Week 8a - Cash Flow Statement

Question 1

Why is cashflow more important than profit?

Answer 1

• Profit is good, but cash is king!

• People will only normally accept cash in settlement of their claims
• Cash is necessary to pay bills
• Cash is necessary for survival

Question 2

What does the cashflow statement summarise?

Answer 2

The inflows and outflows of cash (and cash equivalents) for a business over a period

Question 3

Using a simple example, explain the difference between profit and cash

Answer 3

• You buy a £2 phone card on Monday
• A friend asks you to make an urgent phone call for him on Tuesday. You use up all the units on the card. You friend agrees to pay you £3 on Wednesday

Your profit and cash flow on each of the three days:

            Monday    Tuesday      Wednesday    Total Profit             0                1                    0                 1 Cash flow     (2)              0                    3                 1

We can learn from the above example that:
• Profit and cash flow on any one day are not the same
• Over the three days, profit and cash flow are the same. With businesses, total profit and total cash flow are usually the same in the long run. The difference between them is a matter of timing

Question 4

State the effects of the following business/accounting
events on profit and cash

a. Repayment of borrowings
b. Making a profitable sale on credit
c. Buying a current asset on credit
d. Receiving cash from a credit customer (trade receivable)
e. Depreciating a non-current asset
f. Buying some inventories for cash
g. Making a share issue for cash

Answer 4

a = Cash decreased
b = Profit increased
c = No effect on profit or cash
d = Cash increased
e = Profit decreased
f = Cash decreased
g = Cash increased

Question 5

Not all receipts of cash are revenues. Explain.

Answer 5

• Receipts of cash that are not revenues

Some receipts do not add to profits:

• Sale of non-current assets;
• Borrowing money;
• Proceeds from issuing shares;
• Receipts from receivables this period in respect of sales for the previous period

Question 6

Not all revenues are receipts of cash. Explain.

Answer 6

• Revenues that are not receipts

Some revenues are added to profits although
there is no receipt of cash in the year:

• Sales that are made during this period, but the money
  is not received until the next period;
• Discount allowed by suppliers for settling accounts promptly;
• Reduction in a provision

Question 7

Not all payments of cash are expenses. Explain.

Answer 7

• Payments of cash that are not expenses

Some payments are not a charge against profits:

• Payments to buy stocks of goods that are not sold until the next period;
• Payments to creditors for expenses incurred in the previous period;
• Purchase of non-current assets;
• Investing in other companies;
• Repaying loans

Question 8

Not all expenses are payments of cash. Explain.

Answer 8

• Expenses that are not payments

Some expenses are charged although no payment of cash is required in the year:

• Depreciation and amortisation;
• Expenses incurred this period but which are not paid for until the next period;
• Creating a provision;
• Increase in a provision for bad debts;
• Discount allowed to customers for settling their accounts promptly

Question 9

What three headings are cash flows classified under in the cash flow statement IAS7?

Answer 9

Operating activities
Investing activities
Financing activities

Question 10

What cash flows are included under the operating activities heading?

Answer 10

• All receipts and payments resulting from sales and costs based on the profit figure
• Includes interest, tax and dividend paid*

*Note that dividend paid can alternatively be shown as a financing activity

Question 11

What cash flows are included under the investing activities heading?

Answer 11

• Payments for purchase of non-current assets

- Receipts from disposal of non-current assets

Question 12

What cash flows are included under the financing activities heading?

Answer 12

• Cash inflows from sale of shares and new long term loans

- Payments to redeem shares and loans

Question 13

How is the net increase (or decrease) in cash and cash equivalents over the period calculated using the cash flow statement?

Answer 13

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

Question 14

What are the two methods for deducing net cash flows from operating activities?

