Revise lecture 29

Statement of cash flows – IAS 7

Statement of cash flows – IAS 7 Objective of the statement of cash flows IAS 7 To ensure that all entities provide information about the historical changes in cash and cash equivalents by means of a statement of cash flows. To classify cash flows (i.e. inflows and outflows of cash and cash equivalents) during the period between those arising from operating, investing and financing activities.

Statement of cash flows – IAS 7 Usefulness of cash flow Users of financial statements need information on the liquidity, viability and financial adaptability of entities. Deriving this information involves the user making assessments of the future cash flows of the entity. Future cash flows are regarded (in financial management theory and increasingly in practice in large companies) as the prime determinant of the worth of a business.

Statement of cash flows – IAS 7 Although IAS 7 does not prescribe a format for statements of cash flows, it does require the cash flows to be classified into: Operating activities Investing activities Financing activities

Statement of cash flows – IAS 7 This classification may require a particular transaction to be shown partly under one heading and partly under another. For example, when the cash repayment of a loan includes both interest and capital, the interest might be shown as an operating activity and the capital element as a financing activity.

Statement of cash flows – IAS 7 The objective of the standard headings is to ensure that cash flows are reported in a form that highlights the significant components of cash flow and facilitates comparison of the cash flow performance of different businesses.

Statement of cash flows – IAS 7 One reason why the statement of cash flow was considered necessary is that final profit figures are relatively easy to manipulate. There are many items in an income statement involving judgement: Inventory valuation Depreciation Allowance for receivables

Statement of cash flows – IAS 7 This makes it difficult to interpret a company’s results with confidence. A statement of cash flows showing merely inflows and outflows of cash is easier to understand and more difficult to manipulate.

Statement of cash flows – IAS 7 Definitions Cash: cash on hand (including overdrafts) and on demand deposits. Cash equivalents: short-term, highly liquid investments that are readily convertible into known amounts of cash and are subject to an insignificant risk of changes in value.

Adjustments to profit before tax Depreciation Depreciation is not a cash flow. Capital expenditure will be recorded under ‘investing activities’ at the time of the cash outflow. Depreciation has to be added back to reported profit in deriving cash from operating activities.

Adjustments to profit before tax Profit / loss on disposal on non-current asset When a non-current asset is disposed of: The cash inflow from sale is recorded under ‘investing activities’ A loss on disposal is added to profit in deriving cash from operating activities. Similarly, a profit on disposal is deducted from profit.

Adjustments to profit before tax Change in receivables An increase in receivables is a deduction from profit in deriving cash from operating activities. Similarly, a decrease in receivables is an addition to profit.

Adjustments to profit before tax Change in inventory An increase in inventory is a deduction from profit in deriving cash from operating activities. Similarly, a decrease in inventory is an addition to profit.

Adjustments to profit before tax Change in payables An increase in payables is an addition to profit in deriving cash from operating activities. Similarly, a decrease in payables is a deduction from profit

Adjustments to profit before tax Interest paid and income taxes paid The final adjustments to find cash flow from operating activities are: Deduct interest paid Deduct interest element of finance lease payments Deduct income taxes paid

Investing activities Investing cash flows include: Cash paid for property, plant and equipment and other non-current assets Cash received on the sale of property, plant and equipment and other non-current assets Cash paid for investments in or loans to other entities Dividends received on investments.

Financing activities Financing cash flows comprise receipts or repayments of principal from or to external providers of financing including: Receipts from issuing shares or other equity instruments. Repayments of amounts borrowed (other than overdrafts)

Financing activities The capital element of finance lease rental payments. Receipts from issuing debentures, loans, notes and bonds and from other long-term and short-term borrowings (other than overdraft, which are normally included in cash and cash equivalents).

Advantages of the statement of cash flows It may assist users of financial statements in making judgements on the amount, timing and degree of certainty of future cash flows. It gives an indication of the relationship between profitability and cash generating ability and thus of the quality of the profit earned.

Advantages of the statement of cash flows Analysts and other users of FS often, formally or informally, develop models to assess and compare the present value of the future cash flow of entities. Historical cash flow information could be useful to check the accuracy of past assessments.

Advantages of the statement of cash flows A statement of cash flows in conjunction with a statement of financial position provides information on liquidity, viability and adaptability. Cash flows cannot be manipulated easily and are not affected by judgement or by accounting policies.

Interpretation of statements of cash flow The statement of cash flows should be reviewed after preparation. In particular, cash flows in the following areas should be reviewed: Cash generation from trading operations Dividends and interest payments Capital expenditure Financial investment Management of financing Net cash flow

Limitations of the statement of cash flows Statements of cash flows are based on historical information and therefore do not provide complete information for assessing future cash flows. There is some scope for manipulation of cash flows, e.g. a business may delay paying suppliers until after the year end.

Limitations of the statement of cash flows Cash flow is necessary for survival in the short-term, but in order to survive in the long-term a business must be in profitable. A huge cash balance is not a sign of good management if the cash could be invested elsewhere to generate profit.