Bookkeeping & Accounting All-in-One For Dummies (2015)

Book IV

Working to Prepare Financial Statements

Chapter 3

In This Chapter

Separating the three types of cash flows

Figuring out how much actual cash increase was generated by profit

Looking at a business’s other sources and uses of cash

Being careful about free cash flow

Evaluating managers’ decisions by scrutinising the cash flow statement

This chapter talks about cash flows - which in general refers to cash inflows and outflows over a period of time. Suppose you tell us that last year you had total cash inflows of £145,000 and total cash outflows of £140,000. We know that your cash balance increased by £5,000. But we don’t know where your £145,000 cash inflows came from. Did you earn this much in salary? Did you receive an inheritance from your rich uncle? Likewise, we don’t know what you used your £140,000 cash outflow for. Did you make large payments on your credit cards? Did you lose a lot of money at the races? In short, cash flows have to be sorted into different sources and uses to make much sense.

The Three Types of Cash Flow

Accountants categorise the cash flows of a business into three types:

· Cash inflows from making sales and cash outflows for expenses - sales and expense transactions - are called the operating activities of a business (although they could be called profit activities just as well, because their purpose is to make profit).

· Cash outflows for making investments in new assets (buildings, machinery, tools and so on) and cash inflows from liquidating old investments (assets no longer needed that are sold off); these transactions are called investment activities.

· Cash inflows from borrowing money and from the additional investment of money in the business by its owners, and cash outflows for paying off debt, returning capital that the business no longer needs to owners and making cash distributions of profit to its owners; these transactions are called financing activities.

The cash flow statement (or statement of cash flows) summarises the cash flows of a business for a period according to this three-way classification. Generally accepted accounting principles require that whenever a business reports its Profit and Loss statement, it must also report its cash flow statement for the same period - a business shouldn’t report one without the other. A good reason exists for this dual financial statement requirement.

The Profit and Loss statement is based on the accrual basis of accounting that records sales when made, whether or not cash is received at that time, and records expenses when incurred, whether or not the expenses are paid at that time. (Book II, Chapter 2 explains accrual basis accounting.) Because accrual basis accounting is used to record profit, you can’t equate bottom-line profit with an increase in cash. Suppose a business’s annual Profit and Loss statement reports that it earned £1.6 million net profit for the year. This doesn’t mean that its cash balance increased by £1.6 million during the period. You have to look in the cash flow statement to find out how much its cash balance increased (or, possibly, decreased!) from its operating activities (sales revenue and expenses) during the period.

In the chapter, we refer to the net increase (or decrease) in the business’s cash balance that results from collecting sales revenue and paying expenses as cash flow from profit (the alternative term for cash flow from operating activities). Cash flow from profit seems more user-friendly than cash flow from operating activities, and in fact the term is used widely. In any case, don’t confuse cash flow from profit with the other two types of cash flow - from the business’s investing activities and financing activities during the period.

Before moving on, here’s a short problem for you to solve. This summary of the business’s net cash flows (in thousands) for the year just ended, which uses the three-way classification of cash flows explained earlier, has one amount missing:

Note that the business’s cash balance from all sources and uses decreased by £15,000 during the year. The amounts of net cash flows from the company’s investing and financing activities are given. So you can determine that the net cash flow from profit was £1.1 million for the year. Understanding cash flows from investing activities and financing activities is fairly straightforward. Understanding the net cash flow from profit, in contrast, is more challenging - but business managers and investors should have a good grip on this very important number.

Setting the Stage: Changes in Balance Sheet Accounts

The first step in understanding the amounts reported by a business in its cash flow statement is to focus on the changes in the business’s Assets, Liabilities and Owners’ Equity accounts during the period - the increases or decreases of each account from the start of the period to the end of the period. These changes are found in the comparative two-year Balance Sheet reported by a business. Figure 3-1 presents the increases and decreases during the year in the assets, liabilities and owners’ equity accounts for a business example. Figure 3-1 isn’t a Balance Sheet but only a summary of changes in account balances. We don’t want to burden you with an entire Balance Sheet, which has much more detail than is needed here.

Figure 3-1: Changes in Balance Sheet assets and operating liabilities that affect cash flow from profit.

Take a moment to scan Figure 3-1. Note that the business’s cash balance decreased by £15,000 during the year. (An increase isn’t necessarily a good thing, and a decrease isn’t necessarily a bad thing; it depends on the overall financial situation of the business.) One purpose of reporting the cash flow statement is to summarise the main reasons for the change in cash - according to the three-way classification of cash flows explained earlier. One question on everyone’s mind is this: How much cash did the profit for the year generate for the business? The cash flow statement begins by answering this question.

