statement of cash flows

Question 1

what is the statement of cash flows?

Answer 1

a summarised report of cash coming into and going out of the business during an accounting period. The statement shows where the cash came from in terms of activities and where it went.

Question 2

what does the statement of cash flows show?

Answer 2

Shows net cash flows into/out of the business from operating, financing and investing activities for an accounting period

Question 3

why is the statement of cash flows important?

Answer 3

only one of three key financial reports that is not based on accrual principle.
suppliers and financial creditors such as banks and bond holders are paid in cash and hence the cash generating ability of firms is of particular interest to them. Many companies fail because they have run out of cash.

Harder to manipulate than Statement of Profit and Loss…but SOPL gives better picture of profitability and underlying performance

Question 4

what is cash flows from operating activities?

Answer 4

cash flows from operating activities: shows investors how much cash the firm is generating from its trading activities and comprise inflows from customers for goods and services the firm has sold them less out outflows to suppliers for goods and services the firm has bought from them; to employees for services provided; and to tax authorities for taxes owed.

Question 5

what is cash flows from investing activities?

Answer 5

cash flows from investing activities investors whether the firm is investing for the future and concerns the acquisition and disposal of non-current assets, largely in PP&E but potentially also purchases of intangible assets and long-term financial investments

outflows come from purchases; inflows come from the disposal of such assets

Question 6

what is cash flows from financing activities?

Answer 6

cash flows from financing activities shows investors whether the firm relies on raising new funds to support its operating and investing activities or has surplus cash that is available to pay off long-term debt or return cash to investors

inflows come from borrowings from banks, bonds issuance and equity issuance. Outflows are for interest on debt, debt repayments, dividend payments to shareholders and share repurchases.

Question 7

what does the sum of cash flows give?

Answer 7

the net change in the cash position in the period, reconciling with the actual change in the position that can be found from the SOFP. It is really helpful for analysts and other users of the report to be able to see cash flows broken down this way.

Question 8

what does the overall structure of the statement of cash flows

Answer 8

cash flows from operating activities
+ cash received from customers for goods and services paid
-cash paid to suppliers and employees for goods and services bought
-tax paid on trading operations

cash flows from investing activities
- cash spent on buying non-current assets (capital expenditure)
+ cash received from disposal of non-current assets
+ investment income

cash flows from financing activities
+ cash received from issuing bonds or borrowing from banks
- interest payment and principal repayment of loans and bonds
+ equity raised from rights issues & private placements
- dividend payments to owners and share buy banks

CHANGE IN CASH POSITION

Question 9

what do cash flows for operating activities comprise?

Answer 9

• cash flows - cash received from customers for goods and services the company has sold them
• less cash outflows cash payments made to suppliers and employees for goods and services the firm has paid for and cash payments for taxes on profits

Question 10

what is the direct method for cash flows from operating activities?

Answer 10

the direct method presents cash inflows from customers and cash outflows to suppliers, employees, and tax authorities. It may be calculated directly from actual cash movements or from revenue and expenses adjusted for changes in related working capital items and non-cash charges such as depreciation.

Question 11

what is the indirect method for cash flows from operating activities?

Answer 11

the vast majority of firms present cash flows from operating activities using the indirect method as follows:

Cash flows from operating activities =
PBIT
- tax expenses
+ non-cash charges
reverse investment income
reverse gains/losses on disposals on non-current assets
- increase in non-cash working capital

Question 12

what is the rational for the indirect method?

Answer 12

the indirect method starts from the understanding that cash flows from operating activities will be equal to a firm’s operating profits less tax expenses, provided:

• all its revenues and expenses are paid for in cash, when earned or incurred,
• it sells all the inventory it produces in the accounting period they are produced
• it has no non-current assets

it follows that we can work out cash flows from operating activities by starting with operating profits less tax expenses and making the following adjustments, to account for circumstances where the conditions above do not apply:

• taking account of non-cash charges such as depreciation and amortisation. These need to be reversed or we will overstate the amount of cash paid for expenses.
• reversing any investment income which needs to be included in cash flows from investing activities
• reversing any gains or losses on the disposal of non-current assets. The proceeds from disposals will be recognised as investing cash flows,
• adjusting for changes in working capital items concerning revenue and expenses such as trade receivables, prepaid expenses, trade payables, unearned income, inventory and tax payable.

Question 13

some firms start with PBT or PAT instead of operating tax, how would you work it out with these starting points?

Answer 13

profit before tax includes finance expenses (not an operating item) but does not include tax expenses (is an operating item). If we want to use PBT at the starting point finance expenses need to be excluded which we do by adding them back. Tax has not yet been taken and will need to be subtracted.

+ finance expenses
- tax expenses

Profit after tax means tax expenses are already included in the value for profit after tax as are finance expenses. The only adjustment needed is to reverse finance expense which we do by being added it back

+finance expenses

PBIT - tax expenses
= PBT + finance expenses - tax expenses
= PAT + finance expenses

Question 14

if a firm has non-current assets (PP&E and intangible assets) then part of its reported expenses will be in the form of non-cash expenses from what?

