Chapter 8

The Statement of Cash Flows

In This Chapter

Exploring the statement of cash flows

Understanding operating activities

Getting a grip on investments

Figuring out the financing section

Looking at other line items

Finding net cash from all company activities

Cash is a company’s lifeblood. If a company expects to manage its assets and liabilities and to pay its obligations, it has to know the amount of cash flowing into and out of the business, which isn’t always easy to figure out when using accrual accounting. (You can find out more about accrual accounting in Chapter 4.)

Accrual accounting makes it hard to pinpoint exactly how much cash a company actually holds, because cash doesn’t have to change hands for a company to record a transaction. The statement of cash flows is the financial statement that helps the financial report reader understand a company’s cash position by adjusting for differences between cash and accruals. (Refer to Chapter 4 for more information on cash and accruals.) This statement tracks the cash that flows in and out of a business during a specified period of time and lays out the sources of that cash. In this chapter, we explore the basic parts of the statement of cash flows.

Digging into the Statement of Cash Flows

Basically, a statement of cash flows gives the financial report reader a map of the cash receipts, cash payments, and changes in cash that a company holds minus the expenses that arise from operating the company. In addition, the statement looks at money that flows into or out of the company through investing and financing activities. As with the income statement (go to Chapter 7), a company provides two years’ worth of information on the statement of cash flows.

When reading the statement of cash flows, look for answers to these three questions:

Where did the company get the cash needed for operation during the period shown on the statement – from revenue generated, funds borrowed, issue of new shares, or the proceeds of sales of fixed assets?

What cash did the company actually spend during the periods shown on the statement?

What was the change in the cash balance during each of the years shown on the statement?

Knowing the answers to these questions helps you determine whether the company is thriving and has the cash needed to continue and grow its operations, or whether the company appears to have a cash-flow problem and could be nearing a point of fiscal disaster. In this section, we show you how you can use the statement of cash flows to find the answers to these questions.

The parts

Transactions shown on the statement of cash flows prepared under International Financial Reporting Standards are grouped in three parts:

Operating activities: This part includes cash transactions that involve revenue that was taken into the company through sales of its products or services and expenses that were paid out by the company to carry out its operations. (For more on operating activities, see the upcoming section ‘Checking Out Operating Activities’.)

Investing activities: This part includes the purchase or sale of the company’s investments and can include the purchase or sale of long-term assets, such as a building or a company division. Spending on capital improvements (upgrades to assets held by the company, such as the renovation of a building) also fits in this category, as does any buying or selling of short-term invested funds. (For more on this topic, see the upcoming section ‘Investigating Investment Activities’.)

Financing activities: This part involves raising cash through long-term debt or by issuing new shares. It also includes using cash to pay off debt or buy back shares. Companies also include any dividends paid in this section. (For more on operating activities, see the upcoming section ‘Understanding Financing Activities’.)

The sections of the cash flow statement using UK standards

Companies following UK standards have an amazing nine sections in the cash-flow statement:

Operating activities

Dividends from joint ventures and associates

Returns on investments and servicing of finance

Taxation

Capital expenditure and financial investment

Acquisitions and disposals

Equity dividends paid

Management of liquid resources

Financing

On the other hand, companies satisfying the legal definition of a small company (refer to Chapter 3) do not need to prepare a cash-flow statement at all!

Operating activities is the most important section of the statement of cash flows. In reading this section of the statement, you can determine whether the operations of a company are generating enough cash to keep the business viable. We discuss how to analyse this statement and make these determinations in Chapter 12.

The formats

A company can choose between two different formats when preparing its statement of cash flows, both of which arrive at the same total but use different information to get there:

Direct method: The International Accounting Standards Board (IASB; see Chapter 18) prefers the direct method, which groups major classes of gross cash receipts and gross cash payments. The IASB says that the direct method provides information that may be useful in estimating future cash flows and that is not available under the indirect method. The direct method is easier for the user to understand. Figure 8-1 shows you the direct method.

Indirect method: The indirect method starts with the figure for profit or loss in the income statement and adjusts it for the effect of transactions of a non-cash nature, deferrals, or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. The indirect method is easier for the company to prepare. Figure 8-2 shows you the indirect method.

The direct and indirect methods differ only in the operating activities section of the report. The investing-activities and financing-activities sections are the same, as shown in Figures 8-1 and 8-2. Despite the fact that the direct method is easier for the user to understand and is preferred by the IASB, it is rarely used in practice because the figures which are needed to prepare the statement are not usually readily available from the accounting system. Ease of preparation wins out over quality of information.

Figure 8-1: The direct method.

Figure 8-2: The indirect method.

You can easily calculate the information in the indirect method by using two years of financial statements. Anyone who reads the balance sheet and compares the data between the current and previous year can calculate most of the numbers shown by using the indirect method. The rest of the numbers can be obtained from the notes to the accounts.

For example, you can calculate changes in accounts receivable, inventories, and accounts payable by comparing the totals shown on the balance sheet for each of the two years. If a company shows £1,500,000 in inventory in 2006 and £1,000,000 in 2007, the change in inventory is shown using the indirect method ‘Decrease in Inventory – £500,000’. The statement of cash flows for the indirect method summarises information already given in a different way, but it doesn’t reveal any new information.

