Understanding and Managing Finance 6 This Presentation is in Self-Study Form To start the presentation: Press F5 (Top Row of Keyboard) Then use the navigation buttons at the foot of each page

Understanding & Managing Finance Presentation 6 Cash Flow Statements

Week 6 – Cash Flow Statements Learning outcomes: Understand the purpose of the Cash Flow Statement Know the format of a Cash Flow Statement and understand the terms which comprise it. Be able to amend a Cash Flow Statement as a result of transactions Construct a Cash Flow Statement from information given Derive a the net cash flow from operating activities from the information in a Balance Sheet and the Profit & Loss Account.

Menu  A : Cash versus ProfitCash versus Profit  B : The Format of Cash Flow StatementsThe Format of Cash Flow Statements  C : Example of a Cash Flow StatementExample of a Cash Flow Statement  D : Net Cash Flow From Operating ActivitiesNet Cash Flow From Operating Activities  E : Seminar 6 ActivitiesSeminar 6 Activities

Section A: Cash versus Profit

The Cash Flow Statement  Cash is critical to the ongoing survival of an organisation - employees and suppliers will (sooner or later) require payment in “cash”  Traditional financial statements (Profit & Loss Account and Balance Sheet) do not necessarily highlight the cash- flow position  New Financial Standard (1991) required all except the smallest companies to publish Cash-Flow Statements  Cash-Flow Statement = Summary of all cash movements over a period of time

Profit & Cash  As we have seen earlier: Profit = Revenue (Turnover) – Expenditure.  We now look at: Net Cash Flow = Cash In – Cash Out  Please note that these are not the same thing. Cash can come in and go out of a business for all sorts of things that are not profit-related. To give one example: On one particular day, a customer might pay a long standing debt of £500 in cash. On the same day we might go to the wholesaler and buy £400 goods for cash. The net cash flow for the day is £100. The profit for that day is zero, since we have not sold any new goods.

The Three Financial Statements  The Balance Sheet offers a ‘snapshot at a moment in time’ of the assets & claims. Included in this account are two items: Profit (Normally Part of the owners’ claim) Cash ( Normally in the Bank)  The Profit & Loss Account looks at how the owners’ claim has increased or grown or decreased over the period.  The Cash Flow Statement looks at how Cash has increased or decreased over the same period.  All three statements are linked together.

Balance sheet at the start of the accounting period Owner’s claim Cash Balance sheet at the end of the accounting period Owner’s claim Cash Cash flow statement Profit and loss account The relationship between the balance sheet, the profit and loss account and the cash flow statement

SAQ 6.1 Discuss the immediate effect of the following transactions on: a) Profit and b) Cash 1. Repaying a loan Repaying a loan 2. Making a sale on credit Making a sale on credit 3. Buying a fixed asset for cash Buying a fixed asset for cash 4. Receiving payment from a trade debtor Receiving payment from a trade debtor 5. Allowing for the Depreciation of a fixed asset Allowing for the Depreciation of a fixed asset 6. Buying some stock with cash Buying some stock with cash 7. Making a share issue for cash Making a share issue for cash Click on the transactions for the solution.

SAQ 6.1: Solution 1.Repaying a loan: Profit:  This has no effect. (Profit = turnover – costs). Cash  This reduces our cash by the amount repaid.

SAQ 6.1 : Solution 2. Making a sale on credit: Profit:  This increases profit, since we have increased turnover. Cash  This has no effect. No money changes hands.

SAQ 6.1 : Solution 3. Buying a fixed asset for cash: Profit:  This has no effect. Assets are not part of the profit equation. Cash  This reduces our cash.

SAQ 6.1 : Solution 4. Receiving cash from a trade debtor: Profit:  This has no effect on profit, as we have already counted this sale in our turnover figures. Cash  This increases our cash.

SAQ 6.1 : Solution 5. Allowing for the Depreciation of a fixed asset: Profit:  This decreases our profit, since it is part of our indirect costs. Cash  No money changes hands, so it would appear that cash is unchanged. However, at a technical level, depreciation increases our cash, since it releases part of the money that was originally paid for the item.

SAQ 6.1 : Solution 6. Buying some stock for cash: Profit:  This has no effect on profit, since we only account for this when we sell it. Cash  This reduces our cash.

SAQ 6.1 : Solution 7. Making a Share Issue for Cash: Profit:  This has no effect on profit, since capital is not part of the profit equation. Cash  This increases our cash.

