Cash Flow and funds Flow

8/7/2019 Cash Flow and funds Flow

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Cash Flow and funds Flow


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Objectives Acc ording to SF A S No. 95, the statement of c ash flows is

intended to help finan c ial statement readers assess 1. a firms ability to generate positive future net c ash flows;

2. a firms ability to meet its obligations, its ability to paydividends, and its need for external finan c ing; 3. the reasons for differen c es between net in c ome and

asso c iated c ash re c eipts and payments; and 4. the effe c ts on a firms finan c ial position of both its c ash and

its non c ash investing and finan c ing transa c tions. Ultimately, a firms c ash-generating ability affe c ts its solven c y,

its c apa c ity to pay dividends and interest, and the pri c e of itsse c urities. Acc ordingly, a firms ability to generate c ash isimportant to finan c ial statement users.


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A ccrual Earnings Versus Cash Flow as aPerformance Measure Keep in mind that a cc rual earnings (net in c ome from

the in c ome statement) do not ne c essarily refle c t c ash

flows. Many revenue and expense transac

tions haveno immediate c ash flow effe c t. Nevertheless, netinc ome is a very useful performan c e measure.

It refle c ts a cc omplishments by the firm (su c h as c reditsales that will subsequently result in c ash inflows) aswell as resour c es c onsumed by the firm in generatingrevenue (for example, employee salaries that remainunpaid at the end of a period).

If net in c ome is a useful performan c e measure, why isc ash flow information needed?


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Earnings and c ash flows are differentperforman c e measures of a businessorganization. T hey should be viewed ascomplements, rather than substitutes . E achmeasure contains information not necessarily reflected in the other. In parti c ular, thestatement of c ash flows provides information

about a firms liquidity and finan c ial flexibility(the ability to respond to unexpe c ted events byaltering the amounts and timing of its c ash

flows).


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Cash and Cash EquivalentsFirms c an ele c t to fo c us their statement of c ash flows on either (1 ) c ash or ( 2 ) c ash and c ash equivalents. The term cashinc ludes c ash on hand and c ash in bank a cc ounts that c an bewithdrawn on demand. Cash equivalents are short-term

,highly liquid finan c ial instruments with maturities of less thanthree months; they are qui c kly c onvertible into c ash. Examplesinclude money market funds, treasury bills, and certificatesof deposit (CDs). Because cash equivalents are so similar to cash, many firms prefer to combine them with cash,

rather than with other investments .Firms must c onsistently apply a poli c y of using either c ash or c ash and c ash equivalents.

Additionally, the beginning and ending balances that appear on the statement of cash flows must correspond to

similarly titled items on the balance sheet .


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CL ASSI F ICATI ON OF A CTI VITI ES As illustrated in E xhibit 5- 1 , a firms c ash flows are

pla c ed in one of three c ategories operating, investing,or finan c ing.

Operating A ctivitiesOperating activities typic ally involve transa c tionsrelated to providing goods and servi c es to c ustomers.T hey reflect the cash flow effects of the typicaland recurring transactions that appear on theincome statement . E xamples of operating c ashinflows are re c eipts from c ustomers, receipt of dividends and interest .

Operating c ash outflows in c lude payments to

employees and suppliers and payments for interestand taxes.


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Investing

ActivitiesInvesting activities usually involve c ash flows from the

a c quisition and disposal of non current assets . Cashoutflows arise from pur c hasing (investing in) property ,plant,and equipment, making loans, and a c quiring investments in

other c orporations. Cash inflows result from disposing of property, plant, and equipment; collecting loans (other thanthe interest); and selling investments.Financing A ctivitiesFinancing activities inc lude c ash flows from obtaining andrepaying finan c ing. Cash inflows result from c ontributions byowners (issuing sto c k to shareholders in ex c hange for c ash)and from loans. Cash outflows arise from payments toshareholders (as dividends or payments to repurchasetheir shares) and the repayment of loans (but not theassociated interest as it is Operating activity!!).


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EXHIBI T 5.1 DIRE CT APPROA CH Cash flows


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An a cc eptable alternative in preparing the operating activitiessection is the indirect approach. T his method begins with net income and makes adjustments to it in order to arrive at cash

generated by operating activities. T he indirect approach isillustrated in Ex hibit 5-3 . Although both the dire c t and indire c t approa c hes produ c e the

same figure for c ash provided from operating a c tivities, theinternal compositions of the statements differ substantially. A major advantage of the direct method is that the primarysources and uses of cash are listed. A s will be seen in alater section, this is highly useful information.A major advantage of the indirect method is that thereasons for the difference between net income and cashgenerated by operations is detailed. T his can help reduceuncertainties or answer questions raised by financialstatement readers .


