Lecture 7

Unit 5 - Reporting Cash Flows

The Importance of Cash and Cash Flow

Cash is important because organisations and people will not normally accept any other
form of settlement of claim against the business
Businesses fail as a result of inability to find sufficient cash to settle their responsibilities
These factors make cash the pre-eminent business asset, and therefore the one
analysts and others watch carefully in assessing survivability of the business and other
factors
Balance sheet and profit and loss reports show movements in wealth and the net
increase or decrease in wealth for the period concerned
The cash flow statement is required to be produced because the above two reports do
not concentrate sufficiently on liquidity (cash flow)
The accrual nature of the above two reports are thought to obscure the question of how
and where a company is generating the cash it needs to continue operating

Cash and Cash Equivalents

The expression 'cash and cash equivalents' is used in the preparation of a cash flow
statement. This recognises that there are other items that are considered 'cash' from the
perspective of a cash flow statement.

Cash represents cash on hand and demand deposits

Cash equivalents represent short-term, highly liquid investments that can readily be
converted to a fixed amount of cash
Examples include:
- Cash at Bank
- Bank Overdraft
- Short-term Money Market Deposits
- Bank Bills

Cash vs. Accrual Transaction Recognition

Cash-based - Revenue is recognised when cash is received and expenses are
recognised when cash is paid
Accrual-based - Revenue is recognised when it is earned and expenses are recognised
when they are incurred
Accrual-based accounting removes the distortion of the entitys performance from the
cash-based system and reflects the economic reality of what has been earned

Differences between the Three External Financial Reports

Balance Sheet static report made at a given point in time and based on balances
in assets, liabilities and owners equity, normally based on accrual transactions
Income Statement (Profit & Loss) measures the financial performance over a
period of time - normally one year, related to revenues earned less expenses
incurred
 Cash flow statement identifies all cash receipts and cash payments for the period.
All account types are included and is based on cash, not accrual transactions

Income statement
Balance sheet Balance sheet
at the start of at the end of
the accounting the accounting
period period
Owners Owners
Cash flow statement
claim claim

Cash Cash

Figure 5.1 - The relationship between the balance sheet, the income statement and the cash flow stateme

The Cash Flow Statement

The cash flow statement is basically an analysis of the business cash movements over
the period concerned
All payments of a particular type are added together to give just one figure, which
appears in the statement
The net total of the statement is the net increase or decrease in cash of the business
over the period

The three components of the cash flow statement are:

Operating activities - represents net inflows from operations. Only cash received
and paid, not expenses earned and revenue incurred, are featured (that is, cash
flows associated with the operating activities of the business)

Investing activities - concerned with cash payments to acquire additional non-

current assets, and cash receipts from the disposal/sale of such assets e.g. plant and
machinery, shares etc (that is, cash flows from changes in Non Current Assets and
Investments)

Financing activities - deals with financing the business excluding short-term credit
e.g. debt and equity sources, share issues, repayment of debt etc (that is, cash flows
from changes in Non Current Liabilities and Equity)

Interest, Dividends and Taxes

Cash flows from taxes on income, interest received, interest paid, dividends received and/or
dividends paid are shown separately in the Cash Flow Statement. Additionally, interest paid,
interest received and dividends received can be classified differently in the Cash Flow
Statement. These differing classifications are shown below:
Interest paid may be shown under Operating Activities (because it is used to help determine
profit or loss) or under Financing Activities (because it is a cost of obtaining financial
resources).

Interest received and dividends received can be shown under operating activities (because
they help determine profit or loss) or under Investing activities (because they are returns on
investment).

Net cash flows from

operating activities
plus or
minus

Net cash flow from

investing activities
plus or
minus

Net cash flow from

financing activities

Net increase or decrease in

cash and cash equivalents
over the period

Figure 5.2 - Standard layout of the cash flow statement

Non-cash Transactions

Non-cash transactions are transactions that do not directly involve cash

Most relate to the operating activity section of the cash flow statement and are linked to
the difference between cash-based and accrual-based transactions

Examples - depreciation, revaluations, doubtful debts, accruals (receivables, inventory,

prepayments, payables, gains or losses on disposal of non-current assets) etc

Some relate to the investing and financing activity section e.g. direct exchanges such as
shares for assets, non-current assets for reduction in debt, bonus issues from reserves
etc

Preparation of the Cash Flow Statement - an Overview

Can be produced in two ways:

1. Independently viewing the cash receipts and cash payments for the period and
allocating transactions to the different activities and categories
2. Reconstructing the income statement by tracking the changes in the balance sheet
for the period and eliminating accrual transactions so that only cash transactions
remain, forming the basis for preparing the cash flow statement. The information can
be reconstructed in the following ways:
 Schedule approach using additions and subtractions
Ledger reconstructions
Worksheets

You will only be expected to use the first approach to prepare a Cash Flow Statement. You
will not be expected to use method 2 to prepare a cash flow statement.

Preparation of the Cash Flow Statement - a Simple Example

Refer to Example 5.1 on page 231 for detailed information on how reconstructions are used
to prepare a cash flow statement. You will not be expected to use these reconstructions
in this course. However you may be interested in these calculations as a matter of interest.

Cash flow statement for the year ended 30 June 2009

$m $m
Cash flows from operating activities
Cash receipts from customers 95
Cash payments to suppliers and employees (80)
Interest paid (3)
Income taxes paid (4)
Net cash provided by operating activities 8
Cash flows from investing activities
Purchase of property, plant and equipment (20)
Net cash used in investing activities (20)
Cash flows from financing activities
Proceeds from issue of share capital 15
Proceeds from long-term borrowings 5
Dividends paid (15)
Net cash provided by financing activities 5
Net decrease in cash and cash equivalents held (7)
Cash and cash equivalents at the beginning of the financial year 12
Cash and cash equivalents at the end of the financial year 5

Reconciling Cash from Operations with Operating Profit

In addition to the main report above, there are a number of notes to the cash flow statement.
One of these notes is a reconciliation of cash from operations with operating profit.

The purpose of the reconciliation is to reconcile the net operating profit or loss after
tax with the cash flows from operating activities
The starting point is the operating profit after tax
We then effectively add back the depreciation charged in arriving at that profit and
adjust this total by movements in non-cash current asset and current liability
accounts to arrive at cash flow from operations

Refer Example 5.1 on page 231 for data.

Reconciliation would be as follows: $m

Operating profit after tax 10
Depreciation 5
Increase in inventory (8)
Increase in accounts receivable (5)
Increase in accounts payable 5
Increase in tax payable 1
Net cash flow provided by operating 8
activities
You will not be expected to prepare this reconciliation but you will need to be aware
of it.

Reporting Cash Flows from Operating Activities

The accounting standard (AASB107) on the cash flow statement provides preparers of this
report with a choice as to how they report (and present) this section of the cash flow
statement. Preparers can use the direct method to report cash flows from operating
activities which is shown on the previous page and then include the above reconciliation as a
note to the report. Alternatively preparers can use the indirect method which involves
placing the above reconciliation in the body of the cash flow statement under the operating
activities section rather than providing it as a note to the report.
The accounting standard encourages entities to use the direct method to report cash flows
from operating activities and as such, we will be focusing on the direct method.

What Does the Cash Flow Statement Tell Us?

The cash flow statement tells us how the business has generated cash during the period
and where that cash has gone
It tracks the sources and uses of cash over time, which is indicative of trends and useful
for predicting future opportunities and patterns of cash flow
Provides an insight to working capital management (working capital will be covered in a
later lecture)
Is a good indicator of debt management practices
Identifies non-operational cash flows