Section B: The Format of the Cash-Flow Statement

The Cash Flow Statement  The usual way in which a Cash-Flow Statement is compiled is to group all the cash transactions into various headings which summarise all the transactions.  In this way, we can see at a glance where the problem areas might be.  These headings are things like  “Operating Activities” - the day-to-day running of the business: cash sales, less money paid for stock, wages, rent etc. We would normally expect this to have a net cash inflow  “Tax” – the money paid out in all forms of tax (Corporation Tax, VAT etc.) We would normally expect this to have a net cash outflow!

Equity Dividends paid Financing Capital expenditure Returns from investment and servicing of finance Taxation Management of liquid resources Operating activities Cash balance Elements of the Cash Flow Statement Inflows and Outflows Click on the text for the definition

Capital Expenditure Cash Outflows:  Cash purchases of additional fixed assets such as machinery, land, buildings, fixtures & fittings. Cash Inflows:  Cash sales of the above fixed assets, at the end of their useful life for salvage value (machinery or transport) or at a profit (Land & Buildings)

Equity Dividends Cash Outflows:  Cash dividends paid to shareholders as a reward or ‘bonus’ for the investment in the company. Note that businesses frequently declare a dividend on one year’s P & L account, but the money is not actually paid until the following year. It is treated as a current liability until it is fully paid. Cash Inflows:  Normally None.

Financing Cash Outflows:  Repayment of Long-Term Loan Capital (not interest) Cash Inflows:  Taking out of new Long-Term Loans. The full amount of the loan is counted as a cash inflow.

Management of Liquid Resources Cash Outflows:  Any Cash purchases of disposable investments, such as shares in or loans to other companies, land and property bought for investment purposes, or other items acquired for investment. (Normally bought as a repository for a short-term cash surplus) Cash Inflows:  Any sales of the above, releasing the cash.

Operating Activities (Operating Activities are Normal Trading Operations) Cash Inflows:  Cash receipts from trade debtors, and cash sales. Cash Outflows:  Stock purchases in cash, payments to trade creditors, cash payments for rent, wages, fuel, transport costs etc.

Taxation Cash Outflows:  Cash payments made during the period of the statement. Note that this may not be equal to the Taxation shown elsewhere. Normally companies pay 50% tax this year, 50% shortly after. Cash Inflows:  Tax Rebates made for overestimates or miscalculations (rare).

Returns from Investment & Servicing of Finance Cash Outflows:  Interest paid on Long Term Loans, Preference shares, Debentures, and other forms of loans used to finance the business. Cash Inflows:  Interest earned on Long Term Loans, Preference shares, Debentures, and other forms of loans held by the business as investments in other companies or organisations.

Cash Balance  In this case cash means Cash in Hand + Deposits in the Bank or Building Society or elsewhere, which provides funds accessible within 24 hours.  This is the ‘bottom line’ of the Cash Flow Statement and it represents the total amount of Cash Flowing IN, or Flowing OUT of the business over the accounting period.

plus or minus equals plus or minus Increase or decrease in cash over the period Net cash flow from operating activities Returns from investment and servicing of finance Taxation Capital expenditure Equity dividends paid Management of liquid resource Financing Standard layout of the cash flow statement

SAQ 6.2 Which direction (in or out) would you normally expect the net cash-flow to be for the following:  Operating Activities  Returns from investments and servicing of finance  Taxation  Capital expenditure  Equity Dividends  Management of liquid resources  Financing Solution

SAQ 6.2 Direction of net cash-flow normally:  Operating ActivitiesININ  Investments/ servicing of financeOUTOUT  TaxationOUTOUT  Capital expenditureOUTOUT  Equity DividendsOUTOUT  Management of liquid resourcesEITHEREITHER  FinancingEITHEREITHER For an explanation, click on the answers

SAQ 6.2 Explanation (IN) Direction of net cash-flow normally:  OperationsIN This is the day-to day trading. A healthy business would normally expect to generate a net cash inflow. In addition, as most of the other items on the Cash Flow statement are outflows, then it is important that the Operating Activities generate a sufficiently large inflow to cover these. If this is not the case, the business will experience severe cash flow problems.

SAQ 6.2 Explanation (OUT) Direction of net cash-flow normally:  Investments/ servicing of financeOUT This is the interests paid on bank loans etc. Business would normally expect to pay interest out here; the exception would be where the business has loaned money to other businesses.  TaxationOUT Taxation is normally a one-way street to the Inland Revenue. Occasionally we might get a rebate, but don’t bank on it.  Capital expenditureOUT We would normally expect to buy or replace some part of our fixed assets in the course of a year. Occasionally we might dispose of an item, but not replace it – this would give an inflow.  Equity DividendsOUT We would normally expect to pay out dividends to shareholders in the course of a year, unless the business is doing so badly we could not afford it, or we have decided to use all the profit for expansion.

