Lecture 2 With Comments (1) PDF

Statement of Cash Flows Source: Financial Reporting & Analysis Gibson, 13th edition, CENGAGE Learning (Chapter 10)  Learning Outcomes Understand: The need for the Statement of Cash Flows Cash flow classifications – Operating, Investing and Financing The different types of Cas...

Statement of Cash Flows Source: Financial Reporting & Analysis Gibson, 13th edition, CENGAGE Learning (Chapter 10)  Learning Outcomes Understand: The need for the Statement of Cash Flows Cash flow classifications – Operating, Investing and Financing The different types of Cash Flow-related ratios Calculating Cash From Operations (CFO) Preparing the Cash Flow Statement 2  The Statement of Cash Flows It was only in the year 1992 that the IASB issued IAS 7, Cash Flow Statement (effective since 1994) which made it mandatory for businesses to prepare and present a Statement of Cash Flows (CFS) in addition to their Income Statement and Balance Sheet The CFS aims at providing insights into the inflow and outflows of cash and cash equivalents during an accounting year Cash equivalents include items such as highly liquid, marketable securities and cash on deposit The CFS explains cash inflows and outflows by dividing them into three categories – Operating, Investing and Financing The information concerning is also available in the Balance sheet, but it does not 3 Utility of the CFS==== explains how the company generates cash from operating The Statement of Cash Flows is important to various users of financial information for the following activities reasons: Management: To determine their ability to pay dividends and ascertain their financial and investment policy Bankers: To determine the ability of the firm to pay interest and principal repayments on time Suppliers: The ability of the firm to pay for credit purchases within the stipulated credit period Tax authorities: The ability of the firm to pay annual taxes Competitors: The general market position of the company in terms of cash management ---- In case of negative cash, it is possible for the firm to contract short-term loans 4 (eg: Overdraft) , or the account receivable can be sold to the bank Statement of Cash Flows – general structure XYZ Co. Statement of Cash Flows, for the year ended December 31, 20XX Cash Flows from Operating activities (paying salaries, selling , purchasing ….) A Cash Flows from Investing activities (selling and purchasing plants and B equipment…) Cash Flows from Financing Activities (contracting or paying loans) C 5 Statement of Cash Flows – general structure XYZ Co. Statement of Cash Flows, for the year ended December 31, 20XX Cash Flows from Operating activities A Cash Flows from Investing activities B Cash Flows from Financing activities C Net increase (decrease) in Cash and Cash Equivalents A+B+C 6 Statement of Cash Flows – general structure XYZ Co. Statement of Cash Flows, for the year ended December 31, 20XX Cash Flows from Operating activities A Cash Flows from Investing activities B Cash Flows from Financing activities C Net increase (decrease) in Cash and Cash Equivalents A+B+C Cash and Cash Equivalents, beginning of year D Cash and Cash Equivalents, end of year E Change in Cash and Cash Equivalents (E – D) 7 Statement of Cash Flows – general structure XYZ Co. Statement of Cash Flows, for the year ended December 31, 20XX Cash Flows from Operating activities A Cash Flows from Investing activities B Cash Flows from Financing activities C Net increase (decrease) in Cash and Cash Equivalents A+B+C Cash and Cash Equivalents, beginning of year D Cash and Cash Equivalents, end of year E Change in Cash and Cash Equivalents (E – D) Should equal A + B + C 8 The CFS classification of activities Operating Investing Financing Represent inflows Represent cash inflows Represent cash inflows cash and outflows from and outflows out of and outflows out of ‘normal operations’ of acquisition and disposal financing, i.e. taking and the business, such as (sale) of long-term assets repaying long-term loans, routine revenues and investments issue/ buy-back of equity, expenses and and payment of dividends 9 The CFS classification of activities Financing Loans, bonds, Operating Investing stock, Typical Infl ows: Typical Infl ows: dividends Typical Inflows: Cash Sales Receipt of loans granted to other entities Issue of new equity for cash (selling Interest income Sale of debt/ equity securities held as shares in the stock market) Issue of bonds (FR: obligation), Dividend received (also accepted in investments investing activity) Sale of property, plant and equipment debentures, mortgages and notes for Receipts from customers cash Typical Outflows: Typical Outflows: Typical Outflows: Loans granted to other entities Payments to suppliers for purchases Payment of dividends to equity Investment made in debt/ Salaries paid Buy-back of one’s own equity shares equity securities Taxes paid Repayment of loans Purchase of property, plant Interest paid (also accepted in Financing) and equipment Other expenses paid 1 0 Exercise ALPHA is facing a dangerous and worrying situation (close to bankruptcy) with negative cash, especially in the operating activity , and a lot of debts It seems that OWENS is a young and growing firm with many investments and many sources of financing the activity. But cash from operating is still negative (normal for young firms) Arrows is with small investments and financing, so it’s the slow-growing firm It is acceptable to say that OWENS is a slow growing firm because of the negative cash from operating Calculating Cash from Operating Activities (CFO) This involves one of most crucial calculations for preparing the Cash Flow Statement The final amount of CFO calculated could be both positive or negative A negative CFO indicates that the business used up more cash in operations than it generated To a financial analyst, a negative CFO is an absolute red flag in terms of a company’s financial