of the winding up of the firm
- However, the increase or decrease of cash ( or cash as it is referred to) in any single accounting period does not likely to relate to the profit earned
- Things that ‘decouple’ cash and profit are adjustments such as those for inventory, depreciation, accruals and prepayments
- The effect of inventory can make profit and cash different on a week by week basis
What is the purpose of the Cash Flow Statement (CFS)?
- The CFS completes the historical financial picture of the company, it shows how cash has been acquired and from what sources together with how cash has been used
- The CFS gives an insight into the ability of managers to both produce operating profit manage working capital
- It gives investors, lenders and suppliers an idea of the future cash generating potential of the business and therefore their exposure to risk
what are some sources of purely outflows into a business?
- Equity dividend payouts
- Taxation
What are some inflows and outflows in `a business?
- capital expenditure –> buying to invest or selling off asset e.g. land we dont need
- financing –> receiving or paying them off
- Management of liquid resources –> too much cash put into saving or certificate of deposit - profit/less
- Returns from investment and servicing of finance
What are the three areas of interest in the Cashflow Statement?
Operating activities and Financing activities into Cash and cash equivalent balance, out of that comes investing activities
- Operating activities –> all ‘business as usual’ inflows and outflows (inc. dividends, interest and tax –> normally provides positive cash flow and therefore increase the business’s cash resources
- Financing Activities –> Money raised and repaid from/to investors - not interest paid –> depending on the financing strategy at the time, since businesses seek to expand, there is a general tendency for this area to lead to cash coming into the business rather than leaving it
- Investing activities –> investments in other firms + profit returns & asset disposals –> typically cause net negative cash flow
- this is because many non-current assets either wear out or become obsolete and need to be replaced
- While non-current assets may be sold and give rise to positive cash flow, in net term however the cash flows are normally negative, with cash spent on new assets far outweighing that received from the sale of old ones
How is Financing defined?
- involves raising funds
- the act of arranging loans and attracting share capital
- That is - money coming in
How is Investing defined?
- involves spending money on assets to bring benefits in future
- can be non-current or current assets e.g. building up inventory, to improve customer, service levels, also increasing receivable
What are the two was of deducing net cash flow from operating activities?
- The direct method - essentially the bank account analysed into the headings ion the CFS
- The indirect method - ( most popular method) takes summary data from the other two accounting statements
what are some important things to note from the indirect method of creating a Cashflow statement?
Note: it is only cash movements during the year that are represented and thus:
1 - Dividends and taxation are shown as the amounts that have been paid out during the year, not the amounts that have been provided for as the latest Income Statement was finalised, Usually decided upon after the year has ended and the final profit figures are know –> uses last figures from last year to put in this years CFS
2- Depreciation that has been deducted in arriving at the Operating Profit is added back in the CFS because no cash has left the company that year (cash only leaves when the asset was first purchased
What is the standard layout of a cashflow statement?
- Cash flows from operating activities, plus or minus,
- Cash flows from investing activities, plus or minus,
- Cash flows from financing activities, equals,
- Net increase (or decrease) in cash and cash equivalents over the period
What is Cashflows from operating activities?
- these represent the cash inflows and outflows arising from normal day-to-day trading activities, after taking account of the tax paid and financing cost (equity and borrowings) relating to these activities
- the cash inflows for the period are the amounts received from trade receivables (credit customers settling their accounts( and from cash sales for the period
- The cash out flows for the period are the amounts paid for inventories, operating expenses (such as rent and ages), corporation tax, interest and dividends
What is important to note about inflows and outflows that appear on the Cashflow Statement?
- that they are cash inflows/outflows not revenue and expenses for that period
- Similarly, tax and dividends that appear in the statement of cash flows are those actually paid during the period
- Many companies pay tax on their annual profits in four equal instalments
- Two of these are paid during the year concerned and the other two are paid during the following year
- Thus by the end of each year, half of the tax will have been paid and the remaining half will still be outstanding, to be paid during the following year
- This means that the tax payments during a year is normally equal to half of the previous year’s tax charge and half of that of the current year