SAQ 6.2 Explanation (EITHER) Direction of net cash-flow normally:  Management of liquid resourcesEITHER These are sales OR purchases of disposable assets and investments. Depending upon what the company is doing, the flow could be either way.  FinancingEITHER This is the taking out OR redemption of loans. Depending upon what the company is doing, how long the loans have been in force, and the financial circumstances, the flow could be either way.

Section C: Example of a Cash Flow Statement

CASHFLOW STATEMENT STANDARD FORMAT Net Cash-flow from Operating Activities (Receipts from Cash sales and debtors less payments for stocks, wages, rent etc) +/- Returns from investment and servicing of finance (Receipts of interest etc less payments of interest and other fixed returns) +/- Taxation (Receipts of tax less payments of tax during the period) +/- Capital Expenditure (Receipts from sale of fixed assets less payments made to purchase fixed assets) - Equity Dividends paid (Payments of dividends to shareholders) +/- Management of liquid resource (Sale or purchase of disposable investments) +/- Financing (Input or redemption of long-term borrowings) = Increase or Decrease in Cash over Period These items must come exactly in this order They are + or - depending on whether the cash flows IN or flows OUT

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ This is the “normal” everyday working part of the statement

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Receipts from sales and debtors, less payments made for stock & wages etc.

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Interest gained, less payments of interest or other fixed items.

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Tax Rebates less any tax paid out.

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Receipts from the sale of fixed assets less any payments made to buy new fixed assets

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ This is the “special” part of the statement for one-off transactions

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Money paid out to shareholders

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Sale or purchase of disposable investments, such as real estate, shares, bonds etc.

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ Addition or redemption of long-term loans

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+ The Bottom Line: By how much have we increased or reduced our cash over the period? The Bottom Line: By how much have we increased or reduced our cash over the period?

Cash Flow Statement – A Summary  Shows how cash has been generated & where it has gone  A negative cash flow from operating activities may tell us that the business is trading unprofitably, or there may be other reasons (e.g. expansion requiring additional cash)  The subtotal after “Capital Expenditure” highlights the Cash Flows from ”normal” activities  The subtotal after “Equity Dividends” highlights additional external borrowings used to support trading  Note That: The Cash Flow Statement can be generated from figures incorporated in the P & L Account and this year’s and last year’s Balance Sheets

SAQ 6.3 Show how each of the following in turn will affect the Cash Flow Statement given in the previous example? 1. Buying £5,000 of Stock for Cash Buying £5,000 of Stock for Cash 2. Paying 12.5% interest on a Loan of £200,000 Paying 12.5% interest on a Loan of £200, Paying a VAT bill of £150,000 Paying a VAT bill of £150, Selling a piece of machinery that has come to the end of its life for £50,000 Selling a piece of machinery that has come to the end of its life for £50, Taking out a Bank loan for £100,000 Taking out a Bank loan for £100,000 View Original Cash Flow

CASHFLOW STATEMENT - EXAMPLE Net Cash-Flow from Operating Activities300,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 20,000 Equity Dividends paid 30, Subtotal 10,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 50,000+

CASHFLOW STATEMENT 1 Net Cash-Flow from Operating Activities295,000 Returns from investment and servicing of finance100,000- Taxation 30,000- Capital Expenditure150, Subtotal 15,000 Equity Dividends paid 30, Subtotal 15,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 45,000+ Buy £5,000 worth of stock for cash Net Cash Inflow reduces by £5,000 View Previous Cash Flow

CASHFLOW STATEMENT 2 Net Cash-Flow from Operating Activities295,000 Returns from investment and servicing of finance125,000- Taxation 30,000- Capital Expenditure150, Subtotal 10,000- Equity Dividends paid 30, Subtotal 40,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 20,000+ Pay 12.5% interest on a loan of £200,000 Net Cash Inflow reduces by £25,000 View Previous Cash Flow

CASHFLOW STATEMENT 3 Net Cash-Flow from Operating Activities295,000 Returns from investment and servicing of finance125,000- Taxation180,000- Capital Expenditure150, Subtotal160,000- Equity Dividends paid 30, Subtotal190,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period130,000- Pay VAT bill of £150,000 Changes a Net Cash Inflow of £20,000 to a net Cash Outflow of £130,000 View Previous Cash Flow

