INTERPRETATION OF FINANCIAL INFORMATION CASH AND FUNDS FLOW ANALYSIS Paper to: UDSM Business School (UDBS)-Bcom 3rd

Year 2012 Presented by: Gasper Njuu-gasper.njuu@gmail.com CASH VS. PROFIT: To better understand the cash and funds flow analysis we must distinguish between Cash and Profits. The cash flow statement differs from the income statement in that the latter is prepared under the accruals principle. This principle states that revenue is recognized during the period when it is earned and expenses are recognized when they are incurred, whether or not cash is received or expended. While a sale may have been closed and goods delivered, the related payment may be deferred as a result of giving credit to the customer. At the same time, there are demands on cash from suppliers, staff, and so on. Cash must be invested in replenishing inventories and new equipment may have to be purchased. Similarly, the company might pay rent in advance, but the income statement will reflect the portion of the charge that relates directly to the reporting period in question, whereas the cash flow statement will reflect the full payment. The net result is that cash receipts often lag cash payments and, whilst profits may be reported, the business may experience a short-term cash shortfall. Accounting profit as reported in the income statement is derived after the application of numerous accounting techniques and policies, for example, inventory valuation and depreciation policy, this gives management potentially wide latitude in reported profits. A Cash Flow Statement: Over the years the needs of accounts users have resulted in the financial statements, such as the balance sheet and income statement, being augmented by the cash flow statement. A cash flow statement is a statement showing an entitys cash inflows and outflows over a period. Its a very important financial statement that often get left behind in media reports on company performance. Cash flow statements can be used to assess the timing, amount, and predictability of future cash flows and can be used as the basis for budgeting. You can use a cash flow statement to answer the following questions: Where did the company money come from? and Where did it go?\

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USES OF THE CASH FLOW STATEMENT: The cash flow statement provides a lot of information. In particular it can help users to: 1. 2. 3. 4. Determine corporate health; Reconcile profit and cash; Project future cash flow; Assess the firms liquidity

The cash flow statement is capable of answering rudimentary questions concerning the ability of a company to: Fund its needs from internally generated cash in the event of outside capital no longer being forthcoming; Continue meeting its debt obligations in the event of a business downturn; Sustain dividend payments. (i) It is good practice to focus initially on operating activities, and in particular the reconciliation of operating profit to net cash inflow; this provides an explanation as to how the profit figure was arrived at. When analyzing cash flow keep a close eye on items such as: Sharply rising levels of inventory and/or accounts receivable; Associate companies which, while highly profitable, hold on to money rather than remitting it; Timing differences on amounts provided for, say, restructuring. (ii) The cash flow statement provides a starting point for projections of future cash flows. When analyzing a current statement, it is necessary to distinguish one-off changes from those likely to continue. A sharp fall in accounts receivable with no corresponding fall in turnover may represent improved debt collection. This improved debt collection may be sustainable, but the fall in debtors is unlikely to be repeated the following year. Acquisitions and disposals, and any form of restructuring or repositioning, are likely to have a significant effect on future cash flows, making it difficult even for the group itself (to say nothing of the analyst) to make accurate projections. (iii) If there is any doubt about the companys liquidity, the cash flow statement should be examined in as much detail as possible. The immediate question to ask is whether current year cash flow will cover cash requirements. There are three main areas to look at. (a) Repayment of existing loans: Loans due in the next year or two, including convertible loans whose conversion rights are unlikely to be exercised.

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(b) Increase in Working Capital: Working Capital trends, in an inflationary period and/or when a business expands, to rise roughly in line with turnover. It is useful, therefore, to use the working capital/sales ratio to establish the relationship between working capital and sales revenue: Working capital to sales = Inventory + Accounts receivable Accounts payable Sales (c) Increase in Capital Expenditure Capital expenditure items should not be financed by short term financing which ideally should only finance working capital. Capital Expenditure typically should be financed by term financing or equity. Working Capital level There are different ways for calculating the amount of the required working capital. For trading companies the most used method is to calculate the days gap and then funding gap: Steps Accounts receivables x 365= days receivables Sales Inventory x 365= days inventory Sales

Accounts payables x 365= days payables Sales Days receivables + Days Inventory-Days payables =Funding Days Gap

Then: Sales X Funding Days Gap=WORKING CAPITAL GAP AMOUNT 365 You may then compare the derived working capital gap amount with the projected working capital short fall/surplus as presented in the cash flow projections WORKING CAPITAL AND CASH FLOW: The connection between investment in working capital and cash flow may be illustrated by means of what is known as the operating cycle. The operating cycle can be expressed as a period of time and is summarized below: The operating cycle is the period between the payment of cash to payables (cash out) and the receipt of cash from receivable (cash in). If the periods for inventories and accounts receivable lengthen, or the accounts payable period shortens, then the operating cycle will lengthen and the investment in working capital will increase. Many businesses are seasonal in that sales tend to be higher in certain months of the year and lower in other months in that sales tend to be higher in certain months of the year and lower in other months. The assets of a firm tend to vary over time with the level

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of sales. The peak sales months are usually the months when inventories and accounts receivable are also at highest levels. Since Assets Liabilities = Equity, any change in assets levels must be offset by a corresponding change in financing. Therefore, firms often find that they need to borrow money when sales increases require an increase in cash, inventories, and receivables. These loans are often then repaid after the peak sales period, when sales and assets levels decline. The vast majority of commercial loans made by banks are short-term loans to finance seasonal working capital requirements. Symptoms of Poor Working Capital Management: The symptoms of poor working capital management include: 1. Over-capitalization; 2. Over-trading. Over-trading happens when a business tries to do too much too quickly with too little long-term capital, so that it is trying to support too large a volume of trade with the capital resources at its disposal. Signs of over-trading include: Rapid increase in turnover; Rapid increase in the volume of current assets (and possibly fixed assets) Inventory and accounts receivable turnover might slow down; Current ratio and quick ratios fall (current liabilities may even exceed current assets); Only a small increase in owners capital. If a firm has very high levels of inventories, accounts receivable, and cash, and very few accounts payable, the company will have over-invested in working capital and will thus be over-capitalized. Such over-capitalization is often due to excessive inventory/accounts receivable turnover and very short periods of credit taken from creditors. In this case, long-term funds will be unnecessarily tied up when they co uld be
invested elsewhere to earn profits.

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