Cash Flow Statement

Cash Cash is king. It is relatively easy to “manufacture” profits but creating cash is virtually impossible (UBS Philips and Drew Jan 1991.Accounting for Growth)

Cash flow statement It is defined as a statement prepared periodically that summarises the cash flows into and out of a business A cash flow statement records the inflow and outflow of cash over a period of time The statement is required under FRS1 It differs from a cash flow forecast in that it concerns what has happened rather than what is expected to happen It is different from a profit and loss account in that it concerns cash flow not accounting profit

How does it differ from a P&L Account? A cash statement is concerned with movements of cash into and out of the businesses A cash statements does not feature “promised” moneys or payments It ignores non cash expenses. For instance, depreciation is a negative item on a P&L account but as it does not involve a flow of cash into or out of a business and therefore it is not part of a cash flow statement A P&L account does not include spending on capital – but cash spending on capital items is recorded in a cash flow statement The cash flow statement includes all movements of cash whether for operating or non-operating reasons

How does it differ from a P&L Account? The P&L account summaries sales during the accounting period and the expenses linked to those sales. Sales are included in a P&L when the sale occurs – not when the cash flows in. Credit sales in 2005 will raise the level of sales revenue in 2005 even if cash does not flow until 2006 A P&L account records income and expenses at the time of sales - not when cash flows Stock purchases linked to those sales are included at the time of the purchase whether or not the stock has been paid for In a cash flow statement we are only concerned with flows of cash at the time of the actual flow

What is in the P&L but not in a cash flow statement? Sales on credit Purchase of stock on credit Tax charge not yet paid Write off of bad debt and stock Depreciation of fixed assets

What is in a cash flow statement but not in the P&L? Cash purchase of stock not used during the year Payments to creditors Cash purchase of fixed asset Payment of dividend Cash payment for redemption of shares Payment by credit customers Cash from sale of fixed assets Cash from loans received Cash received from share issue

Cash flow statement v P&L Profit and Loss Account Sales Only when cash received Include all sales Purchases of stock Only when paid for Include all purchases associated with the year’s sales Opening/closing stock Not included Part of calculation of gross profit Expenses without any period of credit Included Depreciation Included as an expense

Cash v profits Cash flow = Cash inflow (cash paid) minus Cash outflow (cash received) Profit = Income earned minus Expenses incurred

What the cash flow statement shows How cash flows (either positive or negative) have been generated over the year Major financing activities for the year How the company met its obligations to service loans and pay dividends How and in what way reported profits differ from related cash flows during the year

Advantages of cash accounting Focuses attention on the critical issue of cash generation Cash is more objective than profit Creditors are more interested in a firm’s ability to repay debts than its profitability Cash is an easy concept for users to understand The P&L Account can be more easily window-dressed Declared profits may give a false impression if sales are mainly credit sales Cash and liquidity are essential for business survival

Sources and uses of cash Cash from sales Cash injections of capital Long term borrowing Cash proceeds from the disposal of fixed assets Interest received from bank deposit accounts Uses Cash to meet trading expenses Cash payments to suppliers Cash payments for services Cash purchase of new fixed assets Repayment of long term loans Interest paid on loans Tax payments Withdrawal of capital by owners

Headings in a cash flow statement Net cash flow from operating activities Returns on investment and servicing of finance Taxation Capital and financial investment Acquisitions and disposals Equity dividends paid Management of liquid assets Net cash flow before financing Financing Increase/decrease in cash

A simple cash flow statement - example Net cash flow from operating activities 1100 Return on investment and servicing of finance (100) Taxation (200) Capital expenditure and financial investments (900) Net cash flow before financing Financing 500 Increase/decrease in cash 400

Commentary on the example cash flow statement There was a net cash inflow of £1,100,000 from normal trading operations Interest paid net of interest received meant an outflow of £100,000 A tax bill of £200,000 was paid There was expenditure of £900,000 on new fixed assets So far there was a net outflow of £100,000 £500,000 was raised by a share issue At the end of the accounting period there was a £400,000 increase in cash shown in the balance sheet