Getting at the Cash Increase from Profit

Although all amounts reported on the cash flow statement are important, the one that usually gets the most attention is cash flow from operating activities, or cash flow from profit as we prefer to call it. This is the increase in cash generated by a business’s profit-making operations during the year exclusive of its other sources of cash during the year (such as borrowed money, sold-off fixed assets and additional owners’ investments in the business). Cash flow from profit indicates a business’s ability to turn profit into available cash - cash in the bank that can be used for the needs of business. Cash flow from profit gets just as much attention as net profit (the bottom-line profit number in the Profit and Loss statement).

Before presenting the cash flow statement - which is a rather formidable, three-part accounting report - in all its glory, in the following sections we build on the summary of changes in the business’s assets, liabilities and owners’ equities shown in Figure 3-1 to explain the components of the £1.1 million increase in cash from the business’s profit activities during the year. (The £1.1 million amount of cash flow from profit was determined earlier in the chapter by solving the unknown factor.)

The business in the example experienced a rather strong growth year. Its debtors and stock increased by relatively large amounts. In fact, all the ­relevant accounts increased; their ending balances are larger than their beginning balances (which are the amounts carried forward from the end of the preceding year). At this point, we need to provide some additional information. The £1.2 million increase in retained earnings is the net difference of two quite different things.

The £1.6 million net profit earned by the business increased retained earnings by this amount. As you see in Figure 3-1, the account increased only £1.2 million. Thus there must have been a £400,000 decrease in retained earnings during the year. The business paid £400,000 cash dividends from profit to its owners (the shareholders) during the year, which is recorded as a decrease in retained earnings. The amount of cash dividends is reported in the Financing Activities section of the cash flow statement. The entire amount of net profit is reported in the Operating Activities section of the cash flow statement.

Computing cash flow from profit

Here’s how to compute cash flow from profit based on the changes in the company’s Balance Sheet accounts presented in Figure 3-1:

Computation of Cash Flow from Profit (in thousands of pounds)

Note that net profit for the year - which is the correct amount of profit based on the accrual basis of accounting - is listed in the Positive Cash Flow column. This is only the starting point. Think of this the following way: if the business had collected all its sales revenue for the year in cash, and if it had made cash payments for its expenses exactly equal to the amounts recorded for the expenses, then the net profit amount would equal the increase in cash. These two conditions are virtually never true, and they’re not true in this example. So the net profit figure is just the jumping-off point for determining the amount of cash generated by the business’s profit activities during the year.

We’ll let you in on a little secret here. The analysis of cash flow from profit asks what amount of profit would have been recorded if the business had been on the cash basis of accounting instead of the accrual basis. This can be confusing and exasperating, because it seems that two different profit ­measures are provided in a business’s financial report - the true economic profit number, which is the bottom line in the Profit and Loss statement (usually called net profit), and a second profit number called cash flow from operating activities in the cash flow statement.

When the cash flow statement was made mandatory, many accountants ­worried about this problem, but the majority opinion was that the amount of cash increase (or decrease) generated from the profit activities of a business is very important to disclose in financial reports. For reading the Profit and Loss statement you have to wear your accrual basis accounting lenses, and for the cash flow statement you have to put on your cash basis lenses. Who says accountants can’t see two sides of something?

The following sections explain the effects on cash flow that each Balance Sheet account change causes (refer to Figure 3-1).

Getting specific about changes in assets and liabilities

As a business manager, you should keep a close watch on each of your assets and liabilities and understand the cash flow effects of increases (or decreases) caused by these changes. Investors should focus on the business’s ability to generate a healthy cash flow from profit, so investors should be equally concerned about these changes.

Debtors increase

Remember that the debtors asset shows how much money customers who bought products on credit still owe the business; this asset is a promise of cash that the business will receive. Basically, debtors is the amount of uncollected sales revenue at the end of the period. Cash doesn’t increase until the business collects money from its customers.

But the amount in debtors is included in the total sales revenue of the period - after all, you did make the sales, even if you haven’t been paid yet. Obviously, then, you can’t look at sales revenue as being equal to the amount of cash that the business received during the period.

To calculate the actual cash flow from sales, you need to subtract from sales revenue the amount of credit sales that you didn’t collect in cash over the period - but you add in the amount of cash that you collected during the period just ended for credit sales that you made in the preceding period. Take a look at the following equation for a business example:

· £25 million sales revenue - £0.8 million increase in debtors = £24.2 million cash collected from customers during the year

The business started the year with £1.7 million in debtors and ended the year with £2.5 million in debtors. The beginning balance was collected during the year but at the end of the year the ending balance had not been collected. Thus the net effect is a shortfall in cash inflow of £800,000, which is why it’s called a negative cash flow factor. The key point is that you need to keep an eye on the increase or decrease in debtors from the beginning of the period to the end of the period.

