Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle

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Corporate Finance FIN 622

Lesson 25

CASH FLOW STATEMENT & WORKING CAPITAL MANAGEMENT

The following topics will be discussed in this lecture.

Cash flow statement

Direct method

Indirect method

Working capital management

Cash and operating cycle

Cash Flow Statement

The cash flow statement analyses changes in cash and cash equivalents during a period. Cash and cash

equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid

investments that are readily convertible to a known amount of cash, and that are subject to an insignificant

risk of changes in value. Guidance notes indicate that an investment normally meets the definition of a cash

equivalent when it has a maturity of three months or less from the date of acquisition. Equity investments

are normally excluded, unless they are in substance a cash equivalent (e.g. preferred shares acquired within

three months of their specified redemption date). Bank overdrafts which are repayable on demand and

which form an integral part of an enterprise's cash management are also included as a component of cash

and cash equivalents. [IAS 7.7-8]

Presentation of the Cash Flow Statement:

Cash flows must be analyzed between operating, investing and financing activities. [IAS 7.10]

Key principles specified by IAS 7 for the preparation of a cash flow statement are as follows:

· Operating Activities are the main revenue-producing activities of the enterprise that are not

investing or financing activities, so operating cash flows include cash received from customers and

cash paid to suppliers and employees [IAS 7.14]

· Investing Activities are the acquisition and disposal of long-term assets and other investments

that are not considered to be cash equivalents [IAS 7.6]

· Financing Activities are activities that alter the equity capital and borrowing structure of the

enterprise [IAS 7.6]

· interest and dividends received and paid may be classified as operating, investing, or financing cash

flows, provided that they are classified consistently from period to period [IAS 7.31]

· cash flows arising from taxes on income are normally classified as operating, unless they can be

specifically identified with financing or investing activities [IAS 7.35]

· for operating cash flows, the direct method of presentation is encouraged, but the indirect method

is acceptable [IAS 7.18]

The direct method shows each major class of gross cash receipts and gross cash payments. The

operating cash flows section of the cash flow statement under the direct method would appear

something like this:

Cash receipts from customers

xx,xxx

Cash paid to suppliers

xx,xxx

Cash paid to employees

xx,xxx

Cash paid for other operating expenses

xx,xxx

Interest paid

xx,xxx

Income taxes paid

xx,xxx

Net cash from operating activities

xx,xxx

The indirect method adjusts accrual basis net profit or loss for the effects of non-cash

transactions. The operating cash flows section of the cash flow statement under the indirect

method would appear something like this:

Profit before interest and income taxes

xx,xxx

Add back depreciation

xx,xxx

Add back amortization of goodwill

xx,xxx

Corporate Finance FIN 622

Increase in receivables

xx,xxx

Decrease in inventories

xx,xxx

Increase in trade payables

xx,xxx

Interest expense

xx,xxx

Less Interest accrued but not yet paid

xx,xxx

Interest paid

xx,xxx

Income taxes paid

xx,xxx

Net cash from operating activities

xx,xxx

Cash flows relating to extraordinary items should be classified as operating, investing or financing

as appropriate and should be separately disclosed [IAS 7.29]

· The exchange rate used for translation of transactions denominated in a foreign currency and the

cash flows of a foreign subsidiary should be the rate in effect at the date of the cash flows [IAS

7.25]

· Cash flows of foreign subsidiaries should be translated at the exchange rates prevailing when the

cash flows took place [IAS 7.26]

· As regards the cash flows of associates and joint ventures, where the equity method is used, the

cash flow statement should report only cash flows between the investor and the investee; where

proportionate consolidation is used, the cash flow statement should include the venturer's share of

the cash flows of the investee [IAS 7.37-38]

· Aggregate cash flows relating to acquisitions and disposals of subsidiaries and other business units

should be presented separately and classified as investing activities, with specified additional

disclosures. The aggregate cash paid or received as consideration should be reported net of cash

and cash equivalents acquired or disposed of [IAS 7.39]