Tesco’s cash flow for 2005 (£m) Net cash inflow from operating activities 3,004 Dividends from joint venture and associates 135 Net cash outflow from returns on investment and servicing of finance (263) Taxation (483) Net cash outflow from capital expenditure and financial investments (1,458) Net cash outflow from acquisitions and disposals (228) Equity dividend paid (448) Management of liquid reserves- decrease in short term deposits 97 Net cash outflow from financing (235) Increase in cash (121)

Net cash flow from operating activities This refers to cash flows from the normal trading activities of the business Cash received from customers Cash paid to suppliers Cash paid to employees Broadly it is equal to the operating profit (net profit, before deduction of interest) of the business before adjustments relating to depreciation charge for the year changes in debtors, creditors and stock

Cash flow from operating activities This involves reconciliation between operating profits and net cash flow from operating activities Convert operating profits into net cash flow by: Adding back depreciation (a non-cash item) Adjusting for changes in working capital

Net cash inflow from operating activities equals…. Net profit (before interest and tax) Plus depreciation for the year Plus decrease in debtors ( deduct increase in debtors) Plus increase in creditors (deduct decrease in creditors) Plus decrease in stock (deduct increase in stock)

Why the adjustments? Depreciation is excluded because it does not represent a cash cost Changes in creditor and debtor balances are included because they represent an inflow or outflow of cash to the business Reduction in debtors = cash inflow Increase in debtors = cash outflow Increase in creditors = cash inflow Decrease in debtors = cash outflow

Returns on investment and servicing of finance Cash received from investments minus cash paid on loans and dividends. This shows dividend received together with interest paid and received It is the net result of inflow from investments and outflow in the form of cost of finance Inflows Investment income Interest received Dividends received Outflows Interest paid Dividends paid

Taxation Payments of taxes on profits, sales revenue and capital gains Usually an outflow - corporation tax paid by limited companies during the year On occasions it can be an inflow if the company has obtained a repayment of corporation tax Not VAT - which comes under operating activities

Capital expenditure Cash flows relating to the purchase and sale of fixed assets and investment Cash Inflow from: sale proceeds from fixed assets and investment sale of plant and machinery the sale of businesses Cash Outflow from: purchase cost of fixed assets and investments cash outflow from the purchase of fixed assets and subsidiaries

Net cash outflow from capital expenditure Expenditure on new fixed assets less receipts from sale or disposal of such items Usually a negative (net outflow) But can be positive if proceeds from sale exceed cash outflow

Acquisitions and disposals Payments for the purchase or sale of other companies Inflows: sale proceeds from investment and interests in subsidiary companies associated companies joint ventures Outflows-purchase costs of investments in interests in joint ventures

Equity dividends paid An outflow The amount of dividend paid to equity (ordinary) shareholders during the year In the case of a sole trade or partnership the drawings will be shown

Management of liquid assets Inflows sale proceeds from short term investment that are almost as good as cash e.g. treasury bills and term deposits of up to a year with a bank Outflows purchase of short term liquid investments

Net cash flow before financing This is the sum of all previous sections Net cash flow from operating activities Plus net cash flow from investments and servicing of finance Plus net cash from capital expenditure Minus taxation Minus equity dividends paid It is the net cash result of running the business in the period concerned after paying taxes and dividend But if does not include any financing

Financing Cash flows relating to the issue or buying back of shares or loan capital Cash inflow from : the issue of shares the issue of debentures new loans Cash outflow: repayment of loans redemption of shares

Change in cash The final total shows the absolute change in cash levels between the tow balance sheet dates The subtotals from the previous areas of the statement activity are totalled to give the increase/ decrease in cash for the year If this item is positive it will mean that the firm’s holdings of cash have risen If negative, then cash holdings have fallen

A final thought Writing about the collapse of Enron in the USA Jack Welch, a successful American businessman: “There’s one thing you can’t cheat on and that’s cash and Enron didn’t have any cash for the last three years. Accounting is odd, but cash is real stuff. Follow the cash” (Guardian 27.2/02)