· If the amount of credit sales you made during the period is greater than the amount collected from customers during the same period, your debtors increased over the period. Therefore you need to subtract from sales revenue that difference between start-of-period debtors and end-of-period debtors. In short, an increase in debtors hurts cash flow by the amount of the increase.

· If the amount you collected from customers during the period is greater than the credit sales you made during the period, your debtors decreased over the period. In this case you need to add to sales revenue that difference between start-of-period debtors and end-of-period debtors. In short, a decrease in debtors helps cash flow by the amount of the decrease.

In the example we’ve been using, debtors increased £800,000. Cash collections from sales were £800,000 less than sales revenue. Ouch! The business increased its sales substantially over last period, so you shouldn’t be surprised that its debtors increased. The higher sales revenue was good for profit but bad for cash flow from profit.

An occasional hiccup in cash flow is the price of growth - managers and investors need to understand this point. Increasing sales without increasing debtors is a happy situation for cash flow, but in the real world you can’t have one increase without the other (except in very unusual circumstances).

Stock increase

Stock is the next asset in Figure 3-1 - and usually the largest short-term, or current, asset for businesses that sell products. If the stock account is greater at the end of the period than at the start of the period - because either unit costs increased or the quantity of products increased - what the business actually paid out in cash for stock purchases (or manufacturing products) is more than the business recorded as its cost-of-goods-sold expense in the period. Therefore, you need to deduct the stock increase from net profit when determining cash flow from profit.

In the example, stock increased £975,000 from start-of-period to end-of-period. In other words, this business replaced the products that it sold during the period and increased its stock by £975,000. The easiest way to understand the effect of this increase on cash flow is to pretend that the business paid for all its stock purchases in cash immediately upon receiving them. The stock on hand at the start of the period had already been paid for last period, so that cost doesn’t affect this period’s cash flow. Those products were sold during the period and involved no further cash payment by the business. But the business did pay cash this period for the products that were in stock at the end of the period.

In other words, if the business had bought just enough new stock (at the same cost that it paid out last period) to replace the stock that it sold during the period, the actual cash outlay for its purchases would equal the cost-of-goods-sold expense reported in its Profit and Loss statement. Ending stock would equal the beginning stock; the two stock costs would cancel each other out and thus would have no effect on cash flow. But this hypothetical scenario doesn’t fit the example because the company increased its sales substantially over the last period.

To support the higher sales level, the business needed to increase its stock level. So the business bought £975,000 more in products than it sold during the period - and it had to come up with the cash to pay for this stock increase. Basically, the business wrote cheques amounting to £975,000 more than its cost-of-goods-sold expense for the period. This step-up in its stock level was necessary to support the higher sales level, which increased profit - even though cash flow took a hit.

It’s that accrual basis accounting thing again: the cost that a business pays this period for next period’s stock is reflected in this period’s cash flow but isn’t recorded until next period’s Profit and Loss statement (when the products are actually sold). So if a business paid more this period for next period’s stock than it paid last period for this period’s stock, you can see how the additional expense would adversely affect cash flow but wouldn’t be reflected in the bottom-line net profit figure. This cash flow analysis stuff gets a little complicated, we know, but hang in there. The cash flow statement, presented later in the chapter, makes a lot more sense after you go through this background briefing.

Prepaid expenses increase

The next asset, after stock, is prepaid expenses (refer to Figure 3-1). A change in this account works the same way as a change in stock and debtors, although changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.

Again, the beginning balance of prepaid expenses is recorded as an expense this period but the cash was actually paid out last period, not this period. This period, a business pays cash for next period’s prepaid expenses - which affects this period’s cash flow but doesn’t affect net profit until next period. So the £145,000 increase in prepaid expenses from start-of-period to end-of-period in this example has a negative cash flow effect.

As it grows, a business needs to increase its prepaid expenses for such things as fire insurance (premiums have to be paid in advance of the insurance coverage) and its stocks of office and data processing supplies. Increases in debtors, stock and prepaid expenses are the price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.

The simple but troublesome depreciation factor

Depreciation expense recorded in the period is both the simplest cash flow effect to understand and, at the same time, one of the most misunderstood elements in calculating cash flow from profit. To start with, depreciation is not a cash outlay during the period. The amount of depreciation expense recorded in the period is simply a fraction of the original cost of the business’s fixed assets that were bought and paid for years ago. (Well, if you want to nit-pick here, some of the fixed assets may have been bought during this period, and their cost is reported in the investing activities section of the cash flow statement.) Because the depreciation expense isn’t a cash outlay this period, the amount is added back to net profit in the calculation of cash flow from profit - so far so good.

