Cash Flow AnalysisCopyright Notice © wow free nanagement-ebooks.com 2013. All Rights Reserved ISBN 979-1-62620-956-5 ‘The material contained within this electronic publication is protected under International ‘and Federal Copyright Laws and treaties, and as such any unauthorized reprint or use of this material is strictly prohibited You may not copy, forward, or transfer this publication or any part of it, whether in elec tronic or printed form, to another person, or entity Reproduction or translation of any part ofthis work without the permission of the copy- right holder is against the law. Your downloading and use of this eBook requires, and is an indication of, your complete acceptance of these Terms of Use” You do not have any right to resell or give away part, or the whole, of this eBook.CASH FLOW ANALYSIS Table of Contents Preface. 2 Visit Our Website, 3 Introduction. 4 Importance of Managing Working Capital 6 Debtors 7 Inventory/Stock. 8 Creditors, 9 Coth 10 How is Cash Flow Defined? 3 ACash Flow Forecact. 4 A Cash Flow Statement. 5 Understanding the Changes in Cosh. 18 A Direct Format Cath Flow Statement 20 An Indirect Format Cash Flow Statement. 2 Adjustments. 24 Cash for Investing. 30 Cash from Financing 32 [Net Ceth Flow, 32 ‘Supplemental Information 33 ‘Summary, 34 Other Free Resources. 36 References. 36 |SaN 978--€2620-956-5 5 wu fre-management-ebooks.com 1CASH FLOW ANALYSIS Preface This eBook will help you to understand how cash flows are generated and what factors affect them. This knowledge is an integral part of making financial decisions that in- ‘crease a firm's economic value or the capabilities of a nonprofit organization, You will learn ‘© How working capital is generated and why it needs to be actively managed 1+ The purpoze ofa cazh flow statement and how it complaments the other kay finan- cial reports ‘+The counter-intuitive way that the ‘cash account’ is used in published accounts ‘¢ How to analyze an indirect format cash flow statement to see the true financial status of an organization ‘+ How to compare accounts that have been prepared using different accounting methods | 972:-62620-9565 © wu: fre-management-ebooks.com 2CASH FLOW ANALYSIS Visit Our Website More free management eBooks along with a series of essential templates and check- lists for managers are all available to download free of charge to your computer, iPad, or ‘Amazon Kindle, We are adding new titles every month, so don't forget to check our website regularly for ‘the latest releaces. Visit http://www. free-management-ebooks.com | 972:-62620-9565 © wu: fre-management-ebooks.com BICASH FLOW ANALYSIS Introduction Cash flow is simply the flow of cach through the organization over time, In the case of businesses that are run for profit, cash is paid out in return for the labor and materials that are used to provide goods and services that can be sold. The revenues received provide cash that can then be used to finance further production and sales as well a: Increasing the organization's economic value. Cath flows are also essential for nonprofit organizations such as charities, schools, and hospitals that need to meet the various ongoing expenses atcociated with providing their services, ‘As a manager, you need to understand how cash flows are generated and what factors impact those flows. This knowledge is an integral part of making financial decisions that increase a firm's economic value or the capabilities of = nonprofit organization. ‘The management of cash flow is one part of a larger management responsibility known 2 the management of working capital, which refers to the operating liquidity available toon organization, isthe fetid parr pen ion Pennie a ‘An organization can have assets and profitability, but find itself short of liquidity ifits 5+ sets cannot readily be converted into cash. Working capital is required to ensure that the organization ic able to continue its opera- tions and that it has sufficient funds to satisfy operational expenses and any maturing chort-term debt. The management of warking capital invelves managing the four follew- ing aspects of an organization's operations: Inventories (stock, work-in-progress and finished goods) Accounts receivable (debts that are owed to the organization) # Accounts payable (money the organization owes to its suppliers) Cash IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 4CASH FLOW ANALYSIS Effective management of working capital will increase the profitability of the organiza~ tion, It also enables managers to concentrate on their jobs without worrying too much about the potential for insolvency. Effective Management of Working Capital is essential For Commercial ill one aed ered er Se: Increases profitability It can also reduce the amount of capital needed to run the enterprise, so even if you work inthe nonprofit sector itis still an important consideration Pew Cash flow is simply the flow of cash through the organization over time. S S Working capital is required to ensure that the organization is able to continue its day-to-day operations The management of working capital involves actively controling inventories, accounts receivable, accounts payable, and cash. The effective management of working capital can increase profitability in the private sector and reduce the amount of capital required by nonprofit orga- nizations. