1. Chapter 5
Cash flow statement

2. By the end of this chapter, you should be able to:
prepare a statement of cash flows in accordance with IAS 7;
analyse a statement of cash flows;
critically discuss their strengths and weaknesses.

3. Cash Flow Statement
Cash Flow Statement is a summary of a business’s cash receipts and cash payments, over a certain period of time – usually one year.
It shows the cash that has come from and/or gone to sources external (outside) to the business.

4. Cash Flow Statement
IAS 7 Cash Flow Statement classifies the sources of cash in terms of:
cash flows from operations (operating activities),
cash flows from investing activities, and
cash flows from financing activities.
The Cash Flow Statement has two main purposes:
measuring a business’ financial health, and
explaining the relationship between the Income Statement prepared under accrual accounting and the actual movement in cash from operations.

5. Cash receipts and payments on the cash flow statement

6. Cash Flow Statement Why is it important?
Cash is the lifeblood of an entity. A business cannot survive without cash.
Cash, not reported profit, pays the bills.
A business’s ability to raise cash through financing activities is dependent upon its ability to generate cash from operations.
Creditors and shareholders are not keen to invest in a business that does not generate enough cash from operations to assure prompt payment of maturing liabilities, interest, and dividends.

7. format of the cash flow statement brings out key figures
For management decision and control. For example: month-end balances
Assist in the control of liquidity; cash deficiencies – identify how much must be financed;
Early warning – allows management to approach appropriate sources;
Cash surpluses – identify amounts to be invested on the best terms.

8. The Cash Flow Statement is designed to assist stakeholders to assess:
the ability of a business to generate positive cash flows in future periods
both the cash and non-cash aspects of the business’ investing and financing transactions for the period
The Cash Flow Statement reports the business’ investments in such assets as plant and equipment.
the business’ ability to meet its obligations (creditors and suppliers) and to pay dividends (shareholders)

9. Where did the cash go?
Warm up exercise
1 to 10

10. Statement of Cash Flows
Ongoing operations
Investments
Financing
Can we pay debts?
Can we pay dividends?
Can we keep investing?
The statement of cash flows can be used to answer crucial questions such as:
Is the company generating sufficient positive cash flows from its ongoing operations to remain viable?
Will the company be able to repay its debts?
Will the company be able to pay its usual dividend?
To what extent will the company have to borrow money in order to make needed investments?
Why do net income and net cash flow differ?

11. Indirect Method Direct Method
Operating Activities
Indirect Method
Developed from the firm’s cash book information
Direct Method
Developed from the firm’s accrual accounting records – using information contained in the income statement and balance sheet.
Reconciles operating cash flow to net operating profit
Used by 99% companies
U.S. GAAP and IFRS allow companies to compute the net amount of cash inflows and outflows resulting from operating activities using either the direct or indirect method. Both of these methods have the same purpose, which is to translate accrual-based net income to a cash basis. However, they approach this task in two different ways.
Under the direct method, the income statement is reconstructed on a cash basis from top to bottom. For example, the direct method lists cash collected from customers and payments to suppliers. In essence, cash receipts are counted as revenues and cash disbursements pertaining to operating activities are counted as expenses. The difference between the cash receipts and cash disbursements is the net cash provided by operating activities.
Under the indirect method, net income is adjusted to a cash basis. That is, rather than directly computing cash sales, cash expenses, and so forth, these amounts are derived indirectly by removing from net income any items that do not affect cash flows. The indirect method has an advantage over the direct method because it shows the reasons for any differences between net income and net cash provided by operating activities.
Both methods result in the exact same amount of cash provided by operating activities. Most companies (about 99%) use the indirect method. If a company uses the direct method, then it must also provide a supplementary report that uses the indirect method. However, if a company uses the indirect method, there is no requirement that it also report results using the direct method. Because the direct method requires more work, very few companies choose this approach. Therefore, we will cover the indirect method in the main body of the chapter and we will explain the direct method in Appendix 12A.
Used by 99% of companies

12. Operating Activities Indirect Method
Step 1
Net Income +
Depreciation*
The indirect method adjusts net income to net cash provided by operating activities using a three-step process. The first step is to add depreciation charges to net income. The second step is to analyze net changes in noncash balance sheet accounts that impact net income. The third step is to adjust for gains and losses included in the income statement.
*Change in Accumulation depreciation ending balance plus accumulated depreciation debited as a result of disposals.

13. Operating Activities Indirect Method
Step 2
Analyze changes
Noncash Current Assets & Liabilities
The indirect method adjusts net income to net cash provided by operating activities using a three-step process. The first step is to add depreciation charges to net income. The second step is to analyze net changes in noncash balance sheet accounts that impact net income. The third step is to adjust for gains and losses included in the income statement.