When measuring profit on the accrual basis of accounting you count depreciation as an expense. The fixed assets of a business are on an irreversible journey to the junk heap. Fixed assets have a limited life of usefulness to a business (except for land); depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue. Part of the total sales revenue of a business constitutes recovery of cost invested in its fixed assets. In a real sense, a business ‘sells’ some of its fixed assets each period to its customers - it factors the cost of fixed assets into the sales prices that it charges its customers. For example, when you go to a supermarket, a very small slice of the price you pay for that box of cereal goes toward the cost of the building, the shelves, the refrigeration equipment and so on. (No wonder they charge so much for a box of cornflakes!)

Each period, a business recoups part of the cost invested in its fixed assets. In other words, £1.2 million of sales revenue (in the example) went toward reimbursing the business for the use of its fixed assets during the year. The problem regarding depreciation in cash flow analysis is that many people simply add back depreciation for the year to bottom-line profit and then stop, as if this is the proper number for cash flow from profit. It ain’t so. The changes in other assets as well as the changes in liabilities also affect cash flow from profit. You should factor in all the changes that determine cash flow from profit, as explained in the following section.

Net profit + depreciation expense doesn’t equal cash flow from profit!

The business in our example earned £1.6 million in net profit for the year, plus it received £1.2 million cash flow because of the depreciation expense built into its sales revenue for the year. The sum of these figures is £2.8 million. Is £2.8 million the amount of cash flow from profit for the period? The knee-jerk answer of many investors and managers is ‘yes’. But if net profit + depreciation truly equals cash flow then both factors in the brackets - both net profit and depreciation - must be fully realised in cash. Depreciation is, but the net profit amount is not fully realised in cash because the company’s debtors, stock and prepaid expenses increased during the year, and these increases have negative impacts on cash flow.

Adding net profit and depreciation to determine cash flow from profit is mixing apples and oranges. The business didn’t realise a £1.6 million cash increase from its £1.6 million net profit. The total of the increases of its debtors, stock and prepaid expenses is £1.92 million (refer to Figure 3-1), which wipes out the net profit amount and leaves the business with a cash balance hole of £320,000. This cash deficit is offset by the £220,000 increase in liabilities (explained later), leaving a £100,000 net profit deficit as far as cash flow is concerned. Depreciation recovery increased cash flow by £1.2 million. So the final cash flow from profit equals £1.1 million. But you’d never know this if you simply added depreciation expense to net profit for the period.

The managers didn’t have to go outside the business for the £1.1 million cash increase generated from its profit for the year. Cash flow from profit is an internal source of money generated by the business itself, in contrast to external money that the business raises from lenders and owners. A business doesn’t have to find sources of external money if its internal cash flow from profit is sufficient to provide for its growth.

In passing, we should mention that a business could have a negative cash flow from profit for a year - meaning that despite posting a net profit for the period, the changes in the company’s assets and liabilities caused its cash balance to decrease. In reverse, a business could report a bottom line loss in its Profit and Loss statement yet have a positive cash flow from its operating activities: the positive contribution from depreciation expense plus decreases in its debtors and stock could amount to more than the amount of loss. More commonly, a loss leads to negative cash flow or very little positive cash flow.

Operating liabilities increases

The business in the example, like almost all businesses, has three basic ­liabilities that are inextricably intertwined with its expenses: creditors, accrued expenses payable and income tax payable. When the beginning balance of one of these liability accounts is the same as the ending balance of the same account (not too likely, of course), the business breaks even on cash flow for that account. When the end-of-period balance is higher than the start-of-period balance, the business didn’t pay out as much money as was actually recorded as an expense on the period’s Profit and Loss statement.

In the example we’ve been using, the business disbursed £720,000 to pay off last period’s creditors balance. (This £720,000 was reported as the creditors balance on last period’s ending Balance Sheet.) Its cash flow this period decreased by £720,000 because of these payments. But this period’s ending Balance Sheet shows the amount of creditors that the business will need to pay next period - £800,000. The business actually paid off £720,000 and recorded £800,000 of expenses to the year, so this time cash flow is richer than what’s reflected in the business’s net profit figure by £80,000 - in other words, the increase in creditors has a positive cash flow effect. The increases in accrued expenses payable and income tax payable work the same way.