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 5CASH FLOW ANALYSIS Importance of Managing Working Capital ‘Many organizations that fail are profitable at the time, and their demise often comes as ‘a surprise to managers and staff who can see that there is 2 full order book and plenty of satisfied customers. In these circumstances, the reason forthe failure is usually down to a shortage of working capital Peer a ers) This shortage in working capital can cause a company to not be able to pay its workers or suppliers even though there are sufficient sales and profits. Even in cases where these short-term liabilities can be met, the deterioration of cash flow critically undermines 9 company’s ability to reinvest in the business and, ultimately, to survive The four factors that affect the mount of working capital available within on organiza tion are aan Cn (Debtors) Leas es Coe IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 6CASH FLOW ANALYSIS ‘The management role that you perform may only influence one of these areas directly, but having a clear understanding of them ail will give you an incight into how well your orga nization controls its working capital, and by extension haw wel its managed financially. Debtors ‘These are entities that ove your organization money, Many organizations have problems caused by the slow payment of invoices and this in turn affects working capital and, in particular, liquidity. CChazing up unpaid invoices ean be very time concuming and there ie 9 fine lina between maintaining 2 good working relationship with your customers and upsetting them by demanding payment too aggressively Whatever your organization's policy is in the area of debt collection you will need to set expectations appropriately with customers and be polite but ascertive in following through with requests for payment. This is 9 key area you need to moritor closely to lencure problem payers are identified as soon as possible. Ra) sacar! Poca RRs = 7 ee ee) terms in ee oem ean) ca se ey ee ‘There are some things you as a manager may be able do to help: + Make sure that the payment terms are agreed in advance + Send out invoices and statements promptly «Deal with queries quickly and efficiently + Ack early and ack often, preferably by telephone + Remember you are only asking for something that has been previously agreed IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 7CASH FLOW ANALYSIS '* Give credit control highest status and priority «Hove comprehensive credit policies 1+ Concentrate on the biggest debts first Inventory/Stock Your aim should always be to keep stock as low as realistically possible and to achieve 2 high rate of stock turnover In this way you are minimizing theimpacton your organization’ working capital In theory this is an ideal to work towards, but in practiceit is more eificit to-achieve because you have to meet the commitments you have given to customers. ro Progress (WIP) ‘There are three components to what accountants refer to as inventory: ‘+ Raw materials—thece are the materials required to produce goods © Workin process (WIP)—includes partly finished goods and those raw materials ‘and components already committed to production. + Finished goods—are all those goods ready to be sold. Many large and successful manufacturing companies use the just-in-time technique of arranging deliveries from suppliers frequently and in small quantities, This is not easy to ‘achieve and can cause problems ifjust one vital component is missing when its required. Many organizations have sophisticated stock control systems, which keep track of stock levels. Once a pre-determined level of stock is reached, an order is automatically gener- ‘ated co that items are never entirely out of stock. In this way minimum levele of stock tre held and supply is replenished often overnight, IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com aCASH FLOW ANALYSIS Creditors ‘Many organizations adopt a policy of delaying the payment of suppliers as long 2s pos sible. There is an obvious advantage in adopting such 2 policy as the purchaser is effec- tively getting an interest-free loan from the supplier. coca ae caeeeen Cee ere Pee ed Harder to change ‘Supplier won't BS =5 | | aa {your reputation we If your organization adopts this policy then your cash balance will be higher than would otherwise be the case even though slow payments do not affect the net balance of work- ing capital. However, there are also some disadvantages in a policy of slow payment + Suppliers will be reluctant to give discounts + They may treat you as a problem customer and make all of your requests the lowest priority © Ifyouare always a slow payer there will be less scope for taking longer to pay in response to acrisis, + Within your industry you will quickly gain a reputation as a poor payer and many suppliers may refuse to work with you, making it hard to change suppliers ifthe need arises. For these reasons, itis often unwise to adopt a consistent policy of slow payment, at least with important suppliers. It is often better to take only a few days longer than the deadline stipulated in the contract and to encure that this is rewarded with keen prices, timely zerviee, and prompt payment discounts, IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com °CASH FLOW ANALYSIS eed Ce rd ca prices, delivery, Prete eens If your organization is relatively small you may be able to obtain the same price 2s your larger competitors by agreeing an immediate payment plan with the supplier. This is because many large corporations use their extensive purchasing power to justify paying suppliers after an unreasonably long time. This sort of policy can leave many manufacturers and suppliers with serious cash flow problems. In these circumstances, many suppliers are prepared to offer the maximum possible discount in exchange for guaranteed quick payments, irrespective of the size of the order. Cash It is quite commen for an organization to be profitable but short of cash. Cae Eas pyr 7 (oe rr eee ‘There are several reasons why this can happen: + An expanding organization will haveto spend money on materials (items for sale ‘and salaries) before it completes sales and gets paid, It isa fact of business life that purchases and expenses usually come before sales and profits. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 10CASH FLOW ANALYSIS ‘+ Capital expenditure, in the ferm of buying equipment, has an immediate impact ‘on the cach available. Even ifthe equipment is bought on credit, the monthly pay- ‘ments may exceed the monthly depreciation figure. Sales taxes and taxes on profit can both take cash out of an organization and can- not normally be deferred without incurring 2 penalty of some sort. ‘+ Money may be collected from customers more slowly than expected. This often happens when sales people are motivated to bring in revenue but have no re- ‘sponsibility for, or interest in, enforcing the payment terms, ‘To avoid your organization becoming ‘cash insolvent’ itis essential that you and all the company's managers accurately forecast and monitor their area's cash receipts and pay- ments, ‘As a manager you need to plan for the known costs and to allow some contingency for Unanticipated problems, e.g. late payment by a customer or a supplier withholding raw ‘materials until payment has been processed This type of planning is usually referred to as a cach flow forecast and should be part of your overall budgeting management process Eee Beng pipers pan ‘As you plan and prepare your cash flow forecast it will highlight areas where improve- ments or savings can be made. It also has the additional benefit of identifying potential problem reas, For example, The figures for cash payments from trade debtors will be based on an esti= ‘mate of the average number of days’ credit that will be taken. This will pose the question of whether or not payments can be speeded up. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com ”CASH FLOW ANALYSIS Your contingency plans could involve deferring an investment for afew weeks or negeti- ating an additional overdraft with the bank. Either way a well-planned cash flow forecast document helps you to be proactive and to avoid the crises that usually result from run- ning out of cash. KEY POINTS ¥ Many organizations fail because of a shortage of working capital The four factors that affect the amount of working capital available within an ‘organization are: inventories, accounts receivable, accounts payable, and cash, Y With regard to payment times, set expectations appropriately with custom- ‘ers and be polite but assertive when asking for invoices to be paid. Your aim should always be to keep stock as low a¢ realistically possible and to ‘achieve a high rate of stock turnover. The benefit to you of having a policy of slow payment can be more than offset by the damage done to your relationchip with the supplier. Instead of flaunting payment terms, negotiate better prices, delivery speed, ‘and discounts. ¥ To avoid your organization becoming ‘cash incelvent’ itis ecsentil that you ‘and all the company’s managers accurately forecast and monitor their area's ‘cash receipts and payments. | 972:-62620-9565 © wu: fre-management-ebooks.com 2CASH FLOW ANALYSIS How is Cash Flow Defined? Cash flow is a generic term that can be used differently depending on the context. It can refer to actual past flows or projected future flows. It can refer to the total of all flows involved or a subset of them—for example, net cosh flow, operating cach flow, and free cash flow. ‘These terms will be defined later, but for now we will concern ourselves only with actual cozh flows for a period of time in the post. Its important to define what is meant by ‘cash’ Cash includes all of the money that the organization has in bank accounts ‘and short-term investments that can quickly be turned into available cash. {tis common for a balance sheet to show only a tiny amount for cash because businesses often operate with an overdraft and only petty cash is included, IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2CASH FLOW ANALYSIS A Cash Flow Forecast ‘There are two completely different accounting documents that have the words ‘cash flow inthe title and itis important to avoid confusing the two of them. These documents are 2 ‘cash flow forecast! and a ‘cash flow statement’ A cash flow forecast, which has already been mentioned, is an internal document produced on an ad hoc basis to help with bud ‘geting, In contrast, 2 cash flow statement is one of the principal financial reports that an organization publishes each year in accordance with international accounting standards, ‘As a manager, you may be asked te produce a cash flow forecast to show your known ‘and anticipated cash expenditure for some future period of time, usually the next bud getory period or the remainder ofthe current one. You will ususlly be expected to add an element of contingency inte your each flow forecast to eater for any unexpected cozte that may arise, ofthe ee comer] This forecastis an important aspect of your planning and is an essential part of budget- ing as it helps you to identify potential areas where a lack of cash may become an issue. It alse offers you the opportunity to review and where necessary amend your planned expenditure Regular monitoring and reviewing of your cash flow forecast is essential because you never know when your budget may be threatened or cut. You will be able to protect your original budget better if you already have arguments for why your budget should not be affected and exactly what the consequences will bei itis. ‘The better prepared you are, the more protected your budget will be in such circum= stances. It also enables you to communicate accurately and objectively to senior man- ‘agement the consequences of any budgetary changes. