Week 4 - Cash Flow Statement

Question 1

What is the purpose of a statement of cash flows?

Answer 1

To summarise all movements of cash into and out of a entity (business/organisation) during the accounting period- summaries inflows and outflows of cash (and cash equivalents e.g. government bonds, amounts in current bank accounts etc- SEE LATER for more detail) for an entity over a period of time

Question 2

List reasons why cash is important to an entity

Answer 2

1) Entity will not survive with cash
2) To pay suppliers
3) To pay employees
4) To pay dividends to shareholders
5) To repay debts to lenders (creditors)
6) To purchase assets

Question 3

What does the cash flow statement show?

Answer 3

If the financial statement from 1 year end shows cash at £60,000 and the financial statements from the following year show cash at £40,000 then the statement of cash flow would breakdown the decrease of £20,000 in cash into the different activities of the entity

Question 4

Define cash equivalent

Answer 4

Short term, highly liquid (easily convertible to cash) assets that can be quickly and easily converted to cash

Question 5

Give examples of cash equivalents

Answer 5

1) Amounts in current bank accounts (e.g. savings account or normal debit account- money which you actually have)
2) Short term investments and securities e.g. government bonds
3) Bank overdraft (excess amount of money that is withdrawn from an account resulting in a negative account balance- amount taken as overdraft needs to be repaid by the entity (individual/organisation) … short term loan (liability))- treated as ‘negative cash’ in cash flow statement BUT long term bank loans are not

Question 6

What is the general rule about cash equivalents?

Answer 6

If it can be converted into cash within 3 months then it can be treated as a cash-equivalent

Question 7

How many categories are there for cash movements?

Answer 7

3

Question 8

What are the categories for cash movements?

Answer 8

1) Operating activities
2) Investing activities
3) Financing activities

Question 9

How is a statement of cash flow presented?

Answer 9

Cash flows from operating activities (ALWAYS at the top)
Cash flows from investing activities (in the middle)
Cash flows from financing activities (at the bottom)
= NET increase/decrease in cash and cash equivalents over the period

Question 10

List operating activities cash inflows

Answer 10

1) Cash from sale of goods/services
2) Cash from interest received

Question 11

Briefly state what operating activities are

Answer 11

Income statement items so revenue and expenses … cash inflows are essentially revenue and cash outflows are essentially expenses

Question 12

List operating activities cash outflows

Answer 12

1) Cash to employees for services e.g. wages etc
2) Cash to suppliers for inventory (supplies/resources etc)
3) Cash to governments for tax purposes (HMRC)- corporation tax etc
4) Cash to lenders/creditors for interest
5) Cash to others for expenses

Question 13

List investing activities cash inflows

Answer 13

1) Cash from the sale of an asset (property, equipment etc)
2) Cash from the sale of equity securities (e.g. stocks and shares) of other entities (business/organisation) and sale of investments in debt (selling an asset/investment which was bought/financed using a loan e.g. most people when they buy a house)
3) Cash from the collection of principal on loans (principal is the initial size of a loan or the amount still owed on a loan) to other entities

Question 14

List investing activities cash outflows

Answer 14

1) Cash used to purchase an asset (property, equipment etc)
2) Cash used to purchase equity securities (stocks, shares etc) of other entities or purchase investments in debt (an asset/investment that is bought/financed using a loan e.g. most people when they buy a house)
3) Cash used to give out loans to other entities

Question 15

List financing activities cash inflows

Answer 15

1) Cash earned from the sale of ordinary/common shares (normal stocks/shares sold on a public exchange)

Question 16

List financing activities cash outflows

Answer 16

1) Cash given to shareholders as dividends (only paid if profit made by entity)
2) Cash used to acquire or reacquire ordinary/common shares
3) Cash used to pay a loan/obligation

Question 17

What are the 2 types of assets?

Answer 17

1) Current assets
2) Non-current assets

Question 18

What are current assets and give examples?

