Week Six Flashcards
Assess the purpose and usefulness of the statement of cash flows.
The purpose of a statement of cash flows is to show the cash flows of an entity over a set period, in order to assess an entity’s ability to generate cash and to meet future obligations. The heightened awareness of the management of earnings in the income statement has elevated the importance of reviewing the statement of cash flows in conjunction with the income statement.
Outline the format and the classification of cash flows in the statement of cash flows.
The statement of cash flows presents the beginning and ending cash balances and the cash inflows and outflows of a reporting period.
The cash inflows and outflows are classified into operating, investing and financing activities.
A reconciliation of cash from operating activities with the profit in the income statement is presented in a note to the accounts.
Produce a statement of cash flows using the direct method and a reconciliation using the indirect method.
Cash flows from operating activities are determined by examining the income and expenses in the income statement and the non-current assets and non-current liabilities in the balance sheet.
Cash flows from investing activities are determined from changes in balance sheet items dealing with non-current assets.
Evaluate an entity’s performance using a statement of cash flows.
The interpretation of the statement of cash flows requires a general evaluation, as well as the use of trend and ratio analysis. Cash flow warning signals can also indicate a cash flow problem.
Cash-based ratios include the cash adequacy ratio, the cash flow ratio, the debt coverage ratio, the cash flow to sales ratio, and free cash flow.
Despite the complexity of transactions, the basic purpose of a statement of cash flows is to report what cash came in to the business and how it was spent.
What is ‘Cash’
Cash is legal tender or coins that can be used to exchange goods, debt or services. Sometimes it also includes the value of assets that can be converted into cash immediately, as reported by a company.
What is the purpose of drawing up a cash flow statement
The purpose of drawing up a cash flow statement is to see a company’s sources of cash and uses of cash, over a specified time period. The cash flow statement is traditionally considered to be less important than the income statement and the balance sheet, but it can be used to understand the trends of a company’s performance that can’t be understood through the other two financial statements.
What is ‘Cash Flow From Investing Activities’
Cash flow from investing activities is an item on the cash flow statement that reports the aggregate change in a company’s cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries and changes resulting from amounts spent on investments in capital assets such as plant and equipment.
When analyzing a company’s cash flow statement, it is important to consider each of the various sections which contribute to the overall change in cash position. In many cases, a firm may have negative overall cash flow for a given quarter, but if the company can generate positive cash flow from business operations, the negative overall cash flow may be a result of heavy investment expenditures, which is not necessarily a bad thing.
What is ‘Cash Flow From Financing Activities’
A category in a company’s cash flow statement that accounts for external activities that allow a firm to raise capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock. Cash flow fromfinancing activities shows investors the company’s financial strength. A company that frequently turns to new debt or equity for cash, for example, could have problems if the capital markets become less liquid.
What is the difference between a balance sheet and a cash flow statement?
a balance sheet, or statement of financial position, is a summary of the financial balances of a company, while a cash flow statement, or statement of cash flows, shows how the changes in balance sheet accounts and income on the income statement affect a company’s cash position. In essence, a company’s cash flow statement measures the flow of cash in and out of a business, while a company’s balance sheet measures its assets, liabilities and owners’ equity. The cash flow statement is broken down into three parts: operating activities, financing activities and investing activities
WHAT IS A CASH FLOW FORECAST?
A cash flow forecast is an estimate of the amount of money you expect to flow in and out of your business and includes all your projected income and expenses. A forecast usually covers the next 12 months, however it can also cover a short-term period such as a week or month.
WHAT CAN YOU USE IT FOR?
Cash flow forecasts can help predict upcoming cash surpluses or shortages to help you make the right decisions. It can help in tax preparation, planning new equipment purchases or identifying if you need to secure a small business loan.
You can also use it to see the effect of an upcoming business change or decision. If you’re considering hiring a new employee for example, you’d add the additional salary and related costs into your forecast. The new figures in your cash flow forecast will tell you whether hiring that additional employee is likely to place your business in a stronger position and help you decide whether to hire them or not.
Including best, worst and most likely case scenarios allows you to see how your business will fare if you suddenly hit tough times or better than expected trading conditions. Knowing how this effects your cash position allows you to make informed and educated decisions, and you’ll be more confident of running your busines
Causes of Cash Flow Problems (GCSE)
A cash flow problem arises when a business struggles to pay its debts as they become due.
Note that a cash flow problem is not necessarily the same as experiencing a cash outflow. A business often experiences a net cash outflow, for example when making a large payment for raw materials, new equipment or where there is a seasonal drop in demand.
However, when cash flow is consistently negative and the business uses up its cash balances, then the problem becomes serious.
The main causes of cash flow problems are:
Low profits or (worse) losses
There is a direct link between low profits or losses and cash flow problems. Remember - most loss-making businesses eventually run out of cash
Over-investment in capacity
This happens when a business spends too much on production capacity. Factory equipment which is not being used does not generate revenues – so is often a waste of cash
Too much stock
Holding too much stock ties up cash and there is an increased risk that stocks become obsolete (i.e. it can’t be sold)
Allowing customers too much credit
Customers who buy on credit are called “trade debtors” Offering credit to customers is a good way to build revenue, but late payment is a common problem and slow-paying customers put a strain on cash flow
Overtrading (growing too fast)
This occurs where a business expands too quickly, putting pressure on short-term finance. For example, a retail chain might try to open too many stores too quickly before each starts to generate profits
Seasonal demand
Predictable changes in seasonal demand create cash flow problems – but because they are expected, a business should be able to handle them
Problem #1: High overhead costs
Overhead costs are expenses that are not directly related to the specific delivery of your product or service. Examples include rent, electricity, and some salaries.
These costs are important to the business but can easily get out of hand. This problem can affect companies that are growing quickly. They impact the bottom line but contribute little to your revenues.
Action steps
You can fix this problem by going through your business looking for resources that are not essential. Then, cut back on those resources. Be careful and avoid cutting overhead to the point it affects your ability to run the company.
Problem #2: Too much money tied in inventory
Managing inventory is difficult, especially for small business. It requires a very delicate balance. Too little inventory can affect operations and delay orders. Too much inventory, on the other hand, just sits in a warehouse unused.
Having excess inventory is expensive. It ties up cash and often leads to cash flow problems.
Action steps
You can solve this problem by managing your inventory more carefully. Make sure that you have enough inventory to service your clients, but not too much more. Unfortunately, managing inventory is difficult. It usually requires expensive systems that few small businesses can afford.
A short-term solution to fix this problem is to use inventory financing. It allows you to convert inventory into cash. While inventory financing is costly, it can provide funds to operate the business during tight times.
Problem #3: Slow-paying customers
Large clients usually ask for payment terms as a condition of doing business. As such, you have to allow them 30 – 90 days to pay an invoice. Offering payment terms is a cost of doing business. However, slow paying invoices tie up your cash. This can lead to cash flow problems.
Action steps
There are a few ways to solve this problem. One option is to offer clients an early payment discount. A 2% discount on the invoice in exchange for a payment in 10 days often works well. This simple technique can improve your cash flow quickly.
If your clients cannot pay early, you can use financing to improve your working capital. Small companies can use options like Microloans or invoice factoring to accomplish this.
Larger companies that can’t qualify for a business loan should consider asset based lending. These allow you to finance accounts receivable and other company assets. They provide you with immediate funds to pay company expenses.
