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STATEMENT OF CASH FLOWS: PREPARATION, ANALYSIS & LINKAGES How was Lucky Cement Limited Company able to invest Rs. 5.6 billion in a long-term investment while still paying cash dividends of nearly Rs. 2 billion in the year ended 2013? How was the company able to pay back over Rs. 6.5 billion of short and long term debts in the year ended 2012? How did the cash and bank balance account for Honda Atlas Pakistan increase from Rs. 82 million in the March 31, 2012 year-end Statement of Financial Position to Rs. 3.5 billion in the year-end 2013 balance sheet? How was PIA able to invest nearly Rs. 8 billion in property, plant and equipment in 2012 while reporting a net loss of Rs. 33 billion in the same year? Such questions are often asked by those interested in the financial operations of a business enterprise e.g. investors, creditors, top management and board of directors. Balance sheets, income statements and statements of equity often fail to provide answers to these questions; therefore companies are required to prepare a fourth primary financial statement i.e. the statement of cash flows. Commonly referred to as balance sheet. This note was written by Assistant Professor Asad Alam at the Lahore University of Management Sciences to serve as basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. The intent of this note is not to malign or question practices of the cited companies. Questions of scrutiny are raised only for the purpose of academic interest and with scholarly intent. The data has been gathered and analysed with immense diligence and with an aim to represent as valid a picture as possible. This material may not be quoted, photocopied or reproduced in any form without the prior written consent of the Lahore University of Management Sciences. Investors usually consider net income as a key indicator of a company's financial health and future prospects. The following graph shows the net income of a company over a seven year period in millions of rupees. Figure 1 A Company's Net Income over a Seven Year Period in Millions of Rupees 50 40 30 Millions of Rupees -Income 20 10 0 1 2 3 4 7 Year Between years 1 to 4, net income for this company grew from Rs. 31 million to Rs. 41 million i.e. by 32%. The company had consistently paid dividends and interest. As an investor, Does this company look like a good investment? Would you expect its profitability to continue since the net income between years 6 and 7 is on an upward trend? If you answer 'yes' to both the questions by buying the company's stock, you would be in for a rude shock as the company filed for bankruptcy eighteen months later. Detailed examination of the company's financial statements revealed that the company had experienced several years of negative cash flow from its operations, even though it reported profits. How could this happen? It was partly because the sales that the company reported were made on credit and the company was having trouble collecting the receivables from the sales, causing cash flow to be less than the net income. In the wake of recent high-profile scandals, the landscape is beginning to change. The majority of investors are now aware of the concept of quality of earnings. Investors do understand that corporate management can, in various ways, manipulate earnings as reflected in the income statement. As a result, certain investors shun reported earnings and instead focus more attention on other metrics to evaluate the operational health of a business. One of the metrics that many analysts embrace is the cash flow measurement, since cash is more difficult to manipulate than earnings. The statement of cash flows provides information not available from other financial statements. For example, it helps indicate how it is possible for a company to report a net loss and still make large capital expenditures or pay cash dividends. Information about cash inflows and outflows is important because dividends and debt payments are made with cash, not profit. Investors and creditors may be interested in the firm's sources of cash e.g. if they would be recurring or they are one-time events, like the sale of assets. Cash flow measures are more reliable because, unlike profit measures, they are not vulnerable to accounting. For example, accrual accounting has two principal components: The Revenue Recognition Principle, which states that revenue is recorded when it is Searned The Matching Principle, which states that expenses recognised when 'incurred Neither the recognition of revenue nor that of expense necessarily involves the receipt or payment of cash. Accrual basis earnings therefore do not convey much information about cash inflow to and outflows from the entity. Therefore cash becomes the ultimate measure by which a company is judged. According to Sohail Hassan Khan, VP of ICI Paints Pakistan, "Profit is a concept, cash flow is reality. He added that "the study of cash flow often paints a very different picture than profits; cash flow is the real barometer for business, as profit numbers can be more easily manipulated." Analysing