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11 -Statement of c ash flows INDIRE CT APPROA CH EXH 5.3


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USI NG C ASH FLOW INFORM ATI ON: OPER ATI NGA CTI VITI ESMany finan c ial statement users find the operating a c tivitiesse c tion to be quite informative.Creditors, for example, re c ognize that loans c an only be repaidwith c ash and that a firms operations are a likely sour c e of c ash for debt repayment. B e c ause the ability to generate c ashdetermines dividends and share pri c e, shareholders and their advisors are interested in c ash provided by operating a c tivities.

Moreover, some analysts believe that be c ause reported netinc ome c an be manipulated by a cc ounting ploys, c ash flowfrom operating a c tivities is a more reliable performan c emeasure than net in c ome. We will subsequently dis c uss howmanagers c an also manipulate c ash flow figures.K eep in mind, however, that not all healthy firms have alarge positive cash flow from operations. Firms that experience growth in sales invariably need to expand their accounts receivable and inventory. These asset acquisitions must be financed ,and cash generated by operations is a frequently used source .


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S UMMA RY OF LE A RN ING OBJEC TI VES1. Des c ribe the obje c tives of the statement of c ash flows .The statement of c ash flows explains the c hange in c ash from the beginningto the end of a period. It provides finan c ial statement users with informationto assess a firms ability to generate positive future net c ash flows, to meetits obligations, to pay dividends, and to generate finan c ing internally.2. Explain the complementary nature of accrual earnings and cashflows. Acc rual earnings refle c t a firms su cc ess in providing goods andservi c es to c ustomers. Cash flow figures show a firms solven c y and itsc apa c ity to pay dividends and interest.3. Identify the three types of activities that generate and use cash.

Operating a c tivities in c lude providing goods and servi c es to c ustomers (for example, c ollec tin c ash from c ustomers and paying c ash tosuppliers). Investing a c tivities involve a c quiring or disposing of non c urrentassets (su c h as property, plant, and equipment and investments in other c orporations).Finan c ing a c tivities in c lude the obtaining of funds fromshareholders and returning funds to shareholders; finan c ing a c tivities alsoinc lude obtaining and repaying loans.4. Explain the difference between the direct and indirect methods of presenting a statement of cash flows.This distin c tion lies in the operating se c tion. U nder the dire c t method, aseparate line item is provided for ea c h major operating inflow and outflow of c ash. In c ontrast, the indire c t approa c h starts with net in c ome and makesvarious adjustments to arrive at c ash generated by operating a c tivities.A lthough the dire c t method provides the most useful information most firmsuse the indire c t method.


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1 5-PREPARI NG C A S H FLO W ST A TE ME NTS


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EXHIBI T 5A1


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E xhibit 5A2


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INT RODUC TI ONCon c eptually, the statement of c ash flows c ould be prepared byanalyzing the c ash flow effe c ts of ea c h transa c tion anda cc umulating that information. Most a cc ounting systems,however, are not designed to implement su c h an approa c h.Instead,

cash flows are inferred from items on the balan

cesheet and in c ome statement.

Operating A ctivitiesThis se c tion examines the in c ome statement and balan c e sheetrelationships that are relevant to determining c ash flows from

operating a c tivities under the dire c t approa c h.The in c ome statement and c omparative balan c e sheets for theP eak Company that appear in E xhibits 5 A -1 and 5 A -2 ,respe c tively, are used to illustrate these relationships and togenerate the statement of c ash flows that appears in E xhibit 5-1 .


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1 9Collections from Customers P eak began 2000 withan a cc ounts re c eivable balan c e of $ 4 ,000 . Let usassume that P eak c ollec ted these re c eivables in 2000 .(This is a reasonable assumption, but our result wouldnot be affe c ted by c hanging it.) The $ 4 ,000 is a c ash

inflow in2000

.P

eak then made sales of $68

,7 00

in2000 .What portion of these sales was c ollec ted inc ash in 2000 ? B e c ause we assumed that thebeginning balan c e in a cc ounts re c eivable has alreadybeen c ollec ted, the ending balan c e must have been

part of 2000

sales. Therefore, all of 2000

sales havebeen c ollec ted in c ash, ex c ept for the ending balan c ein a cc ounts re c eivable. Acc ordingly , c ash c ollec tedfrom c ustomers c an be c omputed as the beginningbalan c e in a cc ounts re c eivable plus the portion of 2000 sales that has been c ollec ted in 2000 .