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com “CASH FLOW ANALYSIS A Cash Flow Statement In order for a set of financial statements to be complete the accounting profession in- cludes a cash flow statement. Like all other financial statements it has to adhere to ac- cepted accounting principles. The cash flow statement goes beyond what you include in your regular reports showing What cash has come in and what cash went out. One of the best definitions for what 2 cach flow statement is can be found in the McGraw-Hill course, Finance for Non-financial ‘Managers: ‘A Cash Flow statement is a reconciliation ofthe differences between the: © Accrual basis balance sheet and © Income statement and © Cash flow. This statement uses historic data and is usually dated at the end of an organization's financial year. In simple terms it shows how the final cash balance occurred, how much money flowed in and from where, and how much went out and why. any ce Sheet 4 F reconciliation of teal eee ees eas petra CY The cash flow statement reflects a firm's liquidity. It includes only inflows and outflows of cach and excludes transactions that de not directly affect cath receipts and payments. Being 2 each basis report, thie financial ztatement dataile three type: of financial aetivi= ties: operating activities, investing activities, and financing activities. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 6CASH FLOW ANALYSIS Bee basis report Gy Ce) This statement is extremely valuable to management and investors because its intendedto: ‘+ Provide information on an organization's liquidity and solvency and its ability to ‘change cash fiows in future circumstances. + Provide additional information for evaluating changes in assets, lisblities, and equity + Improve the comparability of different organizations’ operating performance by eliminating the effects of different accounting methods. Indicate the amount, timing, and probability of future cash flows. ‘The valuable information and data a cash flow statement provides ensure it plays a key role in an organization's decision making, This is why itis essential for managers to have ‘an appreciation of how its compiled and how to interpret it The cash flow statement has been adopted as a standard financial report because it eliminates come of the problems that occur when trying to compare accounts that have been prepared using different accounting methods, such 2s various timeframes for de- preciating fixed assets, It is this compilation and integration of facts that draw savvy monagers and investors to.utlize this often overlooked financial statement. It is important to remember that all the figures in a cash flow statement can be found somewhere in the income statement, balance sheet, statement of shareholders equity, or any one of the financial statement notes provided IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 6CASH FLOW ANALYSIS Ifyou looked at an income statement prepared using the accrual basis of accounting you could see. figure for reported revenues, but you would not know if they have been col~ lected yet. Similarly the expenses reported on the income statement might or might not have been paid, Alternatively, you could review the balance sheet changes to determine the facts, but the oth flow statement has already integrated al that information, There are many ways you can utiize the information a cash flow statement presents, For example, if an organization's cash generated from operations is consistently above its net income or earnings they are referred to as ‘high quality In circumstances where the ‘opposite is true then the organization's earnings have a ‘red flag’ raised against them. This informs anyone looking into the organization that they need to investigate further why its reported earnings are not turning into cash, Where an organization consistently generates cash in excess of what it needs on a day- torday basis, it has the ability to offer its investors a higher dividend or buy back some ofits own shares. Such an organization is considered to have ‘good stockholder value’ by investors, This iz not the only option and they may choose to use this excess cosh to reduce debt or acquire another organization. In the caze of nonprofit organizations, 2 positive cash flow allows them to expand their operations and offer additional or im- proved services. Cegnonis ¥ Cash flow can refer to actual past flows or projected future flows. ¥ Cash includes all of the money that the organization has in bank accounts and short-term investments that can quickly be turned into available cash ¥ Acash flow forecast is an internal document