Cash flow statements

Contents Introduction – The cash flow statement Usefulness of cash flow information Cash flow cycles Format and structure of the cash flow statement Cash flow from operating activities Cash flows from investing and financing activities Direct and indirect method for operating cash flows Constructing a cash flow statement Disposal of fixed assets Presentational differences

Cash flow statement A cash flow statement presents information about the cash flows associated with the company’s main operations and those associated with its investing and financing activities of the period A cash flow statement functions in conjunction with both the income statement (performance dimension) and the balance sheet (financial position) IAS 7 Cash Flow Statements

Usefulness of cash flow information Ability to generate adequate cash flows is a significant performance dimension Cash flow information clarifies the dynamics of short-term liquidity and long-term solvency Cash flow information is an essential input for economic decision models

Cash flow versus profit Cash flow and profit are different economic phenomena But linked through the mechanisms of accrual accounting! Cash flows are factual details of incoming and outgoing flows of cash, while the balance sheet and income statement emanate from professional judgement and are not a direct projection of objective economic data

Liquidity/solvency and cash flows Relates to “nearness to cash” of the structure of assets Determined by capacity to convert current assets into cash Solvency Relates to future availability of cash in order to settle financial liabilities on due date Determined by timing and uncertainty of expected future cash payments and cash receipts Liquidity and solvency ratios are determined on static financial position data, while cash flows reflect changes in financial position

Relationship with BS and IS Income statement BS at start Cash flow BS at end A cash flow statement reflects both “profit related” and “non-profit related” activities (investing and financing) with an impact on available cash over the period covered in the income statement

Related questions From which sources did the company raise cash last year? How was this cash used? Were the normal operating activities capable of satisfying its need for cash during the year? If not, is the shortage of cash compensated by new borrowings, issuing new share capital or by selling fixed assets? Is a surplus of cash used for repayment of debt, for investments or for distribution of dividends? Why has the balance of cash available decreased, knowing that the company’s operations have been profitable?

Cash conversion cycles Cash flows through the company continuously in a series of short-term and long-term conversion cycles The ST - cash conversion cycle (operating cycle) relates to the main business operations = OPERATING ACTIVITIES

Cash conversion cycles (cont.) The LT- cash conversion cycles relate to the acquisition, renewal and disposal of intangible and tangible infrastructure and the long-term sourcing of funds Productive capacity acquired for cash and subsequently consumed during several ST-operating cycles Acquisition and disposal of infrastructure = INVESTING ACTIVITIES External sourcing of funds = FINANCING ACTIVITIES

Fig. 10.1 Long-term and short-term cash flow cycles Main operations Inventory Procurement Work in Progress Sales Current payables Inventory Current receivables Payments Receipts Cash and cash equivalents Investing/ Productive infrastructure External financing

Format and structure of the cash flow statement Cash flows from operating activities + Cash flows from investing activities + Cash flows from financing activities Net change in cash during period + Beginning cash balance Ending cash balance

Cash flows from operating activities Operating activities are primarily the revenue-generating activities of a company “Operating cash flow” is conceptually most near to “net profit” Main differences: Non-cash expenses and non-cash revenues (f.i. depreciation expense) Non-operating items (f.i. gain on disposal of tangible fixed assets) Timing differences between net profit and underlying cash flow (f.i. changes in the level of inventories, receivables, creditors, etc.)

