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Statements of Cash Flows:

Three International Examples

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This case was written by Anthony O’Grady, Case Writer, under the supervision of Elizabeth Demers, Assistant
Professor of Accounting at INSEAD. It is based upon an earlier Harvard Business School case written by Professors
Julie H. Hertenstein and William J. Bruns (HBS Case No. 193-103). It is intended to be used as a basis for class
discussion rather than to illustrate either effective or ineffective handling of an administrative situation.
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 110-049-1

MBA student Anna Prentice was unable to attend last week’s accounting class, and was
worried about what she missed because accounting is not her best subject. She called on
Robin Banks, her teammate, to obtain the class notes and assignment.

Anna: Hi, Robin! Unfortunately I had to miss last week’s accounting class on the statement of
cash flows. Since accounting is your strongest subject, I was wondering whether you could
help me to catch up? I know that cash flow statements are a required part of a company's full
set of financial statements, but I’m under the impression that they are a less important
component of the package. Is that so? Could you give me a rundown of the class that I missed
and details of the assignment that we need to prepare for next week?

Robin: I'm glad to help, Anna, especially as you typically help me with the assignments for
most of our other classes. I'm familiar with cash flow statements from my work experience, so
I found this week's class easy to follow. I'm sure that I can convince you that the statement of
cash flows is an important part of the financial statement package, and that it’s very useful to
external users of financial statements!

Anna: I've had virtually no exposure to financial statements. Could you please remind me
what the cash flow statements contain?

Robin: The statement of cash flows presents the inflows and outflows of cash for a given
period, all classified into the firm’s three principal areas of activity: operating, investing, and
financing. By summarizing the sources and uses of cash, the statement provides a
reconciliation of the beginning and ending cash balances for the period. To be more precise,
the statement normally explains the changes in “cash and cash equivalents”, where the latter
are short-term highly liquid investments, readily convertible to cash. There is some variance
in practice, but each company will define in their footnotes what they mean by “cash and cash
equivalents”.

As you know, a balance sheet is like a snapshot of a company's financial resources and
obligations at a point in time, while the income statement provides a summary of the firm’s
performance over a stated period. Both of these statements are prepared under an accrual
basis of accounting. Because accruals involve judgment and discretion, which may vary
across managers and across time, the statement of cash flows is useful to external users
because it gives us a statement that is relatively stripped of accounting policy assumptions and
estimates. Consequently, the cash flow statement facilitates comparability across different
companies by partially eliminating the effects of different accounting method choices.
Investors can see where a company's cash is coming from and to what uses it is being put, all
of which helps them evaluate various aspects of the firm’s performance, its prospects, and its
financial position. For anyone familiar with balance sheets and income statements, preparing
a statement of cash flows is not too difficult.

Anna: Do we have to prepare a statement of cash flows for this assignment?

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Robin: No, we have to analyze the cash flow statements of three companies that come from
different countries and different economic sectors: UP, DOWN AND BUMPY. Those are not
the companies' real names and we've been told not to assume that the names describe the
company's performance. Here’s an extra copy of the assignment that I picked up for you.
Have a look at the cash flow statements tonight and we can discuss them tomorrow.

... the next day ...

Anna: I perused the cash flow statements and noticed that each statement shows the three
areas of activity that you mentioned. Beyond this basic commonality, however, I found their
presentation styles to be quite different: BUMPY provides very little detail, UP presents a lot
of detail, and DOWN shows their profit at the bottom of the statement rather than at the top.
As each company is from a different country, maybe they use different sets of accounting and
reporting standards? But before we address that question, I would like to know more about
how the cash flow statements are prepared and what goes into each of the three areas of
activity.

Robin: Okay, let’s start with the operating section. This section shows the cash inflows and
outflows associated with the company's fundamental business activities, including cash
receipts from the sale of goods or the provision of services, and the cash outflows related to
the purchase of inventory and the paying of other operating expenses.

The investing section shows cash flows related to the purchase and sale of fixed assets such as
property, plant, and equipment, or the acquisition and disposition of whole subsidiaries. This
area also includes cash outflows and inflows related to investments in financial assets.

The financing section shows cash flows associated with capital market activities, such as the
issuance, redemption, or repurchase of shares, the issuance or repayment of debt, or the
payment of dividends.