With the direct method, a company has to reveal the actual cash it receives from customers and the cash it pays to suppliers and employees. Someone reading the balance sheet and income statement can’t find these numbers in other parts of the financial report.

According to the IASB, cash flows from interest and dividends received and paid can be classified in any of the three parts of the cash-flow statement – as long as the approach adopted is followed consistently from year-to-year. Tesco follows the example included in International Accounting Standards (IAS) 7 by putting interest paid in the operating section, interest received and dividends received in the investing activities section, and dividends paid in the financing section. By contrast, Marks and Spencer put interest paid in the financing section.

The investing-activities and financing-activities sections for both the direct and indirect methods look something like Figures 8-3 and 8-4, both of which show some of the basic line items. (If you’re interested in finding out about line items that make their way onto the statement only in special circumstances, see ‘Recognising Special Line Items’ later in the chapter.)

Figure 8-3: The investing-activities section.

Figure 8-4: The financing-activities section.

You can find samples of Tesco’s and Marks and Spencer’s statements of cash flows in Appendix A.

Checking Out Operating Activities

The operating-activities section is where you find a summary of how much cash flowed into and out of the company during the day-to-day operations of the business.

Operating activities is the most important section of the statement of cash flows. If a company isn’t generating enough cash from its operations, it isn’t going to be in business for long. Although new companies often don’t generate a lot of cash in their early years, they can’t survive that way for long before going bust.

The primary purpose of the operating-activities section is to adjust the net income by adding or subtracting entries that were made in order to abide by the rules of accrual accounting that don’t actually require the use of cash. In this section, we describe several of the accounts in the operating-activities section of the statement and explain how they’re impacted by the changes required to revert accrual accounting entries to actual cash flow.

Depreciation

A company that buys a lot of new equipment or builds new facilities has high depreciation expenses that lower its net income. This is particularly true for many high-tech companies that must always upgrade their equipment and facilities to keep up with their competitors.

The bottom line may not look good, but all those depreciation expenses aren’t necessarily using cash. In reality, no cash changes hands to pay depreciation expenses. These expenses are actually added back into the equation when you look at whether a company is generating enough cash from its operations, because the company didn’t actually lay out cash to pay for these expenses.

For example, if a company’s net income is £200,000 for the year and its depreciation expenses are £50,000, it adds the £50,000 back in to find the net cash from operations, which is £250,000. Essentially, this company is in better shape than it looked to be before the depreciation expenses because of this non-cash transaction – in other words, the cash generated by operations is higher than it might at first appear. Remember, when the company buys the equipment it must lay out the cash price in full, but this cost is reflected in the investing-activities section of the cash-flow statement.

Inventory

Another adjustment shown on the statement of cash flows that would add cash to the mix is a decrease in inventory. If a company’s inventory on hand is less in the current year than in the previous year, then some of the inventory sold was actually bought with cash in the previous year.

On the other hand, if a company’s inventory increases from the previous year, then the company spent more money on inventory in the current year and it subtracts the difference from the net income to find its current cash holdings. For example, if inventory decreases by £10,000, the company adds that amount to net income.

Accounts receivable

Accounts receivable is the summary of accounts of customers who bought their goods or services on credit provided directly by the company.

Customers who bought their goods by using credit cards from banks or other financial institutions aren’t included in accounts receivable. Payments by outside credit sources are counted as cash instead, because the company receives cash from the bank or financial institution. The bank or financial institution collects from those customers, so the company that sold the goods or services doesn’t have to worry about collecting the cash.

When accounts receivable increase during the year, a company sells more products or services on credit than it collects in actual cash from customers. In this case, an increase in accounts receivable means a decrease in cash available.

The opposite is true if accounts receivable are a lower number during the current year than the previous year. In this case, a company collects more cash than it adds credit to customers’ credit accounts. In this situation, a decrease in accounts receivable results in more cash received, which adds to the net income.

Accounts payable

Accounts payable is an account that summarises the bills due that haven’t yet been paid, which means cash must still be laid out in a future accounting period to pay those bills.

When accounts payable increases, a company uses less cash to pay bills in the current year than it did in the previous one, so more cash is on hand. An increase in accounts payable has a positive effect on the cash situation. Expenses are shown on the income statement because they have been incurred, which means net income is lower. But in reality, the cash hasn’t yet been laid out to pay those expenses, so an increase is added to net income to find out how much cash is actually on hand.

Conversely, if accounts payable decreases, a company pays out more cash for this liability. A decrease in accounts payable means the company has less cash on hand, and it subtracts this number from net income.

The cash flow from activities section

To give you a taste of what all of these line items look like in the statement of cash flows in Table 8-1, we roll together the information from the previous sections to show you how it all comes together.