Answer 14

depreciation of PP&E

amortisation of intangible assets

impairments of PP&E, intangible assets and goodwill

Question 15

what has to be reversed to move them to the correct part of the statement of cash flows?

Answer 15

reverse any investment income or losses: these concern investing activities and need to be reversed
investment income is subtracted from profit while losses are added back

reverse any disposal gains or losses: these are related to investing activities and need to be reversed
gains from disposals are subtracted from profit while losses are added back

Question 16

what do non-cash current assets comprise of?

Answer 16

current assets less cash & cash equivalents.

Question 17

what do increases in non-cash currents assets resulting in lower cash inflows than the reported profit suggest?

Answer 17

• an increase in trade receivables and accrued income, for example, means more revenue has been recognised in the SOPL than has been received in cash.
• an increase in prepayments or prepaid expenses means that more cash has been spent than has been recognised as inventory or as expenses
• an increase in inventory means that more stock has been purchased or created than has been taken through as cost-of-sales.

Question 18

what is the effect of non-cash current assets increasing?

Answer 18

lowering net cash inflows so to adjust the value used for profit we need to subtract any increase in non-current assets.

Question 19

what do non-cash current liabilities comprise of?

Answer 19

current liabilities less overdrafts and other financial liabilities (tax payable and dividends payable) due for payment within 12 months.

Question 20

what do increases in non-cash current liabilities resulting in higher cash inflows than the reported profit suggest?

Answer 20

• an increase in trade payables and accrued expenses means more goods and services have been received than have been paid for
• an increase in unearned income means more cash has been received from customers for goods and services paid for in advance than the firm has delivered goods and services
• an increase in tax payable means more tax expenses have been recognised in the SOPL than have been paid

Question 21

what is the effect of non-cash current liabilities increasing?

Answer 21

increasing net cash flows so to adjust for changes in non-cash current liabilities, we need to add any increase in non-cash current liabilities

Question 22

what is the equation for non-cash working capital?

Answer 22

non-cash working capital = non-cash current assets less non-cash current liabilities

Question 23

for most companies is cash flows from operating activities likely to be positive or negative?

Answer 23

positive - more cash is coming into the firm from its trading operations than is going out but there are cases where it may be negative

Question 24

what does positive cash flows mean for a company?

Answer 24

for profitable, well-established firms cash flows from operating activities are likely to be positive. These cash flows are then available to be reinvested into the firm’s productive non-current assets, used to pay interest and principal owed to financial creditors and pay dividends to shareholders or buy back stock.

Question 25

what does negative cash flows mean for a company and why might it be negative?

Answer 25

• firms are rapidly growing and that have high net current assets may find that increasing working capital requirements causes cash flows from operating activities to be negative
• firms that are content to operate at a loss in order to grow rapidly and build market share are likely to have negative cash flows
• companies that are failing and operating at a loss are likely to have net operating outflows

Question 26

what is an advantage of the indirect method?

Answer 26

it clearly shows the relationship between cash flows that have been generated directly from trading activities and those that have come from changes in non-cash working capital

Question 27

what is an advantage of the direct method?

Answer 27

shows cash inflows from customers and outflows to suppliers explicitly - these are far harder to manipulate than revenue and expenses. In their absence, analysts can estimate these values but most firms do not disclose enough information to be able to work these out exactly.

Question 28

why don’t firms use direct method?

Answer 28

Preferred by IASB but not mandated
inertia - in the absence of a mandated change in the reporting method, it is easier for firms to simply continue with the method that they have used in the past than to change
cost - some firms and professional bodies argued that it would cost a lot more to present the statement of cash flows using the direct method then the indirect method
commercial sensitivity - the direct method allows anyone to see exactly how much cash the firm receives from its customers and pays its suppliers. The management of some firms opposed such disclosures on the grounds of commercial sensitivity
wishing to avoid investor scrutiny - simply that management wish to avoid the additional scrutiny from investors that the direct method would bring

Question 29

what are the outflows for cash flows from investing activities?

Answer 29

-investments in PP&E represent an investment in the future operations of the firm but also require cash outflows
- purchases of intangible assets are also an investment. The costs of most intangible assets developed by the firm are expensed but when purchased intangible assets are recognised immediately in the SOFP
- purchase of financial assets: firms may also buy financial assets such as the shares of other firms and bonds that they intend to keep for more than 12 months. These purchases are treated as cash flows from investing activities

Question 30

what are the inflows for cash flows from investing activities?

Answer 30

-investment income this may include dividends from equity investments, interest on bonds received and rental income on investment properties
-proceeds from disposals - the sale of non-current assets produce cash inflows. Gains and losses on disposals arise when the proceeds are either greater or less than the net book value of these assets at the time of the disposal

Question 31

what is the equation for cash flows from investing activities?

Answer 31

gains (losses) on disposals = proceeds from disposals - net book value of assets disposed of

proceeds from disposals = net book value of assets disposed of +/- gains (losses) on disposals

where net book value = cost of assets disposed of - accumulated depreciation of assets disposed of at the time of disposal

Question 32

for most companies, cash flows from investing activities will comprise net outflows or inflows?