Operating cash flows: Examples Receipts from sale of goods and rendering of services (cashing in of receivables included) Receipts from taxes on sales and VAT Receipts from royalties, fees, commissions,… Payments to suppliers (payment of creditors included) Payments to employees Payments of taxes, VAT, fines, …

Operating cash flows – Direct versus indirect method 2 methods for identifying and presenting the operating cash flow: Direct method: engenders the presentation of the most important categories of gross operating cash inflows and cash outflows Indirect method: net operating cash flow is determined by adjusting the (net) profit figure for the 3 types of differences

Direct method - Example Cash receipts from customers 30,150 Cash paid to suppliers and employees (27,600) Cash generated from main operations 2,550 Income taxes paid (1170) Net cash flow from operating activities 1,380

Indirect method - Example Net profit before tax 3,350 Adjustments for: Depreciation 490 Investment income (100) 3,740 Working capital changes: Increase in trade and other receivables (500) Decrease in inventories 1,050 Decrease in trade payables (1,740) Cash generated from main operations 2,550 Income taxes paid Net cash flow from operating activities (1170) 1,380

Cash flow proxy (xxxxxxxxxxxxxx) Net profit or loss after tax Add back: Depreciation charge for the year xxxxxxxxxxxxxxx Provisions created in year Deduct: Provisions released in year (xxxxxxxxxxxxxx) ‘Cash flow proxy’

Cash flow proxy (bis) Net profit or loss after tax xxxxxxxxxxxx Add back: Depreciation for the year xxxxxx Provisions created in year xxx Deduct: Provisions released (xxxx) Gain on asset disposal (xxxxx) Net change in non-cash working capital ‘Cash flow proxy’

Cash flows from investing activities Investing activities relate to the acquisition and disposal of long-term tangible and intangible assets and other investments Cash flows from investing activities are an indication of the expansion or downsizing of operating capacity Examples: Payments for newly acquired equipment Receipts from the disposal of a building Payments for new investments

Cash flows from financing activities Financing activities relate to changes in the size and composition of contributed capital and financial debt of the company Examples: Receipts from issuing new shares or bonds Receipts from new bank loan Payments for buy-back of shares Repayments of loans Payments of interest and dividend

Constructing a cash flow statement Determine the net change in cash Compare beginning and ending balance Identify all transactions of the period leading to a change in cash Direct: analyze movements in the accounts of cash (equivalents) transaction by transaction Indirect: explain net change of cash by analyzing all other accounts, knowing that each transaction with an impact on cash also affects a non-cash account Use the information (of step 1 and 2) to construct a cash flow statement according to the formal rules

Applying step 2 Information for operating cash flow is primarily derived from balances in the IS, while information for the two other principal categories comes from the Balance Sheet (and details in the Notes) Movements in the accounts indicate a change in financial position and further examination is needed to determine if they had a cash impact Check if balances have been impacted by “accrual-based adjustments” or other “non-cash activities”

Fig. 10.2 Classifying balance sheet movements as inflows or outflows of cash Assets Equity/liabilities Increase Outflow Inflow Decrease

Illustration - Constructing a CFS (1)

Illustration - Constructing a CFS (2)

Disposal of fixed assets - Example Disposal of equipment: Acquisition cost 275 Accum. depreciation - 200 Net carrying value = 115  Sale at 135 Result (gain) on disposal = 135 - 115= 20 Incoming cash flow = 135, composed of a decrease in net carrying value of equipment in the BS (115) and gain on disposal in the IS (20)

Disposal of fixed assets Net profit after tax xxxxxxxxxxxx Add back: Depreciation xxxxxx Provisions created Loss on disposal of assets Deduct: Provisions released Gain on asset disposal +/- Change in non-cash working capital Net cash flow from operating activities

Incoming cash flows Cash + Other assets = Liabilities + Owners’equity (1) + - (2) (3)

Outgoing cash flows - + Cash + Other assets = Liabilities + Owners’equity (1) - + (2) (3)

Presentational choices Interest paid can be classified under either operating or financing activities Interest and dividends received can be included in either operating or investing cash flows Starting from net profit or operating profit under the indirect method (with implications for the adjustments to be made)

IAS 7 - Direct Method (Extract) Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - Direct Method (Extract) Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - Direct Method (Extract- cont.) Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - Indirect Method (Extract) Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - Indirect Method (Extract) Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - Indirect Method (Extract – cont.) Source: IAS 7 – Cash Flow Statements, Appendices