As far as the different accounting and reporting standards are concerned, US GAAP (formerly
FAS 95 and now FASB Codification Topic 310) and IFRS (IAS 7) reporting rules for the
statement of cash flows are quite similar. There are, however, several potential differences,
including, for example, the following:

• US GAAP requires that interest and dividends received on investments be classified as

an operating activity, and similarly that interest paid be included in cash flows from
operations. IAS 7 permits firms to classify cash from interest and dividend revenue as
operating, investing, or financing activities, provided that the classification is
consistent across periods. Similarly, the IFRS rules allow for cash payments in relation
to interest expense to be included in any of the three sections provided that the
classification is consistent across time. Both US GAAP and IFRS require that
dividends paid be included in financing activities.
Another potential difference in cash flow statements across firms in the international arena
concerns their use of the direct versus indirect methods of preparing the statement. Under the
direct method, the operating cash flow section looks like a summary of an operating cash
account, typically consisting of line items related to cash inflows from customers and cash
outflows to suppliers and employees. Payments in relation to interest or taxes, if classified in
the operating section, are shown separately. By contrast, the indirect method starts with

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accrual-based net income (or loss), and adjusts this figure for all non-cash revenues and
expenses (such as depreciation) and then adds or subtracts the changes in working capital
accounts. Under this method, operating cash flows are thereby arrived at indirectly via the
accrual figures. Both methods lead to the same amount being reported for net operating cash
flows. Furthermore, the other two areas of activity, investing and financing, are unaffected by
the direct versus indirect presentation format.

Anna: Was it mentioned in class whether the direct or indirect method is preferable?

Robin: Not exactly. IAS 7 strongly recommends the direct method (because the indirect
method is considered to be less clear) but permits the use of either method. US GAAP
encourages use of the direct method; however, if this preferred method is used for the
statement of cash flows, it must nevertheless be supplemented with a reconciliation of
operating cash flows to the accrual net income (or loss) shown on the income statement (i.e.,
with an indirect method statement of cash flows). Despite standard setters’ recommendations
in favour of the direct method, the indirect method is overwhelmingly more popular on a
worldwide basis, although regional differences on this do exist. As of last week’s class, the
professor informed us that, as part of their convergence project, the US FASB and the IASB
are jointly proposing to mandate the direct method statement of cash flows. These new rules
have not yet been finally confirmed, however, so for now we should continue to expect to see
both methods being used in practice.

Anna: OK, now that I understand the contents of the three sections of the cash flow statement,
and the possibility that the presentation styles may differ across firms, industries, or regions,
how does one go about analyzing the statements?

Robin: You can think of the operating section as being akin to the cash-flow motor of a
company. If the motor works well, it generates at least enough cash to cover a company's
operational needs, and perhaps beyond. It is natural for there to be year-to-year variability in
operating cash flows and/or its main components. Furthermore, different patterns are expected
to be associated with, for example, early stage versus stable and mature firms’ operating cash
flow generating abilities. Assessed over several years, however, a healthy, established
company’s operating activities should generate positive cash flows.

Investing activities usually lead to negative cash flows since healthy companies will typically
invest regularly in fixed assets. Such investments may just replace those assets that have been
used up or that have become obsolete over time, or they may be incurred to enable the firm to
expand and grow.

Cash flows from financing activities may be positive or negative, and could easily vary from
year to year. If cash flows from operations are not sufficient to cover the firm’s desired level
of investing activities, for example, the company will require additional financing that will be
reflected as a positive cash inflow. By contrast, if operating cash flows exceed the cash
required for the firm’s investments, the excess (or “free cash flow”) may be used to pay off
debt, to buy back shares, or to pay out dividends, all of which would show up as negative cash
outflows within the financing section.

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Anna: So for the assignment, we'll need to see whether cash flows from operations are
positive, and if so whether they are sufficient to cover investments, and then remark on what
the firm did with the excess “free cash flows” or how it made up any deficiencies?

Robin: Exactly! We also need to consider what happens over time. For each company, we
need to examine the trends in key line items over the years shown on their statements.

Anna: Wow, that's quite a lot to think about! How does one finally reach a conclusion about
the financial strength, liquidity situation, or performance of the company under review?

Robin: You need to collect as much evidence as possible and then weigh it all up in order to
arrive at an overall picture. This is obviously easier if you have a company's complete set of
financial statements, but the exercise this time is to see just how much we can extract about a
company’s situation from the statement of cash flows alone. Good luck with the UP, DOWN
and BUMPY companies, and don't miss next week's class!