Therefore, liability increases are favourable to cash flow - in a sense the business borrowed more than it paid off. Such an increase means that the business delayed paying cash for certain things until next year. So you need to add the increases in the three liabilities to net profit to determine cash flow from profit, following the same logic as adding back depreciation to net profit. The business didn’t have cash outlays to the extent of increases in these three liabilities.

The analysis of the changes in assets and liabilities of the business that affect cash flow from profit is complete for the business example. The final result is that the company’s cash balance increased £1.1 million from profit. You could argue that cash should have increased £2.8 million - £1.6 million net profit plus £1.2 million depreciation that was recovered during the year - so the business is £1.7 million behind in turning its profit into cash flow (£2.8 million less the £1.1 million cash flow from profit). This £1.7 million lag in converting profit into cash flow is caused by the £1.92 million increase in assets less the £220,000 increase in liabilities, as shown in Figure 3-1.

Presenting the Cash Flow Statement

The cash flow statement is one of the three primary financial statements that a business must report to the outside world, according to generally accepted accounting principles (GAAP). To be technical, the rule says that whenever a business reports a Profit and Loss statement, it should also report a cash flow statement. The Profit and Loss statement summarises sales revenue and expenses and ends with the bottom-line profit for the period. The Balance Sheet summarises a business’s financial condition by reporting its assets, liabilities and owners’ equity. (Refer to Book IV, Chapters 1 and 2 for more about these reports.)

You can probably guess what the cash flow statement does by its name alone: this statement tells you where a business got its cash and what the business did with its cash during the period. We prefer the name given to this statement in the old days in the US - the Where Got, Where Gone statement. This nickname goes straight to the purpose of the cash flow statement: asking where the business got its money and what it did with the money.

To give you a rough idea of what a cash flow statement reports, we repeat some of the questions we asked at the start of the chapter: How much money did you earn last year? Did you get all your income in cash (or did some of your wages go straight into a pension plan or did you collect a couple of IOUs)? Where did you get other money (did you take out a loan, win the lottery or receive a gift from a rich uncle)? What did you do with your money (did you buy a house, support your out-of-control Internet addiction or lose it playing bingo)?

Getting a little too personal for you? That’s exactly why the cash flow statement is so important: it bares a business’s financial soul to its lenders and owners. Sometimes the cash flow statement reveals questionable judgement calls that the business’s managers made. At the very least, the cash flow statement reveals how well a business handles the cash increase from its profit.

The history of the cash flow statement

The cash flow statement was not required for external financial reporting until the late 1980s. Until then, the accounting profession had turned a deaf ear to calls from the investment community for cash flow statements in annual financial reports. (Accountants had presented a funds flow statement prior to then, but that report proved to be a disaster - the term funds included more assets than just cash and represented a net amount after deducting short-term liabilities from short-term, or current, assets.)

In our opinion, the reluctance to require cash flow statements came from fears that the cash flow from profit figure would usurp net profit - people would lose confidence in the net profit line.

Those fears have some justification, considering the attention given to cash flow from profit and what is called ‘free cash flow’ (discussed later in the chapter). Although the Profit and Loss statement continues to get most of the fanfare (because it shows the magic bottom-line number of net profit), cash flow gets a lot of emphasis these days.

As explained at the start of the chapter, the cash flow statement is divided into three sections according to the three-fold classification of cash flows for a business: operating activities (which we also call cash flow from profit in the chapter), investing activities and financing activities.

The cash flow statement reports a business’s net cash increase or decrease based on these three groupings of the cash flow statement. Figure 3-2 shows what a cash flow statement typically looks like - in this example, for a ­growing business (which means that its assets, liabilities and owners’ equity increase during the period).

Figure 3-2: Cash flow statement for the business in the example.

The trick to understanding cash flow from profit is to link the sales revenue and expenses of the business with the changes in the business’s assets and liabilities that are directly connected with its profit-making activities. Using this approach earlier in the chapter, we determine that the cash flow from profit is £1.1 million for the year for the sample business. This is the number you see in Figure 3-2 for cash flow from operating activities. In our experience, many business managers, lenders and investors don’t fully understand these links, but the savvy ones know to keep a close eye on the relevant Balance Sheet changes.

What do the figures in the first section of the cash flow statement (See Figure 3-2) reveal about this business over the past period? Recall that the business experienced rapid sales growth over the last period. However, the downside of sales growth is that operating assets and liabilities also grow - the business needs more stock at the higher sales level and also has higher debtors.

The business’s prepaid expenses and liabilities also increased, although not nearly as much as debtors and stock. The rapid growth of the business yielded higher profit but also caused quite a surge in its operating assets and liabilities - the result being that cash flow from profit is only £1.1 million compared with £1.6 million in net profit - a £500,000 shortfall. Still, the business had £1.1 million at its disposal after allowing for the increases in assets and liabilities. What did the business do with this £1.1 million of ­available cash? You have to look to the remainder of the cash flow statement to answer this key question.

