Accounting for Executives

Week 6 15/4/2010 (Fri)

Lecture 6

Part I Statement of Cash Flows

Learning Objectives

1. Understand the types of transactions that result in cash flows from operating, investing, and financing activities.

2. Develop an ability to analyze the statement of cash flows, including the relation among cash flows from operating , investing, and financing activities for businesses in various stages of their growth.

Overview of the Statement of Cash Flows

The statement of cash flows …

(a) explains the reasons for a change in cash.

(b) classifies the reasons for the change as an operating, investing or financing activity.

The cash flow statement provides information about:

♦ cash receipts (cash inflows)♦ uses of cash (cash outflows) ♦ during a period of time

Inflows and outflows are reported for:♦ operating♦ investing ♦ financing activities

The Cash Flow StatementThe Cash Flow Statement

Define the Three Classifications of Cash

Flows1. Operations –

cash flows related to selling goods and services; that is, the principle business of the firm.

2. Investing – cash flows related to the acquisition or sale of noncurrent assets.

3. Financing – long term and short term cash flows related to liabilities and owners’ equity; dividends are a financing cash outflow.

Cash Inflows and OutflowsCash Inflows and Outflows

Example of a

Statement of Cash

Flows

Components of the Statement of Cash Flows

Cash received fromsale of goodsand services

Cash received fromsale of goodsand services

Cash paid foroperating goods

and services

Cash paid foroperating goods

and services

cash flowfrom operations

cash flowfrom operationsOperations - =

Cash received fromsales of investments

and PP&E

Cash received fromsales of investments

and PP&E

Cash paid for ac-quisition of invest-ments and PP&E

Cash paid for ac-quisition of invest-ments and PP&E

cash flowfrom investing

cash flowfrom investingInvesting - =

Cash received fromissue of debt or

capital stock

Cash received fromissue of debt or

capital stock

Cash paid for dividends and

reacquisition of debt or capital stock

Cash paid for dividends and

reacquisition of debt or capital stock

cash flowfrom financing

cash flowfrom financingFinancing - =

Net change in cashfor the period

Net change in cashfor the period

=

+ -

+ -

Comparison of Cash Flow to Net Income

♦ Net income is an accrual based concept and purports to show the long-term.

♦ Cash flows purport to show the short term.

♦ Consider the outlook for both short-term and long-term and consider that each is either good or poor.

♦ A strong growing firm would show both good long-term and good short-term outlooks.

♦ A failing firm would show both poor long-term and poor short term outlooks.

♦ What about a firm with good cash flows (short-term) but poor net income (long-term)?

♦ What about a firm with poor cash flows (short-term) but good net income (long-term)?

Chapter Summary

♦ The statement of cash flows is presented. It reports the effects on cash flows of a firm’s operating, investing and financing activities.

♦ Information in this statement helps in understanding:

1. How operations affect liquidity,

2. The level of capital expenditures needed to support growth, and

3. The major changes in financing.

Part II

Using Financial Information to

Manage Business Resources

Learning Objectives

After working through this part, you should be able to:

♦ Identify the main elements of the working capital cycle and describe the key factors to be considered when managing each part.

♦ Prepare a cash budget and understand its uses in managing cash flow.

Working Capital♦The working capital of a business is the difference between the short-term assets (current assets) and the short-term debt (creditors), amounts falling due within one year

CURRENT ASSETS – CURRENT LIABILITIES

Current Assets: Trade Debtors, Prepayments, Stock, Cash & Bank

Current Liabilities: Trade Creditors, Bank O/D, accruals

Working Capital CycleBelow illustrates that a business can buy and sell its stock of finished goods for cash. However the majority of businesses buy and sell their stocks on credit terms and this creates the working capital cycle. Cash is used to pay suppliers for stock items or to pay trade creditors for stock bought on credit terms. The stock is sold either for cash or for credit. In the case of credit customers, there will be a delay before the cash is received from the sales. The receipt of this cash completes the cycle.

Operating cycle/ Cash conversion cycle

A starting point to determine the level of working capital is to measure the length of time:♦ between the purchase of stocks and the receipt of cash from debtors for the sale of the stock; and♦the interval between when the cash is paid out for stocks and the cash is received in from debtors.