Answer 18

Current assets are an entity’s short-term assets (that can be liquidated quickly into cash and used for an entity’s immediate needs) e.g. cash, marketable securities (assets that can be liquidated to cash quickly), inventory (refers to an entity’s goods/products/services that are ready to sell, along with the raw materials that are used to produce them) and accounts receivable

Question 19

What are non-current assets and give examples?

Answer 19

Non-current assets are long-term and have a useful life of more than a year e.g. investments, real estate and equipment

Question 20

What are the 2 types of liabilities?

Answer 20

1) Current liabilities
2) Non-current liabilities

Question 21

What are current liabilities and give examples?

Answer 21

A current liability is an obligation that is payable within one year- these kinds of liabilities typically settled using current assets (entity’s short-term assets that can be liquidated quickly into cash and used for an entity’s immediate needs)
E.g. accounts payable, short-term debt, dividends, income taxes owed etc

Question 22

What are non-current liabilities and give examples?

Answer 22

Non-current liabilities are those obligations not due for settlement within 1 year
E.g. long-term loans e.g. mortgages, long-term lease obligations, pension benefit obligations etc

Question 23

Briefly state what investing activities are

Answer 23

Changes in investments and non-current assets (long term assets e.g. property/real estate)

Question 24

Briefly state what financing activities are

Answer 24

Changes in non-current liabilities (long-term loans e.g. mortgages) and equity (money that is actually yours- net- value of the asset minus the amount you owe)

Question 25

For the following 5 transactions state whether they are investing, operating or financing activities:
1) Issued 100,000 £50 par value ordinary shares for £5,000,000 cash
2) Borrowed £2,000,000 from Castle Bank, signing a 5-year note bearing 8% interest
3) Purchased two semi-trailer trucks for £1,700,000 cash
4) Paid employees £120,000 for salaries and wages
5) Collected £200,000 cash for services provided

Answer 25

1. Financing Activities
2. Financing Activities
3. Investing Activities
4. Operating Activities
5. Operating Activities

Question 26

How many methods are there to work out the net cash flow from OPERATING activities?

Answer 26

2

Question 27

State the name of the methods to work out the net cash flow from OPERATING activities?

Answer 27

1) Direct Method
2) Indirect Method

Question 28

Briefly state what the DIRECT method used to work out the net cash flow from OPERATING activities shows?

Answer 28

The direct method only adjusts for all cash movements e.g. cash received from sales, cash purchases of materials etc- BUT imagine how long that would take if you were to adjust for all cash transactions of a large entity- … not a popular option INSTEAD entity’s opt for the indirect method

Question 29

Briefly state what the INDIRECT method used to work out the net cash flow from OPERATING activities shows?

Answer 29

The indirect method takes net profit (profit before tax) from the income statement and then adjusts for all non-cash transactions/movements (e.g. depreciation, investment appreciation etc)

Instead of starting from nothing and adding all cash inflows and subtracting all cash outflows it is easier to take the net profit/income from the income statement to just simply undo all non-cash transactions that have already been adjusted for in the income statement … you keep only the cash transactions hence why you do the opposite to what you think to the net income/net profit figure … you minus a gain on sale of equipment and add depreciation expense etc

Question 30

Give more detail about what the indirect method used to work out the net cash flow from OPERATING activities involves

Answer 30

1) Start with net income (profit before tax) from income statement- end profit figure taken from income statement
2) Minus non-cash transactions from it e.g. depreciation expense, loss on sale of equipment- REMEMBER you start with end figure profit figure from income statement (net income/profit) which has already been adjusted non-cash transaction (I.e any depreciation that has occurred has been taken away, any appreciation has been added, any loss on sale has been taken away and any gain has been added … opposite needs to be done to get initial cash figure which hasn’t been adjusted for any non-cash transactions)
3) Adjust for changes in working capital- so any increases/decreases in value of short term assets (e.g. inventory, accounts receivable) or short term liabilities (accounts payable, income tax payable etc)- amount of an entity’s current assets minus its current liabilities- considered prime measure of short-term liquidity of organisation
4) Minus other cash paid during the year e.g. interest, tax etc
= net cash provided or used (increase/decrease) from operating activities

Question 31

What is working capital?