A very quick read through the rest of the cash flow statement (refer to Figure 3-2) goes something like this: the company used £1,275,000 to buy new fixed assets, borrowed £500,000 and distributed £400,000 of the profit to its owners. The result is that cash decreased £15,000 during the year. Shouldn’t the business have increased its cash balance, given its fairly rapid growth during the period? That’s a good question! Higher levels of sales generally require higher levels of operating cash balances. However, you can see in its Balance Sheet at the end of the year (refer back to Figure 3-2) that the company has £2 million in cash, which, compared with its £25 million annual sales revenue, is probably enough.

Where to put depreciation?

Where the depreciation line goes within the first section (operating activities) of the cash flow statement is a matter of personal preference - no standard location is required. Many businesses report it in the middle or toward the bottom of the changes in assets and liabilities - perhaps to avoid giving people the idea that cash flow from profit simply requires adding back depreciation to net profit.

A better alternative for reporting cash flow from profit?

We call your attention, again, to the first section of the cash flow statement in Figure 3-2. You start with net profit for the period. Next, changes in assets and liabilities are deducted or added to net profit to arrive at cash flow from operating activities (the cash flow from profit) for the year. This format is called the indirect method. The alternative format for this section of the cash flow statement is called the direct method and is presented like this (using the same business example, with pound amounts in millions):

You may remember from the earlier discussion that sales revenue for the year is £25 million, but that the company’s debtors increased £800,000 during the year, so cash flow from sales is £24.2 million. Likewise, the expenses for the year can be put on a cash flow basis. But we ‘cheated’ here - we’ve already determined that cash flow from profit is £1.1 million for the year, so we plugged the figure for cash outflow for expenses. We would take more time to explain the direct approach, except for one major reason.

Although the Accounting Standards Board (ASB) expresses a definite preference for the direct method, this august rule-making body does permit the indirect method to be used in external financial reports - and, in fact, the overwhelming majority of businesses use the indirect method. Unless you’re an accountant, we don’t think you need to know much more about the direct method.

Sailing through the Rest of the Cash Flow Statement

After you get past the first section, the rest of the cash flow statement is a breeze. The last two sections of the statement explain what the business did with its cash and where cash that didn’t come from profit came from.

Investing activities

The second section of the cash flow statement reports the investment actions that a business’s managers took during the year. Investments are like tea leaves, serving as indicators regarding what the future may hold for the company. Major new investments are the sure signs of expanding or modernising the production and distribution facilities and capacity of the business. Major disposals of long-term assets and the shedding of a major part of the business could be good news or bad news for the business, depending on many factors. Different investors may interpret this information ­differently, but all would agree that the information in this section of the cash flow ­statement is very important.

Certain long-lived operating assets are required for doing business - for example, Federal Express wouldn’t be terribly successful if it didn’t have aeroplanes and vans for delivering packages and computers for tracking deliveries. When those assets wear out, the business needs to replace them. Also, to remain competitive, a business may need to upgrade its equipment to take advantage of the latest technology or provide for growth. These investments in long-lived, tangible, productive assets, which we call fixed assets in this book, are critical to the future of the business and are called capital expenditures to stress that capital is being invested for the long term.

One of the first claims on cash flow from profit is capital expenditure. Notice in Figure 3-2 that the business spent £1,275,000 for new fixed assets, which are referred to as property, plant and equipment in the cash flow statement (to keep the terminology consistent with account titles used in the Balance Sheet, because the term fixed assets is rather informal).

Cash flow statements generally don’t go into much detail regarding exactly what specific types of fixed assets a business purchased - how many additional square feet of space the business acquired, how many new drill presses it bought and so on. (Some businesses do leave a clearer trail of their investments, though. For example, airlines describe how many new aircraft of each kind were purchased to replace old equipment or expand their fleets.)

Note: Typically, every year a business disposes of some of its fixed assets that have reached the end of their useful lives and will no longer be used. These fixed assets are sent to the junkyard, traded in on new fixed assets or sold for relatively small amounts of money. The value of a fixed asset at the end of its useful life is called its salvage value. The disposal proceeds from selling fixed assets are reported as a source of cash in the investments section of the cash flow statement. Usually, these amounts are fairly small. In contrast, a business may sell off fixed assets because it’s downsizing or abandoning a major segment of its business. These cash proceeds can be fairly large.

