Detailed in-depth notes for the first year 'Financial Management' paper on 'Cash Flow Statements'. Mainly based on lectures, with summaries of readings (where applicable), learnings from pre-work problems, and personal explanatory notes included where relevant.
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FM Lecture 4: The Cash Flow Statement
Difference from BS/IS
Unlike balance sheet and income statement which are assumptions-based and can be subjective
(can be exploited, can be inaccurate), cash flow statements are objective
Kitchen-sinking approach: Tesco in end 2014 bundled all the bad news of impairments, write-
offs etc. from its balance sheet, to clear its decks for a turnaround- would make the CEO look
good in the long run
Overview
Broken down into: opening balance; operating, investing, financing activities; net cash flow;
closing balance
Categorisation of operating/ investing/ financing activities may be dependent on the intent of
transaction, type of company, business context, industry, lifecycle of company etc.
Cash: cash on hand and demand deposits
o Demand deposit accounts: allow funds to be withdrawn at any time from the financial
institution (eg. Checking/ savings accounts). Different from time/ term deposit accounts
Cash equivalents: 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 (eg. short term
government bonds, marketable securities, commercial papers). Some countries allow
recognition of bank overdrafts as cash equivalents
2 methods to organise cash flows from operating activities
Direct method:
o Shows major classes of gross cash receipts and payments
o Summarize transactions that have been posted to the cash ledger account during the
period and classify transactions into each of the 3 categories
o If direct method chosen, reconciliation of profit/loss before tax to cash flows from
operating activities is disclosed
Indirect method:
o Starts with profit or loss before/after tax and adjusts for non-operating items, non-cash
items and changes in working capital
Use of profit before/after tax is up to the company, both are permitted
o Provides useful information about management of working capital
Working capital = current assets – cash - (current liabilities – short term debt)
Most websites: Working capital = current assets – current liabilities
o Helpful to understand mismatch between net income and cash flows
o General 'de-accrual' principles:
Add increases in liabilities and decreases in assets,
Subtract decreases in liabilities and increases in assets
Add non-cash expenses (eg. D&A) and subtract non-cash revenues
*Remember: subtract assets, add liabilities
Think of it as 'assets = liabilities + equity'. Increase asset, decrease cash.
Increase liabilities, increase cash to balance, all else equal
o 2 steps for getting operating cash flow via indirect method
, Add back non-cash expenses (eg. D&A)
Look through each current account, excluding debt (under financing cash flows).
Investing cash flows would affect non-current accounts (eg. PPE)
Note that change in non-current accounts (PPE) is split into 2 effects:
depreciation (in operating cash flow) and purchase/sale of PPE (in
investing cash flow)
Assumptions made: current account (except debt) changes are directly
associated with operations and non-current account changes are not associated
with operations. May not always be true.
o Indirect method allows you to produce CF with IS (for profit, D&A values) and 2 BS
(before and after to see the change in current assets and liabilities)
o Examples of how to deal with items:
Add
Depreciation: non-cash expense that was subtracted from profit. Add it
back
Increase in account/trade/tax payables: increased liability. No cash
change but was subtracted from profit as a cost to supplier. Add it back
Decrease in prepaid expense: decreased asset. No cash outflow since it
is recognising and subtracting a past prepaid cash outflow. Add it back
Subtract
Increase in inventories: increase asset. Not sold yet so not recognised
but paid for already. Subtract.
Increase in accounts receivable: increase asset. Sales was recognised
and added to profit but no cash inflow yet. Subtract
o Investing/ financing activities section is similar to the direct method (obtained in the
same way). Could also use assets = liabilities + equity method above and examination of
non-current assets to obtain it
Both methods are approved, many companies prepare both
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