Statement of Cash flows IAS 7

Part 2

Chapter 16
Cash flow from Operating Activities
Direct Method (cash flow from Operating Activities)

v Encouraged to use this method

v The relevant cash flows can be derived from:
• Accounting records of the entity by totaling the cash receipts and payments
directly OR
• The opening and closing SFP and SPL for the year by constructing summary
control accounts for:
– sales (to derive cash received from customers)
– purchases (to derive cash payments to suppliers)
– wages (to derive cash paid to and on behalf of employees).
 Advantages & Disadvantages of the 2 methods
Direct Method
Advantages
vInformation is shown which is not
shown elsewhere in the financial
statements
vShow the true cash flows involved in
the trading operations of the entity
Disadvantage
vSignificant cost is involved in
preparing the information
Indirect Method
Advantages
vThe user can easily relate trading profits
to cash flow and thus understand the
‘quality’ of the earnings made by the
entity in the accounting period
vLow cost in preparing the information
Disadvantage
vLack of information on the significant
elements of trading cash flows.
Comparison of SCFs and SPL

Advantages of the statement of cash flows

v Assist
users of financial statements in making judgements on the
amount, timing and degree of certainty of future cash flows
v Givesan indication of “quality” of the profit earned - relationship
between profitability and cash generating ability
v SCFs in conjunction with SFP provides information on liquidity,
viability and adaptability
v Cannot be manipulated easily and are not affected by judgement or
by accounting policies
Comparison of SCFs and SPL

Limitations of the statement of cash flows

• SCFs are based on historical information and therefore do not
provide complete information for assessing future cash flows.
• Manipulation is still possible e.g. a business may delay paying
suppliers until after the year end
• Cash flow is necessary for survival in the short-term, but in order to
survive in the long-term a business must be profitable
Accrual vs Cash flow

v SPLOCI uses accrual or matching concepts

• Help users understand the underlying performance of a company

For example, an item of plant has an estimated useful life of 5 years

and was purchased for $10,000
v Cash flow point of view- An outflow of $10,000 in year 1
v SPL point of view- Matching principle: Depreciation of $2,000 pa is
charged for 5 years
• A subjective item; leading to creative accounting
Practice Questions

• Example ,Ch 16: Jack Plc: Please refer to excel sheet for solution
• Test your understanding Ch 16: Hollywood Refer to excel sheet for
solution
Practice Question

$
Profit before tax 5,600
Non-cash items
Add depreciation 956
Less profit on sale of equipment (62)
Profit before working capital changes 6,494

less increase in inventories (268)

less increase in receivables (101)
add increase in payables 322
Cash generated from operation 6,447
Interpretation of Statement of Cash flows
Areas of interpretation

Cash flows in the following areas should be reviewed:

1. Cash generated from trading operations
2. Dividend and interest payments
3. Capital expenditure
4. Financial investment
5. Management of financing
6. Net cash flow
1. Cash generation from trading operation

vComparison between operating profit and cash generated from

operations
vOvertrading may be indicated by:
• High profits and low cash generation
• Large increase in inventory, receivables and payables

vAreas under discussion:

• Working capital management
• Potential reasons for movements in inventory, receivables and payables & their
impact on cash flow and customer/supplier relations
2. Tax and interest pay-outs

vWhether the normal operations can sustain these payments?

• If cash from operation can’t cover these, business may have a problem
continuing as going concern

vFree cash
• Cash left over after paying the tax and interest
• Where is the business using this (buying assets, repaying debt, paying
dividends)
3.Investing (Capital Expenditure)

vCompare Investment & Depreciation:

• If investment > depreciation => Expansion
• If investment = depreciation => Stability
• If investment < depreciation => Asset base is not maintained

vSales on non-current assets

• One-off transactions
• Significant cash inflow may suggest that the company has needed to raise funds
• Completely normal if sales are low and additions are high in PPE
• For additions, sources of finances should be considered (operations vs.
debt/equity)

vInterests/dividends received will be a regular source of inflow in future

4. Financing activities

vCurrent and future implications of sources of funds

vNew loans mean higher interests and regular repayments in future
vRepayment of loans will help cash flow in future periods
vIssuance of shares means no interests/repayments, however,
shareholders may expect regular dividends
4. Net Cash flow

vShows the end result of company’s operations, in cash terms

vDon’t overestimate the importance of this figure
• Decrease in cash may be a result of surplus figure last year OR the timing of
transactions

vAlso see for the other areas of published accounts

 Interpretation(of the SCFs made in class)
Cash generated form operations ($222 million) from the profit of $53 million

v Good quality of earnings

v 2 major contributors :
• Non-cash items (depreciation & loss on sale of PPE
• Increase in payables ($99 million) means BT is retaining cash till next year; but is also risking relationship with its suppliers (may result in
penalties/higher prices in future)

Free Cash flow of $ 176 million

v Operating activities are a major (sustainable) source of inflow

Investing activities

v Major source of cash outflow- Purchase of PPE (benefit in long run)

v Expenditure($106 million) >depreciation ($37 million) => Expansion in PPE

Financing activities

v Repayment of loan ($24 m) and lease liability ($7 m) decreased the debt:-to-equity ratio =>makes BT a less risky investment

v Proceeds from shares- major source of inflow (mot sustainable/ one-off event)
The End