The Assignment
Exhibits 1, 2, and 3 contain the statements of cash flows for BUMPY Company, DOWN
Group, and UP Corporation, respectively. These three entities, whose real names have been
disguised, come from different countries as well as different sectors of the economy. Each
statement provides three years of comparable data. Examine the statements carefully with a
view to arriving at an overall assessment of each company’s financial situation by answering
the following questions for each firm in turn:

I. Overview

1. Can you tell whether the statement was prepared using: (a) the direct or indirect
method; (b) IFRS or some other set of GAAP?
2. What are the major sources of cash? What are the major uses of cash?
3. Were operating cash flows greater than, or less than, accrual net income (or loss)?
What are the principal items giving rise to the differences between these two figures?

II. More Detailed Analyses

1. Did the entity generate enough cash from operations to cover their capital
expenditures? Were cash flows from operations sufficient to cover both capex and
dividend payments to shareholders? If so, what did the company do with its excess
free cash flow? If not, where did the company obtain the cash used to pay for its capex
and dividends?
2. Does capex exceed depreciation and amortization? What, if any, economic insights are
you able to glean from this comparison?
3. Were working capital accounts (i.e., current assets and liabilities), other than cash and
cash equivalents, mainly sources or uses of cash?
4. Was the company a net borrower or a net repayer of debt?
5. Did any other major items affect cash flows?

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III. Trends (consider all three years when answering these questions)

What are the trends in:

• Accrual net income (or loss)

• Cash flows from operations
• Capital expenditures
• Dividends
• Working capital accounts
• Net borrowings
• Any other changes in the firm’s financial structure?

IV. Overall assessment

1. Based upon the evidence collected in steps I, II and III, what is your overall
assessment of the financial strength of each entity? Rate each entity on a scale from 1
to 5 where:
1 = the company faces the risk of bankruptcy within a year;

2 = the company exhibits significant cash flow problems;

3 = some problems are noted, but the entity is not in imminent danger of failing;

4 = this looks like a stable (or growing) company with few cash flow problems; and

5 = the company is in excellent condition, not facing any apparent issues.

V. Bonus Marks!

Can you guess the country (or region) and/or economic sector in which each entity operates?
Hint: there's a slight connection between the fictional name and the entity's principal area of
business activity.

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Exhibit 1
Bumpy Company

CONSOLIDATED STATEMENTS OF CASH FLOWS

The Year Ended September 30

In Millions 2008 2007 2006
Net profit / (loss) 1.7 (41.6) (88.6)
Items not requiring cash outlays
- Depreciation and amortization 159.0 154.9 150.3
- Other 5.0 16.5 8.2
Net changes in working capital account balances 12.5 61.3 82.0
Cash flow generated by operating activities 178.2 191.1 151.9
Capital expenditures for tangible and intangible assets (72.3) (126.9) (131.2)
Cash flows used in investing activities (72.3) (126.9) (131.2)
Net sales / (purchases) of treasury shares (0.8) - -
Repayments of borrowings (60.8) (0.6) (0.2)
Releases of debt security and other deposits - - 3.7
Cash flows generated by / (used in) financing activities (61.6) (0.6) 3.5
Change in cash and cash equivalents 44.3 63.6 24.2
Cash and cash equivalents, beginning of period 330.0 266.4 242.2
Cash and cash equivalents, end of period 374.3 330.0 266.4

SUPPLEMENTAL CASH FLOW INFORMATION

The Year Ended September 30

In Millions 2008 2007 2006
Supplemental cash flow information:
Interest paid 93.3 67.7 63.2

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Exhibit 2
Down Group

CASH FLOW STATEMENT FOR THE YEAR ENDED 30 JUNE 2009

(In Thousands) 2009 2008 2007

Cash Flow from Operating Activities
Receipts from customers 12,212 10,169 3,866
Payments to suppliers and employees (13,127) (8,858) (3,681)
Income tax paid (366) (525) 0
Interest received 380 142 5
Net cash provided by (used in) operating activities (901) 928 190

Cash Flows from Investing Activities

Purchase of intangibles (406) - (3)
Purchase of property, plant and equipment (125) (103) (8)
Cash balance acquired from reverse acquisition - 2,654 0
Net cash provided by (used in) investing activities (531) 2,551 (11)