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Other Items P eaks in c ome statement and balan c esheets c ontain only a sampling of the a cc ounts thatc ould possibly appear. For example, the in c omestatement c ould in c lude selling expenses and the

balan c e sheet c ould in c lude prepaid expenses anda cc rued liabilities. Acc ordingly, P eaks situation is onlyan illustration of the steps needed to adjust in c omestatement numbers to c ash flow figures.

As a general guide to preparing the operating a c tivitiesse c tion of the statement of c ash flows under the dire c tapproa c h, the following steps should be taken:


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--ily available to a firms a cc ountants, be c auserelatively few transa c tions are involved anddo c umentation (su c h as bank notes) is easily

acc

essible.A

lso note that theinvesting and financing activitiessections are the same under both

the direct and indirect approaches .


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2 9Funds flow statementsThese days Legal dis c losures require the preparation of Cashflow statements in the O rder and fashion dis c ussed so far H owever the syllabus talks of preparation of Funds Flowstatements whi c h was prevalent years ago but not now. There

is little differen c e between c ash flow and Funds flow statementFU NDS flow result from C HA NGE S in N E T WORKI NGCAPI TA LThere are 3 aspe c ts to a Funds Flow statement 1 ) A djusted

P& L a/c that c overs F U NDS MA DE OR LO ST in OPERA TIO NS(only) 2 ) Changes in W ORKI NG C API TA L 3 ) P reparation of a cc ounts for N O N CURRE NT items ( say capital items thatbring out the funds that came in or were lost ) TH ES E 3STAT EMEN TS reflect A LL the FUND S that flowed in theOrganization during the Year


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30 -FOR MA T O F F U NDS FL O W ST A TME NT

SOUR

CE

SAPP

LIC

AT

IONS 1) Funds from OPERA TIO NS Fnds L O ST in OPR NS

2) NO N OPERA TIO NA L INCO ME S Non OP G EXPE NS E S--Issue of shares/ debns -- P ref shre REDEMP TI ON

---Loan borrowings --Debenture redemption---Deposits a cc epted --Loans/ deposits repaid--Sale of assets -- P ur c hase of Fixed assets--Sale of L O NG TER M invest P ur c hase of F IXE D A SS E TS

3) DE CREA S E in WORKI NG C AP--Inc rease in Working Capital


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Format for Statement of Changes in W ORKI NG C API TA L Partic ulars P rev year Curr Y Inc rease in De c rease in

W/c W/cCurrent A ssetsCash in handCash at bank

B/R e cDebtors

Inventory P repaid exp

TO TA L(A )Current liabilities

Bills payableSundry c reditors

O /s expensesST LOA NS

P rov for tax P roposed Div

TO TA L (BWorking c apital (C)( C= A B )

INCREA S E / DE CREA S E in W/C


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32 - Format of A DJ P& L a/c

To B al ( Dr bal) B y bal ( P& l Cr bal)+ A ll items that increase loss + Items tht increase ProfitsNon O pg expenses Non opg INCO ME SDepre c iation on F/ A PRO FIT on sale of Invest

Goodwill w/o P rofit on sale of F/ A P atent w/o Dividend on Invest P reliminary exp R ent re c d, Gifts re c d

Disc ount on ISS UE S Damages re c d under law

Loss on sale of Invest Transfer F RO M General R eserves P remium on redemption of Debns Interim dividend

Final dividend

TO TA L


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To find out the HI DDE N INFOR MA TIO N inNO N CURRE NT A SS E TS/ Liabilities we haveto PREPARE the A /c s of all these itemsWith this the funds flow statement is ready


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E xample


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C l l h F d f O i f h f ll i d il 31 t


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Cal c ulate the Fund from O perations from the following details as on 31 stmar c h 1 999

1 net profit ye Mar c h 31 st R s 6 ,50 ,000 2 Gain on sale of building R s 3 5,5 00 3 written off Goodwill 10% from book value R s 1 ,8 0 ,000 4 O ld ma c hine sold for R s 6 500 WDV R s 8 000

5 R s 1 ,2 5,000 have been transferred to general reserves6 R s 1 ,30 ,000 is provided towards depre c iation

--------------Net profits------------------------------------- 6 ,50 ,000 Add

G/W written off 1 8 ,000Loss on sale of ma c h1 ,5000

General res 1 ,2 5,000Depre c iation 1 ,30 ,000 2 ,7 4 .000

9,24 ,000Gain on sale of bldg ( 3 5,5 00 )

Fund from O perations 8 ,8 9,000

Cash Flow and funds Flow

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