Financing activities

Note that in the annual cash flow statement (refer to Figure 3-2) of the business example we’ve been using, the positive cash flow from profit is £1.1 million and the negative cash flow from investing activities is £1,275,000. The result to this point, therefore, is a net cash outflow of £175,000 - which would have decreased the company’s cash balance this much if the business didn’t go to outside sources of capital for additional money during the year. In fact, the business increased its short-term and long-term debt during the year, and its owners invested additional money in the business. The third section of the cash flow statement summarises these financing activities of the business over the period.

The term financing generally refers to a business raising capital from debt and equity sources - from borrowing money from banks and other sources willing to loan money to the business and from its owners putting additional money into the business. In addition, the term includes making payments on debt and returning capital to owners. Financing also refers to cash distributions (if any) from profit by the business to its owners.

Most businesses borrow money for a short term (generally defined as less than one year), as well as for longer terms (generally defined as more than one year). In other words, a typical business has both short-term and long-term debt. The business in our example has both short-term and long-term debt. Although not a hard-and-fast rule, most cash flow statements report just the net increase or decrease in short-term debt, not the total amount borrowed and the total payments on short-term debt during the period. In contrast, both the total amount borrowed and the total amount paid on ­long-term debt during the year are reported in the cash flow statement.

For the business we’ve been using as an example, no long-term debt was paid down during the year, but short-term debt was paid off during the year and replaced with new short-term notes payable. However, only the net increase (£200,000) is reported in the cash flow statement. The business also increased its long-term debt by £300,000 (refer to Figure 3-2).

The financing section of the cash flow statement also reports on the flow of cash between the business and its owners (who are the stockholders of a ­corporation). Owners can be both a source of a business’s cash ­(capital invested by owners) and a use of a business’s cash (profit distributed to owners). This section of the cash flow statement reports capital raised from its owners, if any, as well as any capital returned to the owners. In the cash flow statement (Figure 3-2), note that the business did issue additional stock shares for £60,000 during the year, and it paid a total of £400,000 cash ­dividends ­(distributions) from profit to its owners.

Free Cash Flow: What on Earth Does That Mean?

A new term has emerged in the lexicon of accounting and finance - free cash flow. This piece of language is not - we repeat, not - an officially defined term by any authoritative accounting rule-making body. Furthermore, the term does not appear in the cash flow statements reported by businesses. Rather, free cash flow is street language, or slang, even though the term appears often in The Financial Times and The Economist. Securities brokers and investment analysts use the term freely (pun intended). Like most new terms being tossed around for the first time, this one hasn’t settled down into one universal meaning although the most common usage pivots on cash flow from profit.

The term free cash flow is used to mean any of the following:

· Net profit plus depreciation (plus any other expense recorded during the period that doesn’t involve the outlay of cash but rather the allocation of the cost of a long-term asset other than property, plant and equipment - such as the intangible assets of a business).

· Cash flow from operating activities (as reported in the cash flow statement).

· Cash flow from operating activities minus some or all of the capital expenditures made during the year (such as purchases or construction of new, long-lived operating assets such as property, plant and equipment).

· Cash flow from operating activities plus interest, and depreciation, and income tax expenses - or, in other words, cash flow before these expenses are deducted.

In the strongest possible terms, we advise you to be very clear on which definition of free cash flow the speaker or writer is using. Unfortunately, you can’t always determine what the term means in any given context. The reporter or investment professional should define the term.

One definition of free cash flow, in our view, is quite useful: cash flow from profit minus capital expenditures for the year. The idea is that a business needs to make capital expenditures in order to stay in business and thrive. And to make capital expenditures, the business needs cash. Only after paying for its capital expenditures does a business have ‘free’ cash flow that it can use as it likes. In our example, the free cash flow is, in fact, negative - £1.1 million cash flow from profit minus £1,275,000 capital expenditures for new fixed assets equals a negative £175,000.

This is a key point. In many cases, cash flow from profit falls short of the money needed for capital expenditures. So the business has to borrow more money, persuade its owners to invest more money in the business or dip into its cash reserve. Should a business in this situation distribute some of its profit to owners? After all, it has a cash deficit after paying for capital expenditures. But many companies like the business in our example do, in fact, make cash distributions from profit to their owners.

Scrutinising the Cash Flow Statement

Analysing a business’s cash flow statement inevitably raises certain questions: What would I have done differently if I were running this business? Would I have borrowed more money? Would I have raised more money from the owners? Would I have distributed so much of the profit to the owners? Would I have let my cash balance drop by even such a small amount?

One purpose of the cash flow statement is to show readers what judgement calls and financial decisions the business’s managers made during the period. Of course, management decisions are always subject to second-guessing and criticising, and passing judgement based on a financial statement isn’t totally fair because it doesn’t reveal the pressures the managers faced during the period. Maybe they made the best possible decisions given the circumstances. Maybe not.