14. Operating Activities Indirect Method
Step 3
Adjust
- Gains or + Losses
The indirect method adjusts net income to net cash provided by operating activities using a three-step process. The first step is to add depreciation charges to net income. The second step is to analyze net changes in noncash balance sheet accounts that impact net income. The third step is to adjust for gains and losses included in the income statement.
Under U.S. GAAP and IFRS rules, proceeds of asset disposals must be included in the investing activities . Under Operating activities substract gains and/or add losses of such asset disposals.

15. Day 2 Cash flow example Apparel.xlsx
Let’s look at an example
Day 2 Cash flow example Apparel.xlsx

16. Operating: related to revenue and expense affecting net income.
cash ins and cash outs
Operating: related to revenue and expense affecting net income.
Investing: related to acquiring
or disposing of noncurrent assets
Financing: related to borrowing and
repaying principal and
activities with the
stockholders
Here is Apparel’s statement of cash flows. All of the information on this slide was derived from our work on the previous slides for Apparel. Take a moment to trace the information on this statement. Notice, the net increase in cash and cash equivalents is $62 million, which agrees with the change in the Cash and Cash Equivalents account shown on Apparel’s balance sheet.
Change in cash balance

17. Summary of Key Concepts
Third, the indirect method requires three steps to compute net cash provided by operating activities. Fourth, record gross cash inflows and outflows in the investing and financing activities sections of the statement of cash flows.

18. Interpreting the Statement of Cash Flows within the company’s context
Start-up
Comparing operating CF to sales
Comparing operating CF to current liabilities
We need to consider a company’s specific circumstances. For example, start-up companies often have negative net cash provided by operating activities, large spikes in net cash used for investing activities and net cash provided by financing activities. As start-up companies mature, the net cash provided operating activities should swing from a negative to a positive number. The net cash used for investing activities should decline somewhat and stabilize and the net cash provided by financing activities should decrease.
Some managers study their company’s trends in cash flow margins by comparing net cash provided by operating activities to sales. Managers also compare the net cash provided by operating activities to the ending balance of current liabilities to see if they generated enough cash flow to pay their bills at the end of the period.
Some managers compare the additions to property, plant, and equipment in the investing activities section of the statement to depreciation included in the operating activities section. If the additions to property, plant, and equipment are less than depreciation, it suggests the company is not investing enough money to maintain its noncurrent assets.

19. Ability to fund Capital expenditures With Operating net cash
Free Cash Flows
Ability to fund Capital expenditures
and
Pay dividends
With Operating net cash
Free cash flow looks at the relationship among three numbers from the statement of cash flows—net cash provided by operating activities, additions to property, plant, and equipment, and dividends. Free cash flow measures a company’s ability to fund its capital expenditures and dividends from its net cash provided by operating activities.
The equation for computing free cash flow is net cash provided by operating activities minus capital expenditures and dividends.

20. Analysing a cash flow statement
Interest cover
Impact of working capital movements
Need for additional information
Evaluating investing activities
Relate expenditure to depreciation charge.
Evaluating financing cash flows
Extent to which investing has been financed.

21. Letter to the bank requesting an overdraft facility
The maximum overdraft facility of xxxxxx
will be required at the end of January.
will be eliminated by July.
Overdraft will fall progressively as per the cash budget.
It might be practical to request a limit of £xxx
for the full 6-month period, reducing it to £xxx thereafter to allow for contingencies.
The facility is only to be called on as required.
Refer to the cash budget to support the request and
confirm that it is based on the most likely scenario.
agree to a repayment schedule.
Specify that collateral security is available in the form of remises if it should be required.
If not an existing customer give outline details of business background. Explain future plans.
How much is needed?
When?
When will it be repaid?
Other option
Analysis as justification
Repayment agreement
Collateral
Other

22. Alternatives to overdraft facility
Consider alternatives such as the following:
Tighter controls on trade receivables
Longer terms with suppliers
Leasing vehicles and/or machinery;
Mortgaging the property;
Introducing more capital.

23. Direct method Reports cash inflows and outflows directly
Starts with gross cash receipts and payments
Provides more information about sources/uses of cash
Shows operating cash receipts and payments
Possibly more useful in assessing future cash flows
Useful in failure prediction models.

24. Cash Flow Statement – direct method
Operating cash flows:
Cash from customers (cash inflow)
Sales XXX,XXX
Less: Changes in Accounts receivable XXX
XXX,XXX
Payments to suppliers (cash outflow)
Cost of sales plus changes in inventory XX,XXX
Less: Changes in Accounts payable (X,XXX)
Expenses XX,XXX
Less: Depreciation (X,XXX)
The difference between cash inflow and cash outflow gives cash flow from operations.

25. Direct method of calculating cash payments from operating activities

26. Direct method of calculating cash payments from operating activities

27. Cash flows from investing activities

28. Cash flows from financing activities

29. References
Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting
18th Edition chapter 5
Ray H．Garrison, Peter C. Brewer,& Eric W．Noreen, Introduction to Managerial Accounting, 4th Edn. (Bilingual Version), 管理会计导论(第4版)(双语版), DongBei University of Finance and Economics Press, 东北财经大学出版社, 2008, (ISBN: ) Chapter 12