Example

A business buys and sells computers. It buys a computer for cash at a cost of £500. The computer is likely to be held for 15 days before it is sold. The computer will be sold on credit for £800. The debtors normally take 50 days to settle their debts.

Operating cycle/ Cash conversion cycle

This illustrates that the £500 to purchase the computer is tied up for 65 days. This is the length of time the cash invested in the stock takes to be converted into cash being received from debtors.

1/3/05 Purchases

15/3 Sales

4/5 Cash rec’d from customer

65 days

Operating cycle/ Cash conversion cycle

♦Consider what will happen if the business purchases the computer on credit and pays its suppliers in 33 days.

The impact on the operating cycle will be as follows:

1/3/05 Purchases

15/3 Sales

4/5 Cash rec’d from customer

2/4 Cash pay to supplier

32 days

Factors influencing working capital levels

There is no fixed level of working capital or a time period for the operating cycle. The level of working capital and the length of the cycle is dependent on the following:

The nature of the business♦ Some businesses require high levels of working

capital while others need little or none1. Retailers require lower levels of working capital, as

most sales are on cash basis2. Manufacturers requires higher levels of working

capital, as the process of manufacturing goods from raw materials to finished goods take several weeks or months

3. Capital intensive industries may take larger amount of working capital

Factors influencing working capital levels

Seasonality of the businessSeasons sensitive business like air-conditioner manufacturers should experience an increased demand during summer time. The cash cycle will usually shorter for the business during the spring and summer time as compare the autumn and winter

Factors influencing working capital levels

The creditworthiness of the business♦This is measured in terms of the willingness of suppliers to give credit to the business. The credit period granted will depend on the length of time the business has been in existence, the track record of the business in paying its debts and the terms of trade expected in the industry. The level of credit granted will influence the level of working capital required to keep a business ticking over on a day-to-day basis.

Example : Levis versus Giordano

Working capital management

Business can improve its liquidity through the management of current assets as well as current liabilities.

Current Assets managementManaging stock♦Stocks may be held in different forms:

♦ Raw materials♦ Work in progress♦ Finished goods

Managing Stock

The level of stocks held will be determined by a number of factors connected to the business and its industry:

♦ The current and future availability of stocks.♦ The forecast of future demands for stocks.♦ The current purchase price, anticipated price changes,

discounts and credit terms.♦ The costs of holding stocks in terms of storage,

insurance, theft, deterioration, and obsolescence.♦ The rate of production and/or the time taken to purchase

finished goods.♦ The pattern of sales over the year.♦ The reliability of stock control records and systems.♦ The availability of finance and the cost of borrowing to

finance to the purchase of stock

Managing DebtorsDebtors represent what is owed to the business in the short term. Trade debtors reflect sales by the business to customers on credit. The terms of credit granted to debtors are likely to depend on such factors as:

♦ The tradition in the industry♦ The need to increase credit so as to increase sales and

profits (business environment)♦ The customer’s reputation based on past payment records♦ The costs associated with debts including administration,

bad debts and the opportunity cost of allowing the debt♦ The effectiveness of a businesses credit control system in

terms of granting, regulating and controlling debts

Managing Creditors

♦ Credit granted by suppliers on the purchase of goods is one important source of short term funds to most businesses. In effect, a business uses the money it owes to creditors to finance part or all of its current assets.

♦ Many businesses rely on creditors to keep down the level of investment required by the business in working capital.

♦ Using creditors is a relatively cheap way to finance current assets and the longer the period of time a business takes to pay its creditors the more of that money is available for other purposes.

♦ Consolidated purchases in a few suppliers, and negotiate for better credit terms (e.g. longer credit period, better cash discount)

Cash Management♦ Cash and money in the bank are part of the working

capital of a business because they are needed to pay the bills. Cash, like stocks and debtors, should be kept at a minimum level.

♦ The aim is to have sufficient cash to meet all debts as they fall due, but this may not involve holding cash for this purpose. For example a business may be able to borrow money quickly, say by a bank overdraft, so reducing the need to hold cash.

♦ Business should also consider the possibility that in holding large cash balances, they do not take advantage of more profitable opportunities that might occur.