produced on an 2d hc basis to help with budgeting, ¥ Acash flow statement shows how the final cash balance occurred, how much ‘money flowed in and where it came from, and how much went out and why. ¥- Acash flow statement provides information on an organization's liquidity and solvency and its ability to change cash flows in future circumstances, IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com vCASH FLOW ANALYSIS ¥ It provides additional information for evaluating changes in assets, liabilities, ‘and equity ¥ It improves the comparability of different organizations’ operating. perfor- ‘mance by eliminating the effects of different accounting methods, ¥ Itindicates the amount, timing, and probability of future cash flows, Understanding the Changes in Cash The vay in which the ‘cath account’ fs used in published accounts ic to zome extent counterintuitive. To help you understand it we wil use as an example afititious compa- ny that you wil be familiar with if you have read any of our other free eBooks inthis kills reo, These con be downloaded irom our website yw free-manazement-ebooks com. ‘The following isa statement showing the balance of the cath account for Gary's Garden Furniture business in the first two months of trading. Gary's Garden Furniture ony er Peed Jan7 Investment 5,000 5,000 Jan Rent & Deposit 10004000 Jan Insurance oo 3,000 Jan 10 Inventory Purchase 2000 1000 Jan15__Saleon Credit NA WA 1000 Feb15 Payment for Sale 1500 2,500 From this table you can see that for a change in: ‘© Assets (other than cash)—the change in the cach account is in the opposite direction, + Lipbilties and owner's equity—the change in the cash account isin the same direction, IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 8CASH FLOW ANALYSIS ‘The following table provided an explanation for each of the above items and reflects the change that occurs in the column of each key financial area a This can be summarized as follows: ‘+ When owner’ equity increases, the cash account increases ‘* When an asset (other than cash) increases, the cash account decreases ‘+ When a lability increases, the cosh account increases Conversely: ‘+ When owner's equity decreases, the cash account decreases, ‘+ When an asset (other than cash) decreases, the cash account increases. ‘+ When a liability decreases, the cash account decreases. a oeCASH FLOW ANALYSIS feu The way in which the ‘cach account’ is used in published accounts is to some ‘extent counter-intuitive When owner's equity increases, the cash account increases. When an asset (other than cash) increases, the cash account decreases. When a lability increases, the cash account increases, A Direct Format Cash Flow Statement Itwould be possible for you to create a report that listed all ofthe individual cash trans- ‘actions as shown in Gary's cash account for January and February. But it does net really ‘add to what you can already see on the bank statement because it doesn't show inflows ‘and outflows in any meaningful way. Grouping cash payments together and showinga tetal movement in cosh over a particu lar period is much more useful. The report below shows Gary's Garden Furniture cash receipts and disbursements for July Ceo a ny venta ny ‘CASH RECEIPTS $ ‘Amount Collected trom Customers 28,000 Sale of Short-Term Investments 2,000 Total Cach Receipts 30,000 ‘CASH DISBURSEMENTS. Paid to Crecitors 16,000 Payroll 4000 Payroll Taxes 1000 Purchase of equipment 3,000 Total Cash Disbursements (24,000) [Net Cash Flow (Drain) 6,000 ‘Add Balance of Cash at Beginning of Period 8000 Balance of Cash at End of Period 14,000 IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 20CASH FLOW ANALYSIS By applying the resulting net cash flow (56,000) to the balance of cash at the beginning of the period ($8,000), itis possible to obtain the cash balance for the end of the month ($14,000). Showing the flow of cash inte and out ofthe organization in this way provides a summary of the cach account. Unfortunately, it does not show net income or make any attempt to explain the difference between any net income and net cazh flow. ‘As well as these shortcomings, it s difficult to analyze these figures in any meaningful way, Consequently, published accounts always use what is known as the indirect method of presentation This is the format that appears in all published financial reports of public companies and is the same format as the report produced by most accounting software. Thisis dis- cussed in the next section Peaon Presenting cazh flow using the ‘diect’ method is etraightforward but not very useful An Indirect Format Cash Flow Statement ‘This statement begine with net income and adjusts for changes in account balances that affect available each. It is elightly more dificult to understand intially but hae far more potential for analysis, enn eer) Er eae eet Financing IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com aCASH FLOW ANALYSIS Italeo serves to answer the important question, what isthe difference between net profit ‘and net cash flow? A statement prepared using this method has four distinct sections: * Operations Investing Financing ‘© Supplemental information Operations When you look st the exomale below of Gary's Garden Furniture you will 2ee that the firet entry i nat income, This figure has been taken fram the Income Statement for the period. The idea is that net income is presumed to be equal to net cash flow except for the adjustments that make up the details ofthis statement. re Income is Cote} Operations is the process of running the organization with all of the related cash flows such as buying and selling goods, services, manufacturing, and paying employees. The entries under this title effectively convert the items reported on the income statement from the accrual basis of accounting to cash, Investing. This reports the purcha: equipment ‘and sale of long-term investments and property, plant, and Financing. This reports the issuance and repurchase of the organization's own bonds and stock and the payment of dividends. