Cash Flow Statements Chapter 15 Luby ODonoghue 2005

Cash Flow Statements Chapter 15 © Luby & O’Donoghue (2005)

Cash is king “profits can be manufactured by creative accounting but creating cash is impossible”. Terry Smith, Accounting for Growth

Typical cash flows CASH FLOWS IN OUT 1. Customer payments X X 1. Suppliers payments 2. Capital grants X X 2. Staff payments 3. Owners buy shares X X 3. Dividends 4. Sale of fixed assets X X 4. Purchase of fixed assets 5. Bank Loans X X 5. Repayment of loans 6. Tax refunds X X 6. Tax 7. Interest received X X 7. Interest paid 8. Sale of Business X X 8. Business acquisitions 9. Dividends received X X 9. Overheads/expenses

Cash in hand deposits repayable on demand with any qualifying financial institution less overdrafts from any qualifying financial institution repayable on demand. Cash includes cash in hand deposits denominated in foreign currencies. (FRS 1) Deposits are repayable on demand if they can be withdrawn at any time without penalty, and notice of not more than 24 hours.

Financial Reporting Standard 1 (FRS 1) is an attempt to ensure that all companies report a summary of their cash flows. FRS 1 applies to all medium and large companies as defined by the Companies Act 1986 and relates to accounting periods ending on or after 23 March 1997.

Purpose of FRS 1 To show the cash inflows and outflows for the financial year and the consequent increase or decrease in cash. The cash flows are reported in various categories to enable the reader to identify key developments. To convert the operating profit or loss into the equivalent amount of cash released or consumed in the day to day running of the business. To show the increase or decrease in cash for the reporting period links the net funds (where cash and bank balances are greater than loans/debt) or net debt (where loans/ debt are greater than bank cash balances) at the start and end of the reporting period.

Categories of cash flow 1. 2. 3. 4. 5. 6. 7. 8. Operating activities Return on investment/serving of debt Taxation Capital expenditure Acquisitions and disposals Equity dividends paid Management of liquid resources Financing

Cash flow statement – 2 steps Step One Calculate overall cash flow Total cash movement €(000) Total movement in cash in the reporting period Cash at 1 Jan 300 Cash at 31 Dec 470 Cash Movement +170 Cash increased by € 170, 000 over the year. Step Two Prepare Cash Flow Statement Categories of cash 1. 2. 3. 4. 5. 6. 7. 8. Operating activities Return on investment/serving of debt Taxation Capital expenditure Acquisitions and disposals Equity dividends paid Management of liquid resources Financing € (‘ 000) 500 (10) (200) (100) (50) 100 + 170

Category 1: Net cash flow from operating activities Cash flows from operating activities are in general the cash effects of transactions relating to the operating or trading activities of the business (the normal trading activities of the business, not capital activities). Operating cash flows will be concerned with: cash collected from customers paid to trade creditors for purchases paid to staff /PAYE/PRSI paid for services (overheads) In calculating the net cash flow from operating activities two formats are permitted by FRS 1 called The Direct Method The Indirect Method

Category 2: Returns on investments and servicing of debt Interest received: from loans given to other businesses. Interest paid: on loans from financial institutions, debentures, interest element on finance lease repayments, dividends paid to non equity shareholders (preference shareholders). Dividends received: from investment in subsidiaries, related companies and fixed asset investments.

Category 3: Taxation Only corporation tax payments and refunds during the year are reported in this section.

Category 4: Capital expenditure and financial investment This category of activity includes divesting activities such as cash flow from the sale of tangible, intangible and financial fixed assets as well purchases of tangible, intangible and financial fixed assets.

Category 5: Acquisitions and disposals This category includes receipts and payments in respect of disposals or acquisitions of interests in subsidiaries, associated or joint venture companies. The cost of buying a business is reported net of any cash included in the purchase price.

Category 6: Equity dividends paid Part of the cash generated by a successful business is paid to the owners as a dividend. This important outflow is reported as a separate item in the cash flow statement.

Category 7: Management of liquid resources This section deals with receipts and payments in respect of current asset investments, which are considered to be liquid (readily marketable). Under the definitions section in FRS 1, liquid resources are those that can be realised (turned into cash) without disruption to the business of the entity or which can be traded in an active market. Examples include commercial paper and short-term investments readily convertible into cash at their carrying value or close to it.

Category 8: Financing This category covers the receipts and payments, which arise from issues or repayments of finance, from or to, the providers of external finance. Cash inflows from this category would include the issue of shares, debentures/bonds or just simply getting a bank loan. The repayments of the capital elements of loans/debentures would be considered a cash outflow.