the cash flow statement is integral to understanding a company's financial performance and position because it often provides a check for the quality of the earnings shown in the income statement. Cash flows are also critical for assessing a company's liquidity and creditworthiness. The primary purpose of the statement of cash flows is to -3- provide information about an entity's cash receipts and cash payments during a period. A secondary objective is to provide information about net change in cash resulting from operating, investing and financing activities of an entity during a period, in a format that reconciles the beginning and ending cash balances. For example, the statement of cash flows for Honda Atlas will provide information on how the company's cash increased from Rs. 82 million at the beginning of the year 2013 to Rs. 3.5 billion at the end of the year 2013. The statement would also provide information on the net change in cash resulting from operating, investing and financing activities during the period. Figure 2 Honda Atlas Cars (Pakistan) Limited Balance Sheet as at March 31, 2013 2013 2012 Current Assets Cash and bank balances (Rupees in thousand) 3,534,967 82.477 A statement of cash flows is useful because it provides answers to the following important questions about an entity: . . Where did the cash come from during the period? What was the cash used for during the period? What was the change in the cash balance during the period? . It is a misconception that the change in a firm's cash position between successive balance sheet dates should equal the reported earnings for that period. There are three reasons why this is not true: 1. Net income reported on the income statement usually will not equal cash flow from operating activities because noncash revenue and expenses are often recognised as part of accrual earnings and certain operating cash inflows and outflows are not recorded as revenues or expenses under accrual accounting in the same period the cash flow occur. 2. Changes in cash are also caused by non-operating investing activities like the purchase or sales of fixed assets. - 4- 3. Changes in cash can also be caused by financing activities like the issuance of stock or bonds, repayment of bank loan or paying dividends to stockholders. The statement of cash flows summarises cash inflows and outflows of a company broken down into three principal activities as shown in Figure 3 below. Figure 3 Format of Statement of Cash Flows 570,000 (319,000) (218,000) (8,000) (5,000) Cash from Operating PKR 20,000 ABC Company Statement of Cash Flows For Year Ended December 31, 2013 Cash flows from operating activities Cash received from customrs PKR Cash paid for merchandise Cash paid for wages and other operating expenses Cash paid for interest Cash paid for taxes Net cash provided by operating activities Cash flows from investing activities Cash received from sale of plant assets Cash paid for purchase of plant assets Net cash provided by investing activities Cash flows from financing activities Cash received from issuing stock Cash paid to retire notes Cash paid for dividends Net cash used in financing activities Net increase in cash Cash balance at prior year-end Cash balance at current year-end 12,000 (10,000) Cash from Investing 2,000 15,000 (18,000) (14,000) Cash from Financing (17,000) PKR 5,000 12,000 PKR 17,000 Cash Provided Details of these activities will be covered in the next section, but the general rule of thumb is that companies that are able to satisfy most of their cash needs from operating activities are generally considered to be in stronger financial health and better credit risks. CLASSIFICATION OF CASH FLOWS Statement of Cash Flows is covered under International Accounting Standard 7 (IAS 7), which requires an entity to present a statement of cash flows as an integral part of its primary financial statements, along with Balance Sheet, Income Statement and Statement of Changes in Shareholders' Equity. IAS 7 defines cash equivalents as "short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Script from IAS 7 covering the definition of Cash and Cash equivalents is stated in Appendix 1. According to IAS 7, "The statement of cash flows analyses changes in cash and cash equivalents during a period. Cash and cash equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid investments that are readily convertible to a known amount of cash and that are subject to an insignificant risk of changes in value. An investment normally meets the definition of a cash equivalent when it has a maturity of three months or less from the date of acquisition 2 The statement of cash flows classifies cash receipts and cash payments by operating, investing and financing activities. Operating activities are revenue producing activities, for example, cash receipts from customers for sale of goods and rendering of services, or cash payments to suppliers for goods and services and employees. These are the core activities of a business contextualised by what is the operative scope of the business and determine the profit or loss of an entity. For