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Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 10Cash 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

Liquidity- 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 questions1. From which sources did the company raise

cash last year? How was this cash used? 2. Were the normal operating activities capable

of satisfying its need for cash during the year?3. If not, is the shortage of cash compensated by

new borrowings, issuing new share capital or by selling fixed assets?

4. Is a surplus of cash used for repayment of debt, for investments or for distribution of dividends?

5. 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

Inventory

Work in Progress Sales

ReceiptsPayments

Procurement

Current payables Inventory Current receivables

Cash and cash equivalents

Main operations

External financingInvesting/ Productive

infrastructure


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:1. Non-cash expenses and non-cash revenues (f.i.

depreciation expense)2. Non-operating items (f.i. gain on disposal of

tangible fixed assets)3. 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 - ExampleNet profit before tax 3,350Adjustments for:Depreciation 490Investment income (100)

3,740

Working capital changes:Increase in trade and other receivables (500)Decrease in inventories 1,050Decrease in trade payables (1,740)Cash generated from main operations 2,550Income taxes paidNet cash flow from operating activities

(1170) 1,380


Cash flow proxy

Net profit or loss after tax xxxxxxxxxxxxxxAdd back: Depreciation charge for the

year xxxxxxxxxxxxxxxProvisions created in year xxxxxxxxxxxxxxxDeduct:

Provisions released in year(xxxxxxxxxxxx

xx)‘Cash flow proxy’ xxxxxxxxxxxxxx


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


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

1. Determine the net change in cash Compare beginning and ending balance

2. 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

3. 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 Inflow Outflow


Illustration - Constructing a CFS (1)

X2 X1 ∆ Outflow Inflow

Assets

Fixed assets (at cost) 980 740 240 240 Acc. depreciation -350 -265 85 85 Inventories 180 171 9 9 Trade receivables 115 98 17 17 Cash 92 110 18 18 1017 854

Financing

Equity Share capital 600 600 __ Reserves 90 90 __ X2 profit 50 __ 50 50 Liabilities Trade payables 62 59 3 3 LT debt 215 105 110 110 1017 854 266 266


Illustration - Constructing a CFS (2)

Operating activities Net profit after tax 50 Add back depreciation 85 135 Changes in non-cash working capital –23 Net cash flow from operations (A) 112 Investing activities Purchase of fixed assets (B) –240 Financing activities New LT debt (C) 110 Net change in cash (A+B+C) –18 Cash balances At beginning of year 110 At balance sheet date 92 Difference –18


Disposal of fixed assets - Example

Disposal of equipment:Acquisition cost 275

- Accum. depreciation- 200Net carrying value = 115 Net carrying value = 115 Sale at 135 Sale at 135

Result (gain) on disposal = 135 - 115= 20Result (gain) on disposal = 135 - 115= 20

Incoming cash flow = 135, composed of a decrease in Incoming cash flow = 135, composed of a decrease in net carrying value of equipment in the BS (115) and net carrying value of equipment in the BS (115) and gain on disposal in the IS (20)gain on disposal in the IS (20)


Disposal of fixed assetsNet profit after tax xxxxxxxxxxx

xAdd back: Depreciation xxxxxxProvisions created xxxxxxLoss on disposal of assets xxxxxxDeduct:Provisions released xxxxxxGain on asset disposal xxxxxx+/- Change in non-cash working capital xxxxxx

Net cash flow from operating activities xxxxxxxxxxxx


Incoming cash flowsCash +

Other assets =

Liabilities +

Owners’equity

(1) + -

(2) + +

(3) + +


Outgoing cash flowsCash +

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

20X2 Cash flows from operating activities Cash receipts from customers 30,150 Cash paid to suppliers and employees (27,600) Cash generated from operations 2,550 Interest paid (270) Income taxes paid (900) Net cash from operating activities 1,380 Cash flows from investing activities Acquisition of subsidiary X, net of cash acquired (550) Purchase of property, plant and equipment (350) Proceeds from sale of equipment 20 Interest received 200 Dividends received 200 Net cash used in investing activities (480) Cash flows from financing activities Proceeds from issue of share capital 250 Proceeds from long-term borrowings 250 Payment of finance lease liabilities (90) Dividends paid* (1,200)

Net cash used in financing activities (790) Net increase in cash and cash equivalents 110 Cash and cash equivalents at beginning of period 120 Cash and cash equivalents at end of period 230 * This could also be shown as an operating cash flow.


IAS 7 - Direct Method (Extract)


20X2 Cash flows from operating activities Cash receipts from customers 30,150 Cash paid to suppliers and employees (27,600) Cash generated from operations 2,550 Interest paid (270) Income taxes paid (900) Net cash from operating activities 1,380 Cash flows from investing activities Acquisition of subsidiary X, net of cash acquired (550) Purchase of property, plant and equipment (350) Proceeds from sale of equipment 20 Interest received 200 Dividends received 200 Net cash used in investing activities (480)


IAS 7 - Direct Method (Extract- cont.)


Cash flows from financing activities Proceeds from issue of share capital 250 Proceeds from long-term borrowings 250 Payment of finance lease liabilities (90)

Dividends paid* (1,200)

Net cash used in financing activities (790) Net increase in cash and cash equivalents 110 Cash and cash equivalents at beginning of period 120 Cash and cash equivalents at end of period 230 * This could also be shown as an operating cash flow.


IAS 7 - Indirect Method (Extract) 20X2 Cash flows from operating activities Profit before taxation 3,350 Adjustments for: Depreciation 450 Foreign exchange loss 40 Investment income (500) Interest expense 400 3,740 Increase in trade and other receivables (500) Decrease in inventories 1,050 Decrease in trade payables (1,740) Cash generated from operations 2,550 Interest paid (270) Income taxes paid (900) Net cash from operating activities 1,380 Cash flows from investing activities Acquisition of subsidiary X net of cash acquired (550) Purchase of property, plant and equipment (350) Proceeds from sale of equipment 20 Interest received 200 Dividends received 200 Net cash used in investing activities (480) Cash flows from financing activities Proceeds from issue of share capital 250 Proceeds from long-term borrowings 250 Payment of finance lease liabilities (90) Dividends paid* (1,200) Net cash used in financing activities (790) Net increase in cash and cash equivalents 110 Cash and cash equivalents at beginning of period 120 Cash and cash equivalents at end of period 230 * This could also be shown as an operating cash flow.



IAS 7 - Indirect Method (Extract) 20X2 Cash flows from operating activities Profit before taxation 3,350 Adjustments for: Depreciation 450 Foreign exchange loss 40 Investment income (500) Interest expense 400 3,740 Increase in trade and other receivables (500) Decrease in inventories 1,050 Decrease in trade payables (1,740) Cash generated from operations 2,550 Interest paid (270) Income taxes paid (900) Net cash from operating activities 1,380



IAS 7 - Indirect Method (Extract – cont.) 20X2 Cash flows from investing activities Acquisition of subsidiary X net of cash acquired (550) Purchase of property, plant and equipment (350) Proceeds from sale of equipment 20 Interest received 200 Dividends received 200 Net cash used in investing activities (480) Cash flows from financing activities Proceeds from issue of share capital 250 Proceeds from long-term borrowings 250 Payment of finance lease liabilities (90) Dividends paid* (1,200) Net cash used in financing activities (790) Net increase in cash and cash equivalents 110 Cash and cash equivalents at beginning of period 120 Cash and cash equivalents at end of period 230 * This could also be shown as an operating cash flow. Source: IAS 7 – Cash Flow Statements, Appendices

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