Answer 31

The amount of an entity’s current assets minus its current liabilities- considered prime measure of short-term liquidity of organisation

Question 32

Why is working capital important and what does it show?

Answer 32

A strongly positive working capital balance indicates robust financial strength, while negative working capital is considered an indicator of impending bankruptcy- when a business has a large positive amount of working capital, it is better able to fund its own expansion without having to obtain debt/loans

Question 33

What is one thing/concept that is important to remember in the cash flow statement?

Answer 33

NEED to think in terms of cash

Question 34

In the cash flow statement, how would you present an increase and decrease in inventory?

Answer 34

Thinking in terms of cash 💵, an INCREASE in inventory would be recorded as NEGATIVE (decrease in net cash from operating activities) as there is a cash 💵 outflow as more cash 💵 is being spent on inventory

Thinking in terms of cash 💵, a DECREASE in inventory would be recorded as POSITIVE (increase in net cash from operating activities) as more cash 💵 is retained as less is spent on buying inventory for an entity

Question 35

In the cash flow statement, how would you present an increase and decrease in receivables (accounts/trade receivables)?

Answer 35

Thinking in terms of cash 💵, an INCREASE in trade receivables would be recorded as NEGATIVE (decrease in net cash from operating activities) as more receivables = less cash 💵 received (you are waiting to receive cash but haven’t actually been paid it)

Thinking in terms of cash 💵, a DECREASE in trade receivables would be recorded as POSITIVE (increase in net cash from operating activities) as less receivables = more cash 💵 received (you are not waiting to receive cash but have actually been paid it already)

Question 36

In the cash flow statement, how would you present an increase in payables (accounts/trade payables)?

Answer 36

Thinking in terms of cash 💵, an INCREASE in trade payables would be recorded as POSITIVE (increase in net cash from operating activities) as more payables = more cash 💵 retained to be paid at a later date (… at the present time you are saving cash 💵 by delaying payment)

Thinking in terms of cash 💵, a DECREASE in trade payables would be recorded as NEGATIVE (decrease in net cash from operating activities) as less payables = more cash 💵 to be paid now than at a later date (… at the present time you are spending cash 💵 by carrying out payments now)

Question 37

What is important to remember about changes in inventory, trade receivables and trade payables?

Answer 37

They all affect net cash from OPERATING ACTIVITIES

Question 38

Is net income the same as net profit?

Answer 38

Yes the 2 terms are interchangeable

Question 39

What must you adjust for in the indirect method for showing the net cash flow from operating activities?
CHECK SECOND BULLET POINT

Answer 39

1) Adjust for non cash movements e.g. depreciation
2) Adjust for difference in sales and purchases cash received- BUT ISN’T THIS CHANGES IN CASH TRANSACTIONS WHEN I THOUGHT THE INDIRECT METHOD ONLY ADJUSTS FOR NON-CASH TRANSACTIONS

Question 40

How many non-cash movements must you adjust for in the indirect method to get the net cash flow from operating activities?

Answer 40

4

Question 41

What are the non-cash movements that you must adjust for in the indirect method to get the net cash flow from operating activities?

Answer 41

1) Depreciation expense
2) Loss/gain on sale of equipment
3) Changes to non-cash current asset accounts
4) Changes to non-cash current liability accounts

Question 42

How is depreciation expense adjusted for in the indirect method to get the net cash flow from operating activities?

Answer 42

Depreciation expense is added to net income/net profit (same as loss on sale of equipment)
REMEMBER do opposite as to what was done in income statement

Question 43

How is loss on sale of equipment adjusted for in the indirect method to get the net cash flow from operating activities?