example, in a company like Unilever, cash flows related to sale of Surf Excel detergent and Clear shampoo will be classified as operating cash flows but the loss on sale of its Walls ice-cream division will not be considered as operating cash flows. Investing activities are the acquisition and disposal of long-term assets and investments e.g. cash payments to acquire fixed assets. These activities need to be analysed as they represent future income and cash flows potential The figure below illustrates the adjustments made to accrual basis net income: Figure 4 Adjustments made to Accrual Basis Net Income Earned Revenues Eliminate Non-cash revenues Net Income Operating cash flow Expenses Incurred Eliminate Non-cash charges Note that cash flow from investing activities and from financing activities is identical under either method. Direct Method The direct method of preparing cash flow shows each major class of gross cash receipts and gross cash payments. The operating cash flows section of the statement of cash flows under the direct method would appear something like Table 1: Table 1 Format of Statement of Cash Flows under Direct Method Cash receipts from customers XX,XXX Cash paid to suppliers XX,XXX Cash paid to employees XX.XXX Cash paid for other operating expenses XX.XXX Interest paid XX.XXX Income taxes paid XX.XXX Net cash from operating activities XX,XXX - 8 - In this format, the cash received from customers, as well as other operating items, is clearly shown. One can contrast the change in revenues from the income statement with the change in cash received from customers. For example, an increase in revenues coupled with a decrease in cash received from customers could signal collection problems. Cash flow from investing activities and from financing activities is identical under both direct and indirect methods. According to IAS 7, cash flows from interest paid and interest and dividends received are usually classified as operating cash flows for a financial institution. However interest paid and interest and dividends received for all other entities may be classified as financing cash flows and investing cash flows respectively, because they are the costs of obtaining financial resources or returns on investments. Dividends paid by an entity may be classified as a financing activity, as a cost of obtaining financial resources or it could be classified as an operating activity to determine the ability of an entity to pay dividends out of operating cash flows. IAS 7 is flexible in disclosing interest and dividends as operating, investing or financing activities as long as it is done in a consistent manner from period to period. Table 2 summarises the classification of interest and dividends under IFRS. Table 2 Classification of Interest and Dividends under IFRS Category Interest received Dividends received Interest paid Dividends paid Classification Operating or investing section Operating or investing section Operating or financing section Operating or financing section According to IAS 7, "an income tax is disclosed separately in the operating activities section unless they can be specifically identified with financing or investing activities." Income determination rules for financial reporting differ from rules for determining income for taxation purposes, because of the very different objectives of both computations. The objective of measuring book income is to reflect a firm's underlying economic success; was the firm profitable during the period? The objective of measuring taxable income is to conform to laws designed to provide a basis for funding government operations. Since the rules that govern income determination for tax purposes result from a national political process, these rules do not necessarily measure changes in firms underlying economic conditions. Most companies maintain two sets of accounting records to facilitate both accurate financial reporting and compliance with tax laws. Income tax expense reported on the income statement is not the actual cash that is paid to the government, due to the timing difference between accounting standards and applicable tax laws. Yearly tax payments are determined under tax laws which are different from accounting standards- there tax laws can potentially delay or promote recognition of revenues or expenses. STEPS IN PREPARING THE CASH FLOW STATEMENT The preparation of the cash flow statement uses data from both the income statement and comparative balance sheets. The following demonstration of how a cash flow statement is prepared uses the income statement and comparative balance sheets for ABC Company as shown in Figures 5 and 6. Figure 5 ABC Company Income Statement ABC Company Income Statement for the period ended December 31, 2013 Revenue Rs. 23,598 Cost of goods sold 11,456 Gross profit 12,142 Salary and wage expense 4,123 Depreciation expenses 1,052 Other operating expenses 3,577 Total operating expenses 8,752 Operating profit 3,390 Other revenues (expenses): Gain on sale of equipment 205 Interest expense (246) (41) income before tax 3,349 Income tax expense 1,139 Net Income Rs. 2.210