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2CASH FLOW ANALYSIS Supplemental information This reports the exchange of significant items that did not involve cash and reports the ‘amount of income taxes paid and interest paid. ‘The report below isan indirect format cash flow statement for Gary's Garden Furniture Coe come ein July NETINCOME 36000 Adjustments | | Depreciation 2000 ‘Accounts Receivable “3000 Decrease in Prepaid Expenses 1000 Decrease in Inventory 3000 | Increase in Accounts Fayable 3,000 (Cash Provided By (Used For) Operations 12,000 INVESTING | | Capital Expencitures 8000) ‘Short Term Investments Sold | 2.000 ‘Cash Provided By (Used For) Investments 000) FINANCING Bank Debt 1000 Dividends Paid 6000) (Cash Provided By (Used For) Financing 6,000) [Net Cash Flow (Drain) 6000 ‘Add Balance of Cash at Beginning of Period 8000 Balance of Cash at End of Period 14,000 ‘To appreciate the information ths indirect format statement provides you with, you need towork through the line descriptions, one line ata time. The explanations below will help you to understand exactly what the above cach flow statement tells you. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com aCASH FLOW ANALYSIS The first line under the Operations ttle is Net Income because the prime objective of this reports to show the differences between net income and net cash flow. This Net Income figure should be the same as that shown on the income statement for the same period, Adjustments rea as ees Preece ee] ‘Accounts Prepaid Receivable — ‘Then you need to work through the meaning of each of the items listed under the head- ing Adjustments’ These are all the operating items that had an impact on cash that were rot included in the income statement + Depreciation + Accounts Receivable + Prepaid Expenses + Inventory Accounts Payable Depreciation Because the cach was all paid out when Gary's bought the arset, the monthly charge for depreciation expenze must be removed from reported net income. In other words, it chould be added back into ineraace the net income. Remember, depreciation is the gradual charging of the cost to expense over the use~ ful life of the item. Its recorded each month after the asset is put into use yet no cash changes hands as 9 result ofthese depreciation entries IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2CASH FLOW ANALYSIS ‘Accounts Receivable At the beginning of the period, Gary's Garden Furniture was owed money by customers who had bought on credit. Some of this would have been collected curing the month, Which would increase the cach figure but decrease the accounts receivable figure However, Gary's would also make additional crecit sales during the period, some of which would remain unpaid. These must also be allowed for. This can be done using the following formula: a eats ee This calculation effectively converts sales to cash collections by comparing the balances of Accounts Raceivable from the beginning of the month and the end of the month. The following example: will help ensure that you understand this aspect of the statement Example ‘An organization makes sales of $1,000; because there has been no change in the accounts receivable, the cash account must have increased by $1,000. -E- - oak, © Accounts receivable at the beginning of the month = $2,000 © Accounts receivable at the end of the month = $2,000 IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2sCASH FLOW ANALYSIS Example 2 ‘An organization has made $1,000 worth of sales and accounts receivable has decreased by $1,000. Therefore, the cash account must have increased by $2,000. ‘© Accounts receivable at the beginning of the month = $2,000 ‘© Accounts receivable atthe end of the month = $1,000 © Sales = $1,000 Example 3 ‘An organization has made $1,000 worth of sales and accounts receivable has increased by $500, to a total of $2,500. Therefore, the cash account ‘must have decreased by $500. (The negative cash figure of $500 would ap- pear in brackets on the cash flow statement.) a Ea Ee - Accounts receivable at the begining ofthe month = $2,000 ‘© Accounts receivable atthe end ofthe month = $2,500 Sales = $1,000 This means that the organization has sold more to its customers during the ‘month that it has collected. Ithas effectively loaned its customers $500. This may be acceptable if sales are growing but ths situation has the poten- tial to cause a liquidity problem ifit is not addressed. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 26CASH FLOW ANALYSIS Prepaid Expenses Prepaid Expenses represent an upfront cost for things like insurance. As with accounts receivable, the net change in the balance of prepaid expenses on the balance sheet from the beginning to the end of the period is a quick way to calculate the net effect of this adjustment on cash flow. Basically, if the net figure of prepaid expences has decreased over the month, there will bbe a corresponding increase in the cash balance and vice versa Inventory Most companies need some inventory on hand and the change in inventory balances works on the cash account in the same way as Accounts Receivable. Remember that the income statement includes the cost of ilinventory sold in the month. The cash flow statement must deduct the cash cost of any inventory added during the period. This can be done using the following formula: — a — Cod IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com a re) PatiCASH FLOW ANALYSIS Conversely, the cash flow statement must add the cash cost of any inventory deducted during the period Example ‘Anorganization has purchased $1,000 worth of inventory, whichit has not sold. This means that the cash flow adjustment must deduct the cash cost of any inventory added. {Inthis.case the cash adjustment would be minus $1,000 and the figure would ‘be shown in brackets. © Inventory at the beginning of the month = $2,000 ‘© Inventory at the end of the month = $3,000 Beginning Pred $2,000 Cre] Peed $3,000 a Crag In this caze the cash adjustment would be minus $1,000. Example 2 ‘An organization has $1,000 less of inventory than it had at the beginning of the period. This indicates that the organization has sold $1,000 worth of goods out of inventory and has not had to spend any cash to replace it. This results in the cash adjustment being plus $1,000. ‘© Inventory at the beginning of the month = $2,000 ‘© Inventory at the end of the month = $1,000 ed ere $2,000 on — $1,000 Jad IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 28CASH FLOW ANALYSIS Inthis case the cash adjustment would be plus $1,000, ‘Accounts Payable ‘The Accounts Payable figure represents those amounts owed to creditors. The cash flow statement must add the cach cost of any increase in accounts payable during the period astthis represents money effectively borrowed from creditors, t -an be done using the following formula: Example The accounts payable figure has increased by $1,000. This means that the organization has effectively borrowed an additional $1,000 from its suppli- crs this month. Cane] peernies pee Cry Pray poe {In this case the cash adjustment would be plus $1,000. Accounts Payable atthe: ‘© Beginning of the month = $2,000 '¢ End of the month = $3,000 Err Pets Poa $3,000 Beginning eerie Poa $2,000 (or $1,000 IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2CASH FLOW ANALYSIS Example 2 The accounts payable figure has decreased by $1,000. This means that the ‘organization has effectively paid back $7,000 to its suppliers this month. In this case the cash adjustment would be minus $1,000. Accounts Payable atthe: ‘© Beginning of the month = $2,000 ‘© End of the month = $7,000 ee r Core} Cash= YAY accounts WY accounts ($1,000) Jam payable ee ee $2,000 Cash for Investing ‘This reports the purchase and sole of long-term investments and property plant, and equipment. This includes: + Capital expencitures + Short-term investments sold (orc fo rey omen ty capil I Expenditures This describes the amount cpent for all fined assets that are not charged to expence when purchased but are recorded on the organization's balance sheet. That is, they are capitalized and then depreciated over the amount of time they are used fer. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 20CASH FLOW ANALYSIS Purchasing read lor pend separates: ee cg Parrett The cash flow statement considers the purchasing of equipment and borrowing the money for the purchase as two separate things. ‘Although the organization might have recovered the purchase cost by borrowing the mon ey the decision to purchase the equipment represents a commitment of cash and appears ‘38. deduction on the cash flow statement. Ifthe organization financed the purchase, an offsetting tem would appear in the financing section ofthe cash flow statement. Short-Term Investments Sold ‘An organization can invest excess cach so that the money is gaining interest until itis needed for operations. This type of investment is usually short term and uses vehicles like bank certificates or securities, which the organization cells when it needs the ca: eo) Deed ‘When such an investment is purchased it appears as 2 cash expenditure that would be shown in this section as a reduction in cash, When investment is cold the net proceeds of the sale, except for the gain or loss on sale (which appears in the income statement), become an additional source of cash. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com aCASH FLOW ANALYSIS ‘Companies that have undergone a successful IPO (Initial Public Offering) often raise a lot of cash before they are ready to use it. Short-term investments are 2 way to earn in come from these otherwise idle cach balances. Cash from Financing Financing activities include the inflow of cach from investors such as banks and share holders, as well as the outflow of cash to shareholders as dividends as the organization generates income Eee > ered = (Other activities that impact the long-term liabilities and equity of the organization are alco listed in this section, These include: Bank Debt—The net amount of any increases or decreases in monies borrowed from the bank. # Dividends—a profitable organization may elect to pay a distribution of profits to its owners. This is usually done in the form of a dividend on the shares held by its stockholders Theze dictributions ore almost slways in each and the cach flow statement