Answer 43

• any loss on sale is added to net income in operating section
• any gain on sale is taken away from net income in operating section
• REMEMBER opposite done to what has already been done in income statement- end profit figure has already been adjusted for non-cash transactions … opposite needs to be done to undo this (remember we are interested in the net cash flow from operating activities)

Question 44

How are changes to non-cash current asset accounts adjusted for, specifically changes in accounts receivable, in the indirect method to get the net cash flow from operating activities?

Answer 44

When the accounts receivable balance decreases, cash receipts are higher than revenue earned under the accrual basis (as more cash is received now and less payment is delayed until a later date)

… company adds the decrease in accounts receivable to net income … the increase in cash receipts is added to net income

Question 45

How are changes to non-cash current liability accounts adjusted for, specifically changes in accounts payable, in the indirect method to get the net cash flow from operating activities?

Answer 45

An increase in accounts payable is added to net income because it means that more payment has been delayed for the future and more cash is kept in the present … it is added- ALSO company received more in goods than it actually paid for … increase added to net income

A decrease in accounts payable is deducted from net income because it means that less payment has been delayed for the future and … less cash is kept in the present

Question 46

How would the following activity be shown under the indirect method to get the net cash flow from operating activities:

An entity reports a $3,000 loss on the sale of equipment (initial value $7,000 and $4,000 cash received from sale of equipment)

Answer 46

Add $3000 to net income

Question 47

How would the following activity be shown under the indirect method to get the net cash flow from operating activities:

An entity reports a $7000 gain on the sale of equipment (initial value $7,000 and $14,000 cash received from sale of equipment)

Answer 47

Deduct $7000 from net income

Question 48

What comes under non-cash current asset accounts?

Answer 48

1) Changes in accounts receivables
2) Changes in inventory

Question 49

What comes under non-cash current liability accounts?

Answer 49

1) Changes in accounts payable
2) Changes in income tax payable

Question 50

How are changes to non-cash current asset accounts adjusted for, specifically changes in inventory, in the indirect method to get the net cash flow from operating activities?

Answer 50

When the inventory balance increases, the cost of merchandise (stock) purchased is greater than the cost of goods sold (because inventory balance is the total of the cost of the goods already sold plus the stock available that is yet to be sold)- CHECK AND CHANGE ACCORDINGLY- NOT SURE ABOUT THIS EXPLANATION- I THINK JUST STICK TO EXPLANATION BELOW
… cost of goods sold doesn’t reflect the cash payments made to purchase the merchandise (stock)

Increase in inventory means that more cash is spent on buying inventory (e.g. resources, goods ready to be sold etc) … lower cash reserves which are then taken away/deducted from net income
Whereas decreases in inventory means that less cash is spent on buying inventory (e.g. resources, goods ready to be sold etc) … greater cash reserves which are then added to net income

Question 51

How are changes to non-cash current liability accounts adjusted for, specifically changes in income tax payable, in the indirect method to get the net cash flow from operating activities?

Answer 51

When income tax payable decreases, more cash is used to pay tax in the present and less tax is payed later
… decrease in present cash subtracted from net income

When income tax payable increases, less tax was paid in the period than the actual expense (less is paid now and more is paid later)
… increase in present cash added to net income

Question 52

How would the following activity be shown:

An entity purchases a non-current asset (an office building) for $120,000 cash

Answer 52

This would be treated as a cash outflow (decrease) of $120,000 reported in the investing section

Question 53

How would the following activity be shown:

An entity receives $20,000 cash for the issue of new shares

Answer 53

Would be included as an increase of $20,000 under Financing activities

Question 54

How would dividends of $29,000 affect retained earnings?

Answer 54

They would decrease retained earnings by $29,000 as they are paid as an outflow to shareholders

Question 55

How would net income of $145,000 affect retained earnings?

Answer 55

It would increase retained earnings by $145,000

Question 56

What would be the overall effect of the following 2 activities:

1) Net income/net profit of $145,000
2) Dividends of $29,000

Answer 56

Retained earnings would increase by $116,000 as net income would increase retained earnings and dividends would decrease them