health (exception: start-up companies which must initially spend more and wait for investments to start generating returns) CFO can be calculated in two ways (both yield the same answer): 1. The Direct Method 2. The Indirect Method ==== more complex. The starting point is ALWAYS the net income 1 3 1. The Direct Method for CFO This is a very simple approach to calculate CF Operating Under this, we simply add up cash inflows from operations and subtract cash outflows from operations If cash inflows exceed outflows, the final CFO is positive If cash outflows exceed inflows, CFO is negative Example: Cash received from customers $370,000 -Cash paid to suppliers (310,000) + Interest received 10,000 - Interest paid (4,000) - Income taxes paid (15,000) Net Cash provided by Operations $51,000 Note that here we use the term ‘provided by’ since Net CFO is positive. If CFO were negative, we would write Net cash ‘used by’. 1 4 2. The Indirect Method for CFO This is a rather detailed and not-so-straightforward approach to calculate CFO Here, we start with the Net Income number from the Income Statement and make adjustments for: Non-cash items (example: depreciation and amortization)=== Depreciation is impacting the income but not the cash, so it should be reintegrated when calculating CFO Items of a ‘non-operating’ nature (example: gain/ loss from sale of plant) ==== Eliminate all transaction that are not operating Changes in working capital (changes in balances of current assets and liabilities from last year)=== explained next page Example: Net Income $40,000 Add: + Provision for depreciation (hint: non-cash) 6,000 + Loss on sale of PPE (hint: non-operating) 2,000 Changes in working capital: -Increase in Receivables (3,000) + Increase in Payables 6,000 Net Cash provided by Operations $51,000 1 5 Changes in Working Capital The Indirect method for calculating CFO requires adjustments to Net Income for changes in working capital Working capital comprises current assets and liabilities The general rule to decide whether to treat increases and decreases in working capital as inflows and outflows is as follows: Current Assets except cash Current Liabilities ( ACCOUNT (INVENTORY , RECEIVABLE, PAYABLE) prepaid ) OPERATING INFLOW (+) Decrease Increase OPERATING OUTFLOW (-) Increase Decrease 1 6 Exercise  Cash flow classification Effect on cas Operati Investin Financin Increase D ng g g (INFLOW) ( Payment of income taxes X Increase in inventory (merchandise, raw material …) X X Decrease in receivable = it means the client paid X X Increase in prepaid insurance ==== prepaid is a X X current asset Issuance of common stock == selling shares on the X X stock market Acquisition of land for cash X Paid cash dividend X Payment of interest on loan X X (accept able) Repayment of bonds using cash X X Solution - Indirect Method Example 1: Calculating CFO using the indirect method (Cf: pages 15 and 16) Frish Company, Income Statement, for the year ended December 31, 2007 Net Sales 640,000 Expenses: Cost of goods sold 360,000 Selling and administration expenses 43,000 Other expenses 2,000 405,000 Earnings before taxes 235,000 Less: Income tax 92,000 Net Income $143,000 Other information: 1. COGS includes depreciation of $15,000 2. Selling and general expenses include depreciation of $5,000 22 000 3. Other expenses include amortization of patent - $2,000 Changes in working capital: 1. Increase in receivables - $27,000 5. Increase in accrued liabilities - $3,000 2. Increase in payables - $15,000 6. Decrease in taxes payable - $10,000 3. Increase in inventories - $35,000 4. Decrease in prepaid expenses - $1,000 ==== Current assets Required: Calculate CFO, using the Indirect method 20 NET INCOME 143 000 + Depreciation and amortization 22 000 - Increase in receivable (27 000) + Increase in payable 15 000 - Increase in inventory (35 000) + decrease in prepaid expenses 1 000 + Increase in liabilities 3 000 - Decrease in taxes payable (10 000) CFO 112 000 Example 2: Preparing a complete CFS The following financial statements for Tax Consultants are provided to you: Tax Consultants, Balance Sheet as on December 31, 2016 2015 Land 70,000 0 Buildings 200,000 0 Less: Accumulated depreciation (11,000) 0 189,000 0 Equipment 68,000 0 Less: Accumulated depreciation (10,000) 0 58,000 0 Receivables 26,000 36,000 Prepaid expenses 6,000 0 Cash 37,000 49,000 TOTAL 386,000 85,000 Share Capital 60,000 60,000 Retained Earnings 136,000 20,000 2 Bonds 150,000 0 2 Net INCOME 134 000 Explanation + Depreciation 21 000 11000+10000 + Decrease in 10 000 36 000 – 26 000 receivables - Increase in prepaid (6 000) 0 – 6 000 exp. + Increase in 35 000 5000 – 40 000 payable Net cash from 194 000 operating activities Cash flow from investing activities Purchase of land (70 000) OUTFLOW Purchase of buildings (200 000) OUTFLOW Purchase of equipment (68 000) OUTLOW Net Cash from investing activity (338 000 ) = it is a (B) negative flow Cash flow from financing activities Issuance of bonds 150 000 - Payment of dividends (18 000) Cash flow from financing 132 000 == It is a activities © positive flow NET Decrease or increase in (12 000) == it is cash (A+B+C) a decrease in cash  Tax Consultants, Income Statement for the year ended December 31, 2016 Revenues 492,000 Operating expenses 269,000 Depreciation 21,000 290,000 Income from Operations 202,000 Less: Tax expense 68,000 Net Income 134,000 Additional information: 1. Cash dividend paid: $18,000 ============ OUTFLOW 2. Long-term bonds issued: $150,000 ======== INFLOW 2 5 Procedures to Develop the Statement of Cash Flows Analyze all balance sheet accounts other than cash and cash equivalents. Increase Decrease Current assets Operating outflow Operating inflow Noncurrent assets Investing outflow Investing inflow Current liabilities Operating inflow Operating outflow Long-term liabilities Financing inflow Financing outflow Stockholders’ equity Financing inflow Financing outflow Thank you! 2 7