chapter 03 cash flow management

33Chapt

er

Chapt

er The Cash Flow

Statement

Khursheed Ahmad BhatHODDepartment of Hospital Administration

2Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU

Chapter 3 – Outline (1)

• Introduction – The cash flow statement• Usefulness of cash flow information• Cash flow cycles• Format and structure of the cash flow statement• Cash flow from operating activities• Cash flows from investing and financing activities• Direct and indirect method for operating cash flows• Constructing a cash flow statement• Disposal of fixed assets• Presentational differences

Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU3

• A cash flow statement presents information about the cash flows associated with the company’s main operations and those associated with its investing and financing activities of the period.

• A cash flow statement functions in conjunction with both the income statement (performance dimension) and the balance sheet (financial position)

• IAS 7 Cash Flow Statements

Cash Flow Statement


Usefulness of cash flow information

• Ability to generate adequate cash flows is a significant performance dimension

• Cash flow information clarifies the dynamics of short-term liquidity and long-term solvency

• Cash flow information is an essential input for economic decision models


Cash flow versus profit

• Cash flow and profit are different economic phenomena But linked through the mechanisms of accrual

accounting!• Cash flows are factual details of incoming and outgoing

flows of cash, while the balance sheet and income statement emanate from professional judgement and are not a direct projection of objective economic data


Liquidity/solvency and cash flows

• Liquidity- Relates to “nearness to cash” of the structure of assets- Determined by capacity to convert current assets into cash

• Solvency- Relates to future availability of cash in order to settle financial

liabilities on due date- Determined by timing and uncertainty of expected future cash

payments and cash receipts

• Liquidity and solvency ratios are determined on static financial position data, while cash flows reflect changes in financial position


Relationship with BS and IS

• Spontaneous Financing Firm will also always have minimum level of Accounts

Payable—in effect, money you have borrowed• Accounts Payable (and Accruals) are generated spontaneously

• Arise automatically with inventory and expenses • Offset the funding required to support current assets

Income statement

BS at start Cash flow BS at end

A cash flow statement reflects both “profit related” and “non-profit related” activities (investing and financing) with an impact on available cash over the period covered in the income statement


Related questions????

1. From which sources did the company raise cash last year? How was this cash used?

2. Were the normal operating activities capable of satisfying its need for cash during the year?

3. If not, is the shortage of cash compensated by new borrowings, issuing new share capital or by selling fixed assets?

4. Is a surplus of cash used for repayment of debt, for investments or for distribution of dividends?

5. Why has the balance of cash available decreased, knowing that the company’s operations have been profitable?


Cash conversion cycles

• Cash flows through the company continuously in a series of short-term and long-term conversion cycles

• The ST - cash conversion cycle (operating cycle) relates to the main business

operations = OPERATING ACTIVITIES


Cash conversion cycles Continues 2

• The LT- cash conversion cycles relate to the acquisition, renewal and disposal of intangible and tangible infrastructure and the long-term sourcing of funds Productive capacity acquired for cash and subsequently

consumed during several ST-operating cycles Acquisition and disposal of infrastructure =

INVESTING ACTIVITIES External sourcing of funds = FINANCING ACTIVITIES

• .


•

Fig. 3.1 Long-term and short-term cash flow cycles

• Inventory

• Work in Progress • Sales

• Receipts• Payments

• Procurement

• Current payables • Inventory • Current receivables

• Cash and cash equivalents

• Main operations

• External financing• Investing/

Productive infrastructure


• Cash flows from operating activities• + Cash flows from investing activities• + Cash flows from financing activities• Net change in cash during period• + Beginning cash balance• Ending cash balance

Format and structure of the cash flow statement


Format and structure of the cash flow statement

Cash flows from operating activities• Operating activities are primarily the revenue-generating activities of a company• “Operating cash flow” is conceptually most near to “net profit”• Main differences:1. Non-cash expenses and non-cash revenues (f.i. depreciation

expense)2. Non-operating items (f.i. gain on disposal of tangible fixed assets)3. Timing differences between net profit and underlying cash flow (f.i.

changes in the level of inventories, receivables, creditors, etc.)



Operating cash flows: Examples

• Receipts from sale of goods and rendering of services (cashing in of receivables included)

• Receipts from taxes on sales and VAT• Receipts from royalties, fees, commissions,…• Payments to suppliers (payment of creditors included)• Payments to employees• Payments of taxes, VAT, fines, …


Operating cash flows – Direct versus indirect method

2 methods for identifying and presenting the operating cash flow:

• Direct method: engenders the presentation of the most important categories of gross operating cash inflows and cash outflows

• Indirect method: net operating cash flow is determined by adjusting the (net) profit figure for the 3 types of differences


Direct method - Example•

Cash receipts from customers 30,150

Cash paid to suppliers and employees (27,600)

Cash generated from main operations 2,550

Income taxes paid (1170)

Net cash flow from operating activities 1,380


Indirect method - Example

Net profit before tax 3,350

Adjustments for:Depreciation 490

Investment income (100)

3,740

Working capital changes:

Increase in trade and other receivables (500)

Decrease in inventories 1,050

Decrease in trade payables (1,740)