Answer 14

The direct method

The indirect method

Question 15

What is the direct method for calculating the cash flows arising from operating activities

Answer 15

The direct method takes each item of operating cash flow separately from the cash records to arrive at the cash flow arising from operating activities

Question 16

Operating cash flows, Year 1
£
Cash received from customers 103
Cash paid to suppliers (58)
Wages paid (20)

Calculate the operating cashflow using the direct method

Answer 16

Operating cash flow = £25

Question 17

What is the indirect method for calculating the cash flows arising from operating activities

Answer 17

• The indirect method starts with
the profit from operations……
then eliminates non-cash expenses such as
depreciation, and adds on or deducts the effects of
changes in working capital……
to arrive at the cash flow arising from operating
activities

Question 18

Give the step by step method as to how the net cash flows from operating activities is calculated using the indirect method

Answer 18

Profit before taxation
plus
Depreciation expense
plus
Interest expense

Now the working capital...
plus or minus
Increase (minus) or decrease (plus) in inventories
plus or minus
Increase (minus) or decrease (plus) in receivables
plus or minus
Increase (plus) or decrease (minus) in 
trade payables

less
Interest paid
less
Taxation paid
less
Dividend paid***
equals
Net cash flows from operating activities

***Dividend paid could be included under the
heading “Cash flows from financing activities”

Question 19

Operating cash flow, Year 1 
                                                 £
Operating profit                     30
Add back depreciation          10
                                                40
(Increase) in inventory          (15)
Decrease in receivables        3
(Decrease) in payables         (3)

Calculate the operating cash flow using the indirect method

Answer 19

Operating cash flow = £25

Question 20

Which method should be chosen for calculating the operating cash flow - direct or indirect?

Answer 20

• Both are allowed by IAS 7
• Both give the same answer for operating cash flow
• The indirect method emphasises management of working capital
• The direct method gives information not available elsewhere in the annual report
• The indirect method is far more popular

Question 21

State how the following investing activities would affect the cash flow statement

• Purchase of a new non-current asset with cash
• Receipts from disposals of non-current assets

Answer 21

• Cash outflow

- Cash inflow

Question 22

State how the following financing activities would affect the cash flow statement

• New loans
• New shares issued
• Redemption of loans and share buyback

Answer 22

• Cash inflow
• Cash inflow
• Cash outflow

Question 23

Give a numbered, comprehensive step by step list as to how to prepare a full cash flow statement

Answer 23

Preparing the Cash Flow Statement

Cash generated from operating activities

1. Profit before tax
2. Depreciation
3. Other items such as profit or loss on the sale of non-current assets
4. Interest expense

(Increase)/decrease in working capital
5. (Increase)/decrease in inventories 
6. (Increase)/decrease in receivables
7. Increase/(decrease) in payables
= Cash inflow/(outflow) from operating activities
8. Interest paid
9. Taxation paid
10. Dividend paid*
= Net cash inflow/(outflow) from operating activities

Cash used in investing activities

11. Purchase of non-current assets
12. Disposal of non-current assets

Cash used in financing activities

13. Issue/(repayment) of loan
14. Issue/(repayment) of shares

Increase/(decrease) in cash during year
+ Opening cash balance
= Closing cash balance

*Can be shown as financing activity

Question 24

How can cash flows from operating activities be used to calculate the dividend times cover ratio?

Answer 24

(Net cash from operating activities + dividends) /

dividends paid

Question 25

How can cash flows from operating activities be used to calculate the interest times cover ratio?

Answer 25

(Net cash from operating activities + dividends + interest) / interest

Question 26

How can cash flows from operating activities be used to calculate cash return on capital employed?

Answer 26

(Net cash flow from operating activities / Equity)*100

Question 27

How can cash flows from operating activities be used to calculate cash flow per share?

Answer 27

Net cash flow from operating activities / number

of shares

Question 28

What does CFS stand for?

Answer 28

Cash Flow Statement

Question 29

Interpreting the CFS

What are nine questions to ask when trying to understand a published cash flow statement?

Answer 29

1. Was there a positive cash flow from operating
   activities?
2. Has working capital increased, and how was it financed? Has there been a reduction in working capital, and what is the significance of this reduction?
3. Have there been significant investing activities?
4. Has there been a reduction in investments in non-current assets and other businesses? How much money was raised, and how was this used?
5. Has the business been raising substantial long-term
   financing? Why do these funds seem to be needed?
6. Are the cash flows from financing activities negative
   (i.e., has there been a reduction in long-term funding)?
   What does this suggest?
7. Has one form of long-term capital been used to redeem another (perhaps issuing shares to repay debentures)? Why might this have been done?
8. Was the amount of dividend covered by cash flows from operating activities?
9. Did the cash balance increase or decrease during the year? Why – what were the main contributors to this?

Question 30

State one of the limitations of the CFS

Answer 30

A cash flow statement provides useful information - but interpret with care!