Cash Flow from Financing Activities

Loans to related parties - (19) (14)
Proceeds from issue of shares - 8,000 0
Cost of capital raising (8) (169) 0
Dividends paid - (800) 0
Interest paid (5) (2) 0
Net cash provided by (used in) financing activities (13) 7,010 (14)

Net increase (decrease) in cash held (1,445) 10,489 165

Cash at beginning of year 10,729 240 75
Cash at end of year 9,284 10,729 240
Reconciliation of cash flow from operations with profit after income tax
Profit/(Loss) after income tax 878 784 242

Non-cash flows in profit:

Depreciation and amortization 146 23 15
Interest not paid in cash 0 0 2
Share based success fee for acquisition - 400 0
Impairment of goodwill - 344 0
Share based expenses 148 7 0
Loss in disposal of P&E - 1 1
Impairment of receivable 817 0 0

Changes in assets and liabilities, net of the effects of purchase and disposal of subsidiaries
(Increase) / decrease in trade and term debtors (434) (1,629) (185)
(Increase) / decrease in other assets (207) (49) 9
(Increase) / decrease in work in progress (1,480) 233 (357)
Increase / (decrease) in trade creditors (797) 508 244
Increase / (decrease) in provisions 27 76 13
Increase / (decrease) in tax movement 1 230 206
Net cash provided by (used in) operating activities (901) 928 190

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Exhibit 3
Up Corporation

STATEMENTS OF CASH FLOWS

Years Ended March 31 2009 2008 2007

Operating Activities (in millions)
(Loss) Income before income taxes and minority interests (59,014) 29,832 52,055
Adjustments to reconcile to net cash provided by operating activities:
Depreciation and amortization 118,043 116,580 117,561
Gains/losses on revaluations and disposals of investments in securities, net (16,619) (18,596) (34,028)
Gaines/losses on disposals and impairments of fixed assets, net 10,448 21,824 8,459
Net reversal of accrued pension and severance costs (524) (32,522) (10,308)
Interest and dividend income (5,303) (7,224) (5,941)
Interest expense 17,536 20,009 19,068
Other (24,203) 681 (2,315)
Change in notes and accounts receivable - trade 68,336 12,179 (32,437)
Change in spare parts and supplies 9,238 (9,055) 813
Change in accounts payable - trade (73,344) 10,775 33,592
Other (18,203) 30,857 486
Subtotal 26,391 175,340 147,005
Interest and dividends received 6,074 7,945 6,982
Interest paid (18,175) (19,300) (19,154)
Proceeds from licensing card-related usage rights 23,426 -
Income taxes paid (5,961) (6,654) (7,085)
Net cash provided by operating activities 31,755 157,331 127,748

Investing Activities
Purchases of investment securities (165,919) (11,906) (25,636)
Proceeds from maturity and sales of investment securities 182,123 34,671 50,306
Purchases of fixed assets (167,856) (174,831) (153,251)
Proceeds from sales of fixed assets 45,789 115,759 54,697
Payments for sales of consolidated subsidiaries (135) (722) 0
Proceeds from sales of consolidated subsidiaries 143 8,811 9,552
Loans receivable made (2,045) (1,397) (2,051)
Collection of loans receivable 1,763 3,182 4,799
Other 480 203 5,367
Net cash used in investing activities (105,657) (26,230) (56,217)
Financing Activities
Decrease in short-term borrowings, net (367) (2,747) 2,556

Proceeds from long-term loans 46,652 82,786 22,122

Repayment of long-term loans (132,015) (122,592) (112,815)
Proceeds from issuance of common and preferred stock - 151,825 147,607
Redemption of bonds (28,000) (70,000) (109,771)
Dividends paid to stockholders (2) (6) (18)
Dividends paid to minority interests (205) (284) (584)
Other (2,829) (2,083) (2,106)
Net cash (used in) provided by financing activities (116,766) 36,899 (53,009)

Effect of exchange rate changes and consolidation adjustments (1,619) (5,342) 724
Net (decreased) increase in cash and cash equivalents (192,287) 162,658 19,246
Cash and cash equivalents at beginning of year 354,036 191,378 172,132
Cash and cash equivalents at end of year 161,749 354,036 191,378

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