CASHFLOW STATEMENT 4 Net Cash-Flow from Operating Activities295,000 Returns from investment and servicing of finance125,000- Taxation180,000- Capital Expenditure100, Subtotal110,000- Equity Dividends paid 30, Subtotal140,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 50, = Increase or Decrease in Cash over Period 80,000- Sell machinery for £50,000 Reduces net Cash Outflow by £50,000 View Previous Cash Flow

CASHFLOW STATEMENT 5 Net Cash-Flow from Operating Activities295,000 Returns from investment and servicing of finance125,000- Taxation180,000- Capital Expenditure100, Subtotal110,000- Equity Dividends paid 30, Subtotal140,000- Management of liquid resource - disposal of investments 10,000+ Financing - additional long-term loan 150, = Increase or Decrease in Cash over Period 20,000+ Take out a Bank Loan of £100,000 Changes net Cash Outflow of £80,000 to a net Cash Inflow of £20,000 View Previous Cash Flow

Section D: Net Cash Flow from Operating Activities

Net Cash-Flow from Operating Activities Probably the most important element on the Cash Flow Statement is the ‘Operating Activities’ This gives the cash flow summary of the day-to-day workings of the business. There are two ways that this can be calculated: The Direct Method: Analysing receipts, invoices and cash book transactions for the business over the period in question. The Indirect Method: This uses a combination of the information from the P & L account and Balance Sheets to deduce the Net Cash-flow from Operating Activities (See McLaney & Atrill - pages for further examples)

Indirect method for Cash-Flow from Operating Activities Principle: The net operating profit (from the P & L Account) is: Turnover – cost of sales – overheads. This is approximately the cash inflow from operating activities, except for a few adjustments. These adjustments are: Stock (any increase in stock means a decrease in cash) Debtors (any decrease in debtors means a increase in cash) Creditors (any decrease in creditors means a decrease in cash) Also Depreciation (Depreciation reduces Operating Profit, but without a corresponding cash outflow. In order to rectify this, we need to add the depreciation charge back onto the profit.

Method For Calculating Net Cash-Flow from Operating Activities This is Calculated by: Net Profit before interest and tax PLUSDepreciation MINUS Increase in Stock or PLUS Decrease in Stock MINUS Increase in Debtors or PLUS Decrease in Debtors MINUS Decrease in Creditors or PLUS Increase in Creditors = Net Cash-flow from Operating Activities (See McLaney & Atrill - pages for further examples)

Net Cash Flow from Operating Activities: Example ABC Manufacturing shows a Net Operating Profit of £255,000. During the year it increased its stock levels by £25,000, reduced its Trade Debtors by £15,000 but increased its Trade Creditors by £20,000. £50,000 was allowed for depreciation of machinery. Calculate the Net Cash Flow from Operating Activities

Net Cash Flow from Operating Activities: Example ABC Manufacturing shows a Net Operating Profit of £255,000. During the year it increased its stock levels by £25,000, reduced its Trade Debtors by £15,000 but increased its Trade Creditors by £20,000. £50,000 was allowed for Depreciation of machinery. Net Operating Profit£255,000 PLUS Depreciation £50,000 + MINUSStock £25,000 - PLUS Trade Debtors £15,000 + PLUSTrade Creditors £20,000 + Net Cash Flow from Operating Activities £315,000

plus plus or minus equals plus or minus Net cash flow from operating activities Net operating profit Depreciation expense Increase (minus) or decrease (plus) in stock Increase (minus) or decrease (plus) in debtors Decrease (minus) or increase (plus) in creditors Summary of the indirect method of deducing The net cash flow from operating activities

SAQ 6.4 Acorn Antiques shows a Net Operating Profit of £125,000. During the year it reduced its stock levels by £25,000, reduced its Trade Debtors by £20,000 and reduced its Trade Creditors by £15,000. £10,000 was allowed for depreciation of machinery. Calculate the Net Cash Flow from Operating Activities Solution

SAQ 6.4 Net Cash Flow from Operating Activities: Acorn Antiques shows a Net Operating Profit of £125,000. During the year it reduced its stock levels by £25,000, reduced its Trade Debtors by £20,000 and reduced its Trade Creditors by £15,000. £10,000 was allowed for depreciation of machinery. Net Operating Profit£125,000 PLUS Depreciation £10,000 + PLUSStock £25,000 + PLUS Trade Debtors £20,000 + MINUSTrade Creditors £15,000 – Net Cash Flow from Operating Activities £165,000

Seminar 6 - Activities  Preparation: M & A Chapter 6  Cash Flow Activity Spreadsheet  M & A Ex. 6.7 (pages ) In order to do this you will need to first of all calculate the net cash flow from operating activities, and then use this figure to start the Cash Flow Statement.