GRI Presentation

Reporting cash flows

BEA1007 Accounting II

Dr Petros Vourvachisp.vourvachis@exeter.ac.ukOffice (STC 0.18) hours: Fridays 11-1 12About today

Well discuss the 8th Accounting II topic with particular objectives to:Understand the importance of cash to a business, and, appreciate the need for a statement of cash flows and prepare it!

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We have a date for the exam!3It will take place on Wednesday 23 May, between 14.15 and 16.15. Held in the Great Hall, but also a number of smaller venues (e.g. PCC 1.1, PCC 1.5) please check your exams timetable to find your room!Well revise for it in the last lecture in three weeks time.

4DefinitionsThis lectures focus on reporting cash flows. According to IAS 7 (the relevant standard):Cash is notes and coins in hand and deposits in banks and similar institutions that are accessible on demandCash equivalents is short-term, highly liquid investments, readily convertible into known amounts of cash, subject to insignificant risk of change in value, held for the purpose of meeting short-term cash commitments rather than for investment

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5Examples include:Notes/CoinsBank deposits (withdrawable on demand)Overnight money market deposits (virtually cash) repayable the following morning (UK)Month-long deposits (International)Key feature: low risk of loss of value (in the short term)

Cash & cash equivalents5

6Importance of cash

The ability to generate cash is essential for a companys survivalEmployees and creditors normally only accept cash payment (or cash equivalents)Analysts focus primarily on cash position when assessing strength of business!Liquidity problems (no cash to pay expenses as they fall due) are the primary cause of business failure, even for profitable businesses6

7Cash vs. profit

The ability to earn profits does not necessarily result in a healthy cash balanceEssential a business can generate enough cash to meet short term commitments78

Balance sheet states the assets and liabilities at a specific point in timeThe income statement shows revenues and expenses rather than cash receipts and paymentsLimited relationship to the cash generatedCFS needed to show cash position!Relationship with BS and IS

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Statement of financial position at the start of the accounting periodEquityCash and cash equivalentsStatement of cash flowsIncome statementStatement of financial position at the end of the accounting periodEquityCash and cash equivalentsRelationship with BS and IS 9

10CFS development

In July 1977 the IASC originally approved IAS 7 Statement of Changes in Financial Position via a statement of sources and use of fundsIAS 7 was revised in 1992 and renamed the Cash Flow StatementMandatory for financial periods from 1 January 2005

1011CFS development

In September 2007 IAS 7 was retitled Statement of Cash Flows as a consequential amendment resulting from revisions to IAS 1Aim: give users a basis on which to evaluate the ability of a business to generate cash and cash equivalents1112CFS: things to consider

The following do not have an impact on the cash flow:DepreciationRepresents a charge for using fixed assetsHow about amortisation? Impairment? Revaluation?Disposal of fixed assetsLoss on sale is deducted from the profit figureProfit on sale is added to the profit figureIt is the actual cash received from the disposing of the assets that will have an impact on cash1213CFS: things to consider

The following have an impact on the CF:InventoryIf inventory increases/decreases this would result in a decrease/increase of cashDebtorsIf debtors take longer to pay then this will have a negative impact on the cash flowCreditorsIf creditors are increasing, the business is retaining cash1314CFS breakdown

Cash Flows within a business can be categorised as arising from three main activities:

Operating activities Investing activities Financing activities

14Net cash inflow/outflow from day-to-day trading activities, after tax and financing costs:Cash receipts from customers less cash payments to suppliers, rent, wages and all other cash expensesNot the same as revenue and expenses in the income statementDepreciation/ amortisation/ impairment expenses are not included in the CF from operating activitiesIn contrast, revenue/expenses in the IS include sales and purchases on credit CF only considers interest and tax paid

15CF from operating activitiesShows the net cash flows from making new investments and disposing of existing ones:Cash payments to acquire non-current assetsCash receipts from disposal of non-current assetsReceipts from investments made outside the companyInterest received on loansDividends received from equity investments16

16CF from investing activitiesShows the net cash flows of raising and paying back long-term finance: Cash received from borrowing obtainedCash repaid to redeem borrowingsCash received from share issues madeCan include dividend payments made by the business here, or under operating activitiesThe standard layout of CFS is thus as follows17

17CF from financing activities18

Standard layout of CFS equalsplus or minusNet increase (or decrease) in cash and cash equivalents over the periodCash flowsfrom operating activitiesCash flowsfrom investing activitiesCash flowsfrom financing activitiesplus or minus1819Direction of cash flows

Normal operating (trading) activities increase cash resources giving positive cash flowsCash generated from trading is most important source of finance for 80% of UK firmsInvesting decreases cash resources but increases non-current assets giving net negative cash flowsFinancing activities give rise to either positive or negative cash flows. However, since firms seek to raise capital by issuing shares or borrowing tendency is for positive cash flows1920

Investing activitiesCash and cash equivalent balancesFinancing activitiesOperating activitiesDirection of cash flows20

Channel Setting Instructions

1. Press the Ch or Go button

2. Enter the channel number (02)

3. Press the Ch or Go button

4. Press and release the "1/A" button. The light should flash amber to confirm.

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Lets check if it works- Has the e-book helped your revision?22Not muchA bitA lotI bought a paper copyWhich one of the following features of cash equivalents is incorrect?

23Held for meeting short-term commitmentsHighly liquidHeld for long-term investment purposesSubject to insignificant risks of changes in valueThe essential difference between the statement of cash flows and the income statement is that:

24IS is based on the accruals concept, whereas CFS reports cash received or paidCFS is a forecast of the future, whereas IS reports historical eventsIS is prepared for external users, whereas CFS for internal usersCFS only deals with items measurable in monetary terms, whereas IS also includes non-monetary itemsIn a statement of cash flows, the cash generated from day-to-day trading activities is known as which one of the following?