ie the only place such payments ean appear Net Cash Flow This isthe sum of all the entries preceding it and should be equal to the actual change in cach balances from the beginning to the end of the period of the report The final step in this statement is to add to this line the beginning balance of cash that ‘appeared in the prior month's balance sheet. This will give the new ending balance of cosh, Inthis way the statement of cash flow istiedinto the income statement (fist line of cash flow statement) and the balance sheet (last lin). IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 2CASH FLOW ANALYSIS ‘Supplemental Information This information does not actually appear on the report itself but is usually appended tit. ea cad re eed reed peeved po) Po) poo It reports the exchange of significant items that did not involve cash and details the ‘amount of income taxes paid and interest paid een en Eee + Penn s s Cyr Non-cash activities may be disclosed here including: + Leasing to purchase an asset # Converting debt to equity + Exchanging non-cash assets or lsblties for other non-cash assets or lablities © Issuing shares in exchange for assets IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 3aCASH FLOW ANALYSIS feu ¥ An indirect format cash flow statement begins with net income and djusts for changes in account balances that affect available cach. ¥ itis slightly more difficultto understand initially but has far more potential for analysis. ¥ A statement prepared using this method has four distinct sections: opera- tions, investing, financing, and supplemental information, Summary The importance of being familior with a cash flow statement has been explained. The Compilation and integration of facts provided in this type of statement make it an excel- lent analysis tool. This tool allows you to compare accounts that have been prepared Using different accounting methods, such as various timeframes for depreciating fixed assets, All the figures that you read in a each flow statement can be found within the ather key financial statements, There are a variety of ways you can utilize the information a cash flow statement presents. This statement also offers those who know how to interpret its contents the opportunity for further investigation into an organization. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com “CASH FLOW ANALYSIS Some of the most comman uses of a cash flow statement are shown in the diagram below: Cash Flow statements enable Identify cach that flow So There are two methods of presenting a cash flow statement: the direct and indirect ‘method. The principal advantage of the indirect method is that it focuses on the diff ences between an organization's net income and its net cash flow from operating activi- ties, This means that it presents a useful link between the statement of cash flows and the income statement and balance sheet. Because it hows the data containedin an income statement information on a cach rath- eerthan an accrual basis, the direct method may lead to the incorrect conclusion that net cath flow from operating activities is equally able to measure an organization's perfor- mance as its net income, Tolearn more about the ather key financial statements and to become more familiar with ‘accounting terminalegy so that you communicate confidently with the financial people in your organization, visit our website www.free-management-ebooks.com and down- load our other financial skills eBooks: Understanding Income Statements + Reading 2 Balance Sheet * Basie Accounting Concepts + Assessing Financial Performance IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com asCASH FLOW ANALYSIS Other Free Resources ‘The Free Management eBooks website offers you over 100 free resources for your own professional development. Our eBooks, Checklists, and Templates are designed to help you with the management issues you face every day. They can be downloaded in PDF, Kindle, ePub, or Doc formats for use on your iPhone, iPad, laptop or desktop. ‘eBooks —Our free management eBooks cover everything from accounting principles to business strategy. Each one has been written to provide you with the practiea!zkille you need to cucceed as 2 management professional Templates—Most of the day-to-day management tasks you need te do have already been done by others many times in the past. Our management templates will save you from wasting your valuable time re-inventing the wheel CChechlists—When you are working under pressure or doing a task for the first time, itis easy to overlook something or forget to ask a key question. These management checklists will help you to break down complex management tazks into small control- lable steps, FME Newsletter—Subscribe to our free monthly newsletter and stay up to date with the latest professional development resources we add every month, Social Media—Share our free management resources with your friends and colleagues by following us on Linkedin, Facebook, Twitter, Google+, and RSS. Visit www:free-management-ebooks.com References ‘Mason, Roger (2012), Finance for Non-Financial Managers ina Week Hodder Education & The McGraw-Hill Companies Inc. Shoffner GH, Shelly 5, and Cooke RA. (2011), The McGraw-Hill 36-hour Course Finance for Non-financial Managers, rd edn, The McGraw-Hill Companies Ine. Siciliane, Gene (2003), Finance for Non-Financial Managers, The McGraw-Hill Companies Inc. IsBN 976-1-<2620-956-5 © wwwidree-management-ebooks.com 36