What is the importance of the analysis of the statement of cash flows? Please identify/provide factors entering into the interpretation of cash flows from operations.

LESSON PROPER:

Week 10

Chapter 5:Cash Flow Statement Analysis

Topic/s: Cash Flow Statement Analysis

Learning Outcomes: At the end of this module, you are expected to:

1. Analyze accounting transactions connected with the Cash Flow Statement.
2. Prepare and explain the differentCash Flow Statement
   1. A company's ability to generate positive future net cash flows.

INTRODUCTION

This module discusses the components and the structure of a Cash Flow Statement (CFS) that will equip you in preparing the said financial report. Furthermore, this lesson aims to discuss the three major sections of the Cash Flow Statement: 1. Operating, 2. Financing, 3. Investing Activities.

LESSON PROPER

Nature and Purpose

The cash flow statement required by PAS 7 provides information about cash inflows and outflows during an accounting period and the next change in cash from the operating, investing, and financing activities in a manner that reconciles the beginning and ending cash balances.

The primary purpose of a cash flow statement is to provide relevant information about a company's cash receipts and cash payments during an accounting period that is useful in evaluating the preceding items. In this regard, the PAS 7 states that the information in a statement of cash flows, if used with the information in the other financial statements, should help users to assess and evaluate:

1. A company's ability to meet its obligations and pay dividends.
2. A company's need for external financing.
3. The reason for differences between a company's net income and associated cash receipts and payments
4. Both the cash and non-cash aspects of a company's financing and investing transactions during the accounting period.

The following information may also be obtained from the cash flow statement:

• The changes in net assets of an enterprise and its ability to affect the amounts and timing of cash flows in order to adopt to changing circumstances and opportunities
• The ability of the enterprise to generate cash and cash equivalents and enables the users to develop models to assess and compare the present value of the future cash flows of different enterprises, and
• It enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events.

The Basic Approach to a Cash Flow Statement

Cash - In preparing a statement of cash flows, the term cash is broadly defined to include bot cash and cash equivalent.

Cash equivalent - consists of short-term, highly liquid investments such as treasury bills, SEC-registered commercial paper, and money market funds.

Classification of Cash Flow Activities

The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to repay loans, maintain the operating capability of the enterprise, pay dividends and make new investments without resources to external sources of financing. Information about the specific components of historical operating cash flows is useful, in conjunction with other information, in forecasting future operating cash flows.

Operating activities include delivering or producing goods for sale and providing services: and the cash effects of transactions and other events that enter into the determination of income. Examples are :

INFLOWS

Sales of goods

Revenue from services

Return on interest-earning assets (interest)

Return on equity securities (dividends)

Receipts from contracts help for dealing and trading purposes

Tax refunds unless identified with financing and investing activities

OUTFLOWS

Payments for purchase of inventories

Payments for operating expenses (salaries, rent, insurance, etc.)

Payments for purchases from supplies other than inventory

Payments for lenders interest)

Payments for taxes unless identified with financial and investing activities

Investing Activities

The separate disclosure of cash flows arising from investing activities is important because the cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Investing activities include acquiring and selling or otherwise disposing of (a) securities that are not cash equivalent (b) productive assets that are expected to benefit the firm for long periods of time; and lending money collecting on loans. Examples are:

INFLOWS

Sales of long-lived assets such as property, plant and equipment, intangibles, and other long-lived assets

Sales of debt or equity securities of other entities

Collection of loans (principal) to others (other than advances and loans made by a financial institution)

OUTFLOWS

Acquisition of long-lived assets such as property, plant and equipment, intangibles and other long-lived assets

Purchase of debt or equity securities of other entities

Loans (principal) to others (other than advances and loans made by a financial institution)

Financing Activities

The separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of capital to enterprise.

Financing activities include borrowing from creditors and repaying the principal; and obtaining resources from owners and providing them with a return on the investment. Examples are;

INFLOWS

Proceeds from borrowing (short-term and long term)

Proceeds from issuing the firm's own equity securities

OUTFLOWS

Repayment of debt principal

Repurchase of firm's own shares

Payment of dividends

Acquisition of the enterprise's own shares

Content and Form of the Statement of Cashflows

A statement of cash flows (SCF) for a period shall report the following:

1. Net Cash
   1. Provide or used by operating activities
   2. Provide or used by investing activities
   3. Provide or used by financing activities
2. The net effect of those flows on cash and cash equivalents during the period in a manner that reconciles the beginning and ending cash and cash equivalents.

Reporting Requirements

1. An entity shall report cash flows from operating activities using either :

(a)Direct method- whereby major classes of gross cash receipts and gross cash payments are disclosed.

(b)Indirect method-whereby profit or loss is adjusted for the effects of transactions of a non-cash nature.

Under the direct method, information about major classes of gross cash receipts and gross cash payments may be obtained either.

(a) from the accounting records of the entity.

(b) By adjusting sales, cost of sales, and other items in the income statement.

1. changes during the period in inventories and operating receivables and payables.