25Cash flows from operating activitiesCash flows from normal activitiesCash flows from trading activitiesCash flows from ordinary activities A business may incur an operating loss for the year yet have more cash at the end of the year than at the beginning. A reason for this could be that:

26Trade receivables were allowed a longer period of creditNon-current assets were sold for cashDividends paid were lower than in the previous yearPayments to trade payables were made more promptly Which one of the following will appear in the statement of cash flows?

27A transfer of profits to reservesThe return of faulty goods purchased on creditA bonus issue of sharesA rights issue of sharesWhich one of the following will not appear in the statement of cash flows?

28Issue of loan notesShare repurchase Increase in share premium reserveIncrease in revaluation reserve29Methods of calculation

There are two methods of determining the cash flow from operating activities, the Direct and the Indirect methodDirect or gross method Involves an analysis of the cash records of the business for the period picking out all payments and receipts relating to operating activitiesIndirect or net methodIt involves starting with the operating profit and adjusting it for non-cash charges and cash inflows & outflows so that one figure of operating cash flow is shown2930

Each has its advantages and disadvantagesThe direct method gives a clearer picture of cash flows and provides details that are not available under the indirect method but (although a matter of routine when computers are used, it still) needs more work to identify all the operating flows form the cash records through detailed analysis of bookkeeping records.The indirect method takes the approach that, while the profit (loss) for the year is not equal to the net inflow (outflow) of cash from operations, they are fairly closely linked to the extent that appropriate adjustment of the figure for profit (loss) for the year will produce the correct figure for cash flow. It is easier to prepare and highlights the effects of working capital on cash flowsThe indirect method is more popular since firms must prepare an IS and BS anyway, and figures in the CFS must reconcile with these statements focus of the lecture on this methodDirect vs. indirect method3031

Requires the following:Balance sheet at the start of the periodBalance sheet at the end of the periodIncome statement for the periodBecause the Income Statement is prepared on an accruals basis, some adjustments must be madeMost complicated adjustments concern estimating the net cash flows from operating activities!This needs to take into consideration the changes in working capital items (current assets & current liabilities) but also any dividend /taxation / interest paid)The indirect method3132

The indirect methodplus or minusplus or minusplus or minuslessequalslesslessNet cash flows from operating activitiesInterest expenseIncrease (minus) or decrease (plus) in inventoriesInterest paidTaxation paidDividend paidplus plus Depreciation expenseIncrease (minus) or decrease (plus) in trade receivablesIncrease (plus) or decrease (minus) in trade payablesProfit before taxation3233

Easier to determine the net cash flows from investing and financing activities!Net cash flows from investing activities usually involve calculating payments to acquire non-current assets (NBV of non-current assets at the start - depreciation of the year - NBV at the end)Net cash flows from financing activities usually involve adjusting for changes in loans and share capital / premium (add increase / deduct decrease)

The indirect method3334

A template CFS

34When deriving cash flows from operating activities, the direct method will produce a different figure than the obtained from using the indirect method

35TrueFalseWhen using the indirect method to determine cash flows from operations in a profitable company, which one of the following is shown as the first entry under the heading cash flows from operating activities?

36Profit after taxation and after interestProfit before taxation and before interestProfit before taxation and after interestProfit before taxation and before interestStarting with the profit before taxation (after interest), it is necessary to .. the annual depreciation charge when working towards the cash flow from operating activities

37ReduceIgnoreAddDeductDuring an accounting period, profit before taxation (after interest) will not normally equal the cash flows from operating activities. Which one of the following could not account for any difference between the two?

38DepreciationIssue of loan notesCredit salesCredit purchasesWhich one of the following groups of items will be added back to profit before taxation (after interest) when calculating the cash flows from operating activities?

39A decrease in inventories and a decrease in trade receivablesA decrease in inventories and an increase in trade receivablesAn increase in inventories and a decrease in trade payablesA decrease in inventories and a decrease in trade payablesWhich one of the following groups of items will be deducted from profit before taxation (after interest) when calculating the cash flows from operating activities?

40A decrease in inventories and an increase in trade payablesAn increase in inventories and a decrease in trade receivablesA decrease in inventories and a decrease in trade receivablesAn increase in inventories and a decrease in trade payablesWhich one of the following items would be shown under the heading cash flows from financing activities in a statement of cash flows?

41Tax paidLoan interest paidDepreciation of non-current assetsRepayment of loan notes42

A simple example Torrent plc

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Torrent plc

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Torrent plcCash flow from operating activitiesmProfit before taxation (after interest)----Adjustments for:Depreciation----Interest expense----Increase in trade receivables----Decrease in trade payables----Decrease in inventories----Cash generated from operations----Interest paid----Taxation paid----Dividend paid----Net cash from operating activities----4445

Torrent plcCash flows from investing activitiesPayments to acquire tangible non-current assets----Net cash used in investing activities----Cash flows from financing activitiesRepayments of loan notes----Issue of ordinary shares----Net cash used in financing activities----Net increase in cash and cash equivalents----Cash and cash equivalents at 01/01/2010----Cash and cash equivalents at 31/12/2010----4546

Torrent plc4647

Torrent plc

4748Independent study for next weekStudy Chapter 6, pages 186-208.Homework question is from a past exam! See next couple of slides (also uploaded on ELE)

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Homework question4950Homework question

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