The business in our example (refer to Figure 3-2) distributed £400,000 cash from profit to its owners - a 25 per cent pay-out ratio (which is the £400,000 distribution divided by £1.6 million net profit). In analysing whether the pay-out ratio is too high, too low or just about right, you need to look at the broader context of the business’s sources of, and needs for, cash.

First look at cash flow from profit: £1.1 million, which isn’t enough to cover the business’s £1,275,000 capital expenditures during the year. The business increased its total debt by £500,000. Given these circumstances, maybe the business should have hoarded its cash and not paid so much in cash distributions to its owners.

So does this business have enough cash to operate with? You can’t answer that question just by examining the cash flow statement - or any financial statement for that matter. Every business needs a buffer of cash to protect against unexpected developments and to take advantage of unexpected opportunities, as we explain in Book V, Chapter 5 on budgeting. This particular business has a £2 million cash balance compared with £25 million annual sales revenue for the period just ended, which probably is enough. If you were the boss of this business how much working cash balance would you want? Not an easy question to answer! Don’t forget that you need to look at all three primary financial statements - the Profit and Loss statement and the Balance Sheet as well as the cash flow statement - to get the big picture of a business’s financial health.

You probably didn’t count the number of lines of information in Figure 3-2, the cash flow statement for the business example. Anyway, the financial statement has 17 lines of information. Would you like to hazard a guess regarding the average number of lines in cash flow statements of publicly owned companies? Typically, their cash flow statements have 30 to 40 lines of information by our reckoning. So it takes quite a while to read the cash flow statement - more time than the average investor probably has. (Professional stock analysts and investment managers are paid to take the time to read this financial statement meticulously.) Quite frankly, we find that many cash flow statements aren’t only rather long but also are difficult to understand - even for an accountant. We won’t get on a soapbox here but we definitely think businesses could do a better job of reporting their cash flow statements by reducing the number of lines in their financial statements and making each line clearer.

Microsoft also has a comprehensive range of templates at http://office.microsoft.com/en-gb/Templates followed by a search term, in this case ‘cash flow’.

Have a Go

1. Using the information presented in the comparative Balance Sheet that follows, determine the business’s cash flow from profit (operating activities) for 2014.

Use the method of solving for the unknown factor as demonstrated ­earlier in this chapter.

2. The beginning and ending balances of certain accounts in a business’s Balance Sheet are as follows:

3. The business records £145,000 depreciation expense for the year and its net profit is £258,000 for the year. Determine its cash flow from operating activities for the year. Present your answer in the indirect format for cash flow from operating activities in the cash flow statement.

Answering the Have a Go Questions

1. Using the method of solving for the unknown factor you set up the problem as follows:

2. Having calculated the missing figure (i.e the one with the question marks), the cash flow from profit is £57,000 for the year.

3. In the comparative Balance Sheet, you can see that the business increases cash £75,000 from its loan and overdraft transactions during the year (£125,000 increase in long-term loans - £50,000 pay-down on the overdraft = £75,000 net increase). The business doesn’t raise money by issuing shares during the year and doesn’t pay cash dividends during the year. Therefore, the net cash increase from its financing activities is £75,000. The firm spends £163,000 on plant and machinery. Therefore, cash flow from profit must have increased cash £57,000: £57,000 cash increase from profit - £163,000 capital expenditures + £75,000 cash from financing activities = £31,000 decrease in cash during year. We hope that you follow all this: cash flow analysis isn’t for the faint-hearted, is it?

4. Using the indirect method, the cash flow from operating activities is as follows:

5. Here’s the process broken down:

· You have the net profit figure as a starting point.

· Stock has a negative impact on cash flow, because the business has increased its stock from the prior year and has had to foot the bill for the additional stock bought.

· Debtors have decreased year on year by £35,000, which means that the business has actually had that much more cash from its customers in the year. This has a positive effect on cash flow.

· Prepaid expenses have decreased year on year by £5,000, which means that the business hasn’t had to pay out as much cash, which has a positive effect on cash flow.

· Depreciation expense isn’t a cash flow item and should be added back to net profit.

· Creditors have decreased by £25,000 year on year. This means that the business paid off more money to its suppliers this year, so this has a negative effect on cash flow.

· Accrued expenses have increased year on year. These are items that have been received and not paid for, and so the fact that they have increased this year means that the business hasn’t paid out as much year on year, and therefore it has a positive effect on cash flow.

· The sum of all these adjustments to the Net Profit figure means that cash flow as a result of operating activities increased by £348,000.