Answer 32

outflows ie have a negative value

Question 33

what do negative cash flows from investing activities mean?

Answer 33

buildings and equipment wear out. Most firms need to constantly invest simply to replace PP&E that is wearing out. If firms stop replacing it, they will eventually cease trading. Firms that are expanding will need to more than simply replace equipment that’s wearing out and have to invest in new capacity.

Question 34

what do positive cash flows from investing activities mean?

Answer 34

you don’t see positive cash flows from investing activities very often. This can only occur if the proceeds from disposals of non-current assets exceeds capital expenditure. Firms doing this are either being wound down or are desperately selling assets to stay afloat.

Question 35

what are the inflows for cash flows from financing activities?

Answer 35

-proceeds from issuing debt - when firms issue bonds or draw down loans with a term of more than 12 months it creates cash in flows from financing activities
- proceeds from issuing equity - firms can raise funds by issuing new equity through a rights issue or private placement. Some forms of stock issuance, for example bonus issues, may result in the number of shares in issue changing but do not actually raise any funds so there is no cash flow
- exercise of employee stock options - some employee stock option plan result in the issues of new shares and do not raise funds but those where the firm buys shares from the market do not

Question 36

what are the outflows for cash flows from financing activities?

Answer 36

• finance expenses: finance expenses comprise interest paid on bonds and bank loans. Some finance expenses taken through the SOPL (e.g. those associated with right-of-use assets) do not involve cash flows and hence do not appear here. Interest that has been capitalised from construction projects should also be reported here
• debt repayments: these include loan principal repayments and bond redemptions when they reach term
• dividend payouts: cash dividends paid to shareholders
• share repurchases: firms buy back their shares, thereby reducing the number of shares in issue, for a variety of reasons. Some prefer to buy back shares than pay dividends. Some share buy backs are to support employee stock option plans, when these options are exercised these shares will be released.

Question 37

what does it depend on whether cash flows from financing activities are positive or negative?

Answer 37

where the firm is in its lifecycle

Question 38

what does positive cash flows from financing activities reflect?

Answer 38

most firms in the early years have positive cash flows as cash flows from operating activities are either negative or too small to meet their capital investment requirements.

Question 39

what does negative cash flows from financing activities reflect?

Answer 39

as firms mature, cash flows from operating activities are usually sufficient to meet all the firm’s investment requirements and have some leftover. At first this may only be enough to service debt and pay dividends but over time it may well be enough to start repaying debt and buying back shares or increasing the dividend payout.

Question 40

what should the net effects of cash flows from operating, investing and financing activities equal?

Answer 40

change in the cash position of the firm

Question 41

what SOPL give a better picture of?

Answer 41

underlying and longer performance of the firm because it is prepared to follow the accrual principle.

Question 42

why is the reported number for profit subjective?

Answer 42

it is prone to manipulation by management because of the number of judgements and choices of accounting methods and accounting estimates involved.

Question 43

is the value of a firm’s cash and cash equivalents objective or subjective?

Answer 43

objective but it may also be subject of management window-dressing to make the firm appear more liquid at the end of the accounting period that is really the case.

Question 44

To achieve the goal of appearing more liquid how would a firm go about doing this?

Answer 44

-reducing non-cash current assets
- increasing non-cash current liabilities

Question 45

how would you reduce non-cash current assets to increase net cash inflows?

Answer 45

inventory: run down inventory levels in the run-up to the end of the accounting period (reducing outflows)

trade receivables: to increase cash inflows, firms may chase customers who have not settled overdue invoices for payment, offer customers incentives for early payment and sell trade receivables (at a discount to their face value) to a factoring financial institution. The disadvantage of factoring is that it can be expensive

prepayments: delay making advance payments to suppliers until the start of the next accounting period (reducing outflows)

Question 46

how would you increase the value of non-cash current liabilities to increase net cash inflows?

Answer 46

• trade payables: delay payments to suppliers for goods and services bought on credit until the next accounting period (reducing outflows). Delaying payment to trade creditors is easy but late payments may results in penalty charges, have an adverse affect on the firm’s creditworthiness and potentially lead to a tightening of credit terms for future orders

unearned income: chase customers who pay for services in advance for early payment (increasing inflows). Difficult to achieve in practice

Question 47

how else can a firm increase cash flows?

Answer 47

use sale-leaseback deals and outright sale of PP&E or financial assets classified as non-current assets

sale-leaseback deals - some firms can use PP&E sale-leaseback deals to improve their cash position. The assets concerned are sold to financial institution and immediately leased back. The length and terms of the lease are a matter of negotiation between lessor and lessee.

sale of PP&E - it may be possible to sell property, plant and equipment which is not being used in operations of the firm

sale of financial assets - some firms have holdings of financial assets (usually bonds) that are classified as non-current assets. They may be sold to generate cash.

Question 48

what is the equation for dividends paid?

Answer 48

retained earnings at the end of the period = retained earnings at the start of the period + profit after tax - dividends paid

or dividends paid = profit after tax - increase in retained earnings