Reconciliation of net cash flow to net debt The first two objectives or purposes of FRS 1 are achieved by preparing the cash flow statement. The third objective of FRS 1 is to show the increase or decrease in cash for the reporting period links the net funds or net debt at the start and end of the reporting period. Net debt is as per the definitions in FRS 1 “the borrowings of the entity less cash and liquid resources”. If cash and liquid resources exceed debt then the term used becomes Net Funds. The revised FRS 1 requires an additional statement ‘Reconciliation of net cash flow to movements in net debt’ to be shown in the notes to the accounts. A further note is required to further analyse the changes in net debt/funds breaking debt into periods of less than one year and greater than one year.

Reconciliation of net cash flow to net debt

Comprehensive example Trading P&L a/c for the year ended 2004 2003 (€, 000) Turnover 4, 210 3, 694 Cost of goods sold 1, 053 924 Gross profit 3, 157 2, 771 Administration expenses Selling and distribution 1, 200 921 Operating profit 2, 121 1, 012 856 1, 868 1, 036 903 Interest 360 230 Net profit before tax 676 673 Corporation tax 200 180 Net Profit after tax 476 493 Transfer to reserve 250 560 Dividends - interim Dividends - final 200 200 Retained profits for the year 650 Balance sheet as at Fixed Assets At N. B. V. 2004 2003 € 000 13, 120 10, 456 Current Assets Stock 140 120 Debtors 400 300 12 25 8 0 10 130 Short-term investments Prepayments and accrued Income Bank 560 585 Creditors < 12 months Trade creditors 480 260 Taxation 200 180 Dividends Bank overdraft 200 110 990 200 10 650 4, 600 3, 500 4, 000 Creditors >12 months 960 (174) (467) Retained profits b/f 218 685 Retained profits c/f 44 218 Additional information 1. Authorised share capital is 20, 000 50 cent ordinary shares 2. Administration expenses for the year ended 31/3/04 are the following: Depreciation on assets in existence at the year-end € 560, 000. Loss on the sale of fixed assets for € 80, 000. The assets had a net book value of € 150, 000 when sold Debentures Bank loans 4, 000 600 8, 090 6, 391 Capital and Reserves Called up Share Capital Ordinary shares nominal value 0. 50 per share 6, 000 5, 000 Reserves Share premium 623 General reserve 1, 423 1, 173 Retained profits 44 218 8, 090 6, 391

Calculate the overall cash flow

Prepare the cash flow statement

Prepare the reconciliation of net debt to net cash flow

Interpreting cash flow statements Is the overall cash movement positive or negative, and is the cash movement significant? Is the company heavily in overdraft? What is the net debt/funds situation and is it getting better or worse? Compare the operating net profit to operating cash flow. Is the company generating sufficient cash from its operating activities? If the company is not generating sufficient cash from its operating activities is this due to large increases in stocks and debtors which can signal poor control over working capital. Identify the main cash inflows to the business. The biggest cash inflow for a business should be its operating activities but other major ones would be issues of shares/debentures. Identify the major cash outflows of a business. These in general would be in the whole area of capital expenditure (investing in new fixed assets or investments). Try and assess how this capital expenditure was financed. Was it through a new issue of shares, debentures or from the cash flows generated from operating activities. Come to an overall conclusion about the cash position of the business in terms of the business’s ability to generate cash and how it spends it. Also link this to the profitability performance of the business.

Sample – Arnotts Group 2003 €’ 000 2002 €’ 000 30, 420 23, 719 64 124 (1, 042) (1, 442) (23) - (3) (6) (1, 007) (1, 350) (4, 315) (3, 129) (6, 253) (9, 136) - 64 Net Cash Outflow from Capital Expenditure and Financial Investment (6, 253) (9, 072) Equity Dividends Paid (5, 955) (5, 107) Cash Inflow Before Financing 12, 890 5, 061 (11, 840) (8, 961) 1, 050 (3, 900) Cash Flow from Operating Activities Returns on Investments and Servicing of Finance Interest received Interest paid Interest element of finance lease rental payments Premium paid on redemption of debenture stock Preference dividends paid Net Cash Outflow from Returns on Investments and Servicing of Finance Taxation Corporation tax paid Capital Expenditure and Financial Investment Purchase of tangible fixed assets Repayment of loan by associated undertaking Financing Increase/(Decrease) in Cash in the Year

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