· Cash flows from investing and financing activities should be reported gross by major class of cash

receipts and major class of cash payments except for the following cases, which may be reported on

a net basis: [IAS 7.22-24]

cash receipts and payments on behalf of customers (for example, receipt and repayment

of demand deposits by banks, and receipts collected on behalf of and paid over to the

owner of a property)

cash receipts and payments for items in which the turnover is quick, the amounts are

large, and the maturities are short, generally less than three months (for example, charges

and collections from credit card customers, and purchase and sale of investments)

cash receipts and payments relating to fixed maturity deposits

cash advances and loans made to customers and repayments thereof

· investing and financing transactions which do not require the use of cash should be excluded from

the cash flow statement, but they should be separately disclosed elsewhere in the financial

statements [IAS 7.43]

· the components of cash and cash equivalents should be disclosed, and a reconciliation presented to

amounts reported in the balance sheet [IAS 7.45]

· the amount of cash and cash equivalents held by the enterprise that is not available for use by the

group should be disclosed, together with a commentary by management [IAS 7.48]

Defining Working Capital

The term working capital refers to the amount of capital which is readily available to an organization. That

is, working capital is the difference between resources in cash or readily convertible into cash (Current

Assets) and organizational commitments for which cash will soon be required (Current Liabilities).

Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course

of business".

Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of

business".

Thus:

WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

In a department's Statement of Financial Position, these components of working capital are reported under

the following headings:

Corporate Finance FIN 622

Current Assets

· Liquid Assets (cash and bank deposits)

· Inventory

· Debtors and Receivables

Current Liabilities

· Bank Overdraft

· Creditors and Payables

· Other Short Term Liabilities

The Importance of Good Working Capital Management

Working capital constitutes part of the Crown's investment in a department. Associated with this is an

opportunity cost to the Crown. (Money invested in one area may "cost" opportunities for investment in

other areas.) If a department is operating with more working capital than is necessary, this over-investment

represents an unnecessary cost to the Crown.

From a department's point of view, excess working capital means operating inefficiencies. In addition,

unnecessary working capital increases the amount of the capital charge which departments are required to

meet from 1 July 1991.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum balance of each of the working

capital components. This includes making sure that funds are held as cash in bank deposits for as long as

and in the largest amounts possible, thereby maximizing the interest earned. However, such cash may more

appropriately be "invested" in other assets or in reducing other liabilities.

Working capital management takes place on two levels:

· Ratio analysis can be used to monitor overall trends in working capital and to identify areas

requiring closer management (see Chapter Three).

· The individual components of working capital can be effectively managed by using various

techniques and strategies (see Chapter Four).

When considering these techniques and strategies, departments need to recognize that each department has

a unique mix of working capital components. The emphasis that needs to be placed on each component

varies according to department. For example, some departments have significant inventory levels; others

have little if any inventory.

Furthermore, working capital management is not an end in itself. It is an integral part of the department's

overall management. The needs of efficient working capital management must be considered in relation to

other aspects of the department's financial and non-financial performance.

Cash Operating Cycle

Cash Conversion Cycle, also known as the asset conversion cycle, net operating cycle, working capital

cycle or just cash cycle, is used in the financial analysis of a business. The higher the number, the longer a

firm's money is tied up in business operations and unavailable for other activities such as investing. The

cash conversion cycle is the number of days between paying for raw materials and receiving cash from

selling goods made from that raw material.

· Cash Conversion Cycle = Average Stockholding Period (in days) + Average Receivables Processing

Period (in days) - Average Payables Processing Period (in days)

with:

· Average Stockholding Period (in days) = Closing Stock / Average Daily Purchases

· Average Receivables Processing Period (in days) = Accounts Receivable / Average Daily Credit

Sales

· Average Payable Processing Period (in days) = Accounts Payable / Average Daily Credit Purchases

Corporate Finance FIN 622

A short cash conversion cycle indicates good working capital management. Conversely, a long cash

conversion cycle suggests that capital is tied up while the business waits for customers to pay.

It is possible for a business to have a negative cash conversion cycle, i.e. receiving customer payments

before having to pay suppliers. Examples are typically companies that employ Just in Time practices such as

Dell, and companies that buy on extended credit terms and sell for cash, such as Tesco.

The longer the production process, the more cash the firm must keep tied up in inventories. Similarly, the

longer it takes customers to pay their bills, the higher the value of accounts receivable. On the other hand, if

a firm can delay paying for its own materials, it may reduce the amount of cash it needs. In other words,

accounts payable reduce net working capital.

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