2. other non-cash items.

3. other items for which the cash effects are investing of financing cash flows.

Under the indirect method, the net cash flow from operating activities is determined by adjusting net profit or loss for the effects of:

(a) changes during the period in inventories and operating receivables and payables.

(b) Non-cash items such as depreciation, provisions, deferred taxes, unrealized foreign currency gains, and losses, undistributed profits of associates, monitory interest.

(c) All other items for which the cash effects are investing or financing cash flows.

The net cash flow from operating activities may be represented under the indirect method by showing the revenues and expenses disclosed in the income statement and the changes during the period in inventories and operating receivables and payables.

2. An entity shall report separately major classes of gross cash receipts and gross cash payments arising from investing and financing activities.

3. Cash flows arising from the following operating, investing, or financing activities may be reported on a net basis.

(a)cash receipts and payments on behalf of the customers.

(b)cash receipts and payments for the items in which the turnover is quick.

4. Cash flows arising from each of the following financial institution activities may be reported on a net basis.

(a)cash receipts and payments for the acceptance.

(b)the placement of deposits with.

(c) cash advances and loans made to customers.

5. Cash flows arising from transactions in a foreign currency should be recorded in an entity's.

6. Cash flows from interest and dividends received and paid should each be disclosed separately.

7. Cash flows arising from taxes on income shall be separately disclosed.

Calculating Cash Flow from Operating Expenses

Direct method

In reporting the cash flows from operating activities, enterprises are encouraged to report major classes of gross cash receipts and gross cash payments and the net cash flow from operating activities. At a minimum, the following classes of operating cash receipts payments should be separately reported.

• Cash collected from customers, including lessees, licensees, and the like
• Interest, fees, royalties, and dividends received
• Other operating cash receipts, if any
• Cash paid to employees and other supplies of goods and services
• Interest paid
• Income taxes paid
• Other operating expenses, if any
• Contracts held for dealing or trading purposes

Indirect Method

Enterprises that choose not to provide the major classes of operating cash receipts and payments by the direct method shall determine and report the same amount of net cash flow from operating activities indirectly by adjusting net income to reconcile it to net cash flow from operating activities.

Steps in Preparing the Statement of Cash Flows

These are the two most commonly used methods of analysis to prepare the statement of cash flows (1) the visual inspection method and (2) the worksheet method.

1. Visual Inspection Method

Step 1:Prepare the heading for the SCF and list the three major sections:

Net cash flow from operating activities b. Cash flow from investing activities c. Cash flow from financing activities STEP 2:Determine the net change in cash that occurred during the accounting period. STEP 3:Determine the company's net income and list this amount as the first item in the net cash flow from the operating activities section. STEP 4:Determine whether the increase or decrease in each statement of financial position account caused an inflow or outflow of cash and, if so whether to an operating investing or financial activities. STEP 5:If no cash glow occurred, determine whether the increase or decrease in cash balance account (except cash) was the result of a non-cash income statement item or as simultaneous investing and financing transactions. STEP 6:complete the various sections of the SCF (based on the analysis in steps 4 and 5). Check the subtotals of the sum of the sections to the net change (increase or decrease) in cash (step 2) and that the sum of the net change and cash and the beginning cash balance equal to the ending reported on the statement of financial position.

Worksheet method of analysis

This method is commonly used in practice because analysis of even the most complex set of financial statements may be documented in a relatively concise working paper. Before the statement of Cash Flows is prepared, a worksheet is prepared, and the cash flow effects of operating, investing, and financing activities during the accounting period are first analyzed. The steps used in the worksheet method are as follows:

Step 1:Enter the accounts from the statements of financial position together with their beginning and ending account balance and the net change in the account balance.

Step 2:Directly add the Net Cash flow from Operating Activities, Cash Flow from Investing Activities, Cash Flow from Financing Activities, and Investing and Financing Activities Not Affecting Cash.

Step 3: Reconstruct the journal entries that caused the changes in the non-cash accounts directly on the worksheet making certain modifications show the cash inflows and outflows related to operating, investing, and financing activities.

General rules for reconstructing journal entries :

1. Start with the net income. Debit to the caption Net Income under the heading Net Cash Flow from Operating Activities and a credit to Retained earnings.
2. Next is Account for all the changes in the current asset and current liability accounts (except cash and non-trade accounts).
3. Account for the changes in the noncurrent accounts. Identify whether the transactions involve an operating, investing, or financing activity and make the entry on the worksheet.

EXAMPLES

• If bonds payable were issued for cash at face value.
• To adjust net income for depreciation (Non-cash expense)
• If an ordinary share was exchanged for land

Step 4: Make a final worksheet entry to record the net change in cash. The difference between the total cash inflows and outflows must be equal to the change in the cash account.

Step 5:Prepare the Statement of Cash Flows and accompanying schedule.

Steps in Preparing the Statement of Cash Flows

These are the two most commonly used methods of analysis to prepare the statement of cash flows (1) the visual inspection method and (2) the worksheet method.