Cash generated from main operations 2,550

Income taxes paidNet cash flow from operating activities

(1170) 1,380


Cash flows from investing activities• Investing activities relate to the acquisition and disposal of long-term

tangible and intangible assets and other investments • Cash flows from investing activities are an indication of the

expansion or downsizing of operating capacity• Examples:

Payments for newly acquired equipment Receipts from the disposal of a building Payments for new investments


Cash flows from financing activities

• Financing activities relate to changes in the size and composition of contributed capital and financial debt of the company

• Examples: Receipts from issuing new shares or bonds Receipts from new bank loan Payments for buy-back of shares Repayments of loans Payments of interest and

dividend


1. Determine the net change in cash Compare beginning and ending balance

2. Identify all transactions of the period leading to a change in cash Direct: analyze movements in the accounts of cash

(equivalents) transaction by transaction Indirect: explain net change of cash by analyzing all other

accounts, knowing that each transaction with an impact on cash also affects a non-cash account

3. Use the information (of step 1 and 2) to construct a cash flow statement according to the formal rules

Constructing a cash flow statement


Applying step 2

• Information for operating cash flow is primarily derived from balances in the IS, while information for the two other principal categories comes from the Balance Sheet (and details in the Notes)

• Movements in the accounts indicate a change in financial position and further examination is needed to determine if they had a cash impact

• Check if balances have been impacted by “accrual-based adjustments” or other “non-cash activities”


Fig. Classifying balance sheet movements as inflows or outflows of cash•

Assets Equity/ Liability

Increase Out flow Inflow

Decrease Inflow Out flow


Matching approach to asset financing

• Fixed Assets

• Permanent Current Assets

• Total Assets

• Fluctuating Current Assets

• Time

• $

• Short-term• Debt

• Long-term• Debt +• Equity• Capital


Conservative approach to asset financing

• Fixed Assets


• Total Assets


• Time

• $


• Long-term• Debt +• Equity• capital


• Fixed Assets


• Total Assets


• Time

• $


• Long-term• Debt +• Equity• capital

Aggressive approach to asset financing

FACTORS DETERMINING WORKING CAPITAL


1. Nature of the Industry2. Demand of Industry3. Cash requirements4. Nature of the Business5. Manufacturing time6. Volume of Sales7. Terms of Purchase and Sales8. Inventory Turnover9. Business Turnover10. Business Cycle11. Current Assets requirements12. Production Cycle

• 13. Credit control14. Inflation or Price level changes15. Profit planning and control16. Repayment ability17. Cash reserves18. Operation efficiency19. Change in Technology20. Firm’s finance and dividend policy

21. Attitude towards Risk

EXCESS OR INADEQUATE WORKING CAPITAL


Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital.

Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.

Disadvantages of Redundant or Excess Working Capital


Idle funds, non-profitable for business, poor ROIUnnecessary purchasing & accumulation of inventories

over required level Excessive debtors and defective credit policy, higher

incidence of B/D.Overall inefficiency in the organization.When there is excessive working capital, Credit

worthiness suffersDue to low rate of return on investments, the market

value of shares may fall

Disadvantages of Inadequate Working Capital


Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI falls sharply

Management Of Working Capital ( WCM )


Management of working capital is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exists between them. In other words, it refers to all aspects of administration of CA and CL.

Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization.


3D Nature of Working Capital Management

• Dimension I• Profitability,

• Risk, & Liquidity

• Dimension I• Profitability,

• Risk, & Liquidity

• Dimension II

• Composition & Level

• of CA

• Dimension II

• Composition & Level

• of CA

• Dimension III

• Composition & Level • of CL

• Dimension III

• Composition & Level • of CL


Principles Of Working Capital Management

• PRINCIPLES OF WORKING CAPITAL

MANAGEMENT

• Principle of Risk

Variation

• Principle of Cost

of Capital

• Principle of Equity Position

• Principle of Maturity of

Payment


Maturity Matching Principle

• Maturity (due date) of financing should roughly match duration (life) of asset being financed Then financing /asset combination becomes self-

liquidating• Cash inflows from asset can be used to pay off loan


Financing Net Working Capital

• According to maturity matching principle Temporary (seasonal) should be financed with short-

term borrowing Permanent working capital should be financed with

long-term sources, such as long-term debt and/or equity

• In practice, firms may use more or less short-term funds to finance working capital


Figure 3.7(a):

Working Capital Financing Policies


Figure 3.7(b):

Working Capital Financing Policies


Short-Term vs. Long-Term Financing

• The mix of short- or long-term working capital financing is a matter of policy

Use of long-term funds is a conservative policy Use of short-term funds is an aggressive policy



• Short-term financing Cheap but risky

• Cheap—short-term rates generally lower than long-term rates

• Risky—because you are continually entering marketplace to borrow

• Borrower will face changing conditions (ex; higher interest rates and tight money)



• Long-term financing Safe but expensive

• Safe—you can secure the required capital

• Expensive—long-term rates generally higher than short-term rates


Working Capital Policy

• Firm must set policy on following issues: How much working capital is used Extent to which working capital is supported by short-

vs. long-term financing How each component of working capital is managed The nature/source of any short-term financing used

Thank You


chapter 03 cash flow management

Documents

cash flow statement

cash solvency

profit cash flow

available cash

cash flow statement

cash flows liquidity

operating cash flows

adequate cash flows