Table 8-1 Cash Flows from Operating Activities

Line Item	Cash Received or Spent
Net income	£200,000
Depreciation	£50,000
Increase in accounts receivable	(£20,000)
Decrease in inventories	£10,000
Decrease in accounts payable	(£10,000)
Net cash provided by (used in) operating activities	£230,000

In Table 8-1, the company has £30,000 more in cash from operations than it reported on the income statement, so the company actually generated more cash than you may have thought if you just looked at net income.

If you compare the statements for Tesco and Marks and Spencer (check out Appendix A) you can see that Tesco’s net cash from operating activities totalled £2,611 million after adjustments on £1,899 million profit for the year ended February 2007. This is a rate of £1.37 of cash for every £1 of profit, Marks and Spencer’s net cash was £1,293 million on £660 million of profit for the year – in other words, £1.96 of cash for every £1 of profit. Adjusting for the scale of the companies in this way, it looks as though Marks and Spencer did a better job of generating cash from its operations. But Marks and Spencer includes interest paid in the financing section rather than the operating section, which can make comparison tricky. However, in this case, working out an adjusted ratio for Marks and Spencer of £1.77 is relatively easy to do by reducing the operating cash flow by the amount of interest paid.

When performing ratio analysis, you must make sure to compare like with like. In Chapter 13, when we look at cash ratios, we use the figure from the top of the cash flow-statement – before deductions for interest and tax – so that we are comparing like with like.

Investigating Investing Activities

The investment activities section of the statement of cash flows, which looks at the purchase or sale of major new assets, is usually a drainer of cash. Consider what’s typically listed in this section:

Purchases of new buildings, land, and major equipment

Mergers or acquisitions

Major improvements to existing buildings

Major upgrades to existing factories and equipment

Purchases of new marketable securities, such as bonds or shares

The sale of buildings, land, major equipment, and marketable securities is also shown in the investment-activities section. When any of these major assets are sold, they’re shown as cash generators rather than as cash drainers.

The primary reason to check out the investments section is to see how the company is managing its capital expenditure (money spent to buy or upgrade assets) and how much cash it’s using for this expenditure. If a company shows large investments in this area, be sure to look for explanations in the Operating and Financial Review (or in some companies, a report with a different title, for example ‘Business Review’)and the notes to the financial statements (see Chapter 9) to get more details about the reasons for the expenditure.

If you believe that a company is making the right choices to grow the business and improve profits, investing in its shares may be worthwhile. If the company is making most of its capital expenditure to keep old factories operating as long as possible, it may be a sign that the company isn’t keeping up with new technology.

Compare companies in the same industry to see what type of expenditure each lists in investment activities and the explanations for this expenditure in the notes to the financial statement. Comparing the company with one of its peers helps you determine whether the company is budgeting its capital expenditures wisely.

In comparing the statements of Tesco and Marks and Spencer (see Appendix A), you can see that Tesco spent considerably more on purchases of property, plant, and equipment. Tesco’s spending totalled more than £2.8 billion, whereas Marks and Spencer spent about £700 million. However, Tesco’s sales are five times those of Marks and Spencer so on a pro rata basis Marks and Spencer spent more. In this case, both companies are investing adequately in the future and you would not consider one to be performing better than the other.

Understanding Financing Activities

Companies can’t always raise all the cash they need from their day-to-day operations. Financing activities are another means of generating cash. Any cash raised through activities that don’t include day-to-day operations can be found in the financing section of the statement of cash flows.

Issuing shares

When a company sells shares, it shows the money raised in the financing section of the statement of cash flows. The first time a company sells shares to the general public this sale is called an initial public offering (IPO; refer to Chapter 3 for more information about an IPO). If a company wants to raise cash later by selling more shares it normally does this by offering shares to its existing shareholders by means of a rights issue which is cheaper than offering shares to the general public. The term rights issue is used to describe the situation where existing shareholders are given the right to buy more shares in the company but this offer is not given to non-shareholders. The price set for a rights issue will be below the current market value of the shares to encourage existing shareholders to take up the rights. If they don’t wish to then they could sell the rights to somebody else.

Usually, when companies decide to raise extra capital by a rights issue, they do so to raise cash for a specific project or group of projects that they can’t fund by ongoing operations. The finance department must determine whether it wants to raise funds for these new projects by borrowing money (new debt) or by issuing shares (new equity). If the company already has a great deal of debt and finds that borrowing more is difficult, it may try to sell additional shares to cover the shortfall. We talk more about debt versus equity in Chapter 12.

Buying back shares

Sometimes you see a line item in the financing section indicating that a company has bought back its shares. Companies that announce a share buyback are usually trying to accomplish one of two things:

Increase the market price of their shares. (If companies buy back their shares, fewer shares remain on the market, thus raising the value of shares still available for purchase.)

Meet internal obligations regarding employee share options which guarantee employees the opportunity to buy shares at a price that’s usually below the price outsiders must pay for the shares.

Sometimes, companies buy back stock with the intention of going private (look at Chapter 3). In this case, company executives and the board of directors decide that they no longer want to operate under the watchful eyes of investors and the stock market. Instead, they prefer not to have to worry about satisfying so many company outsiders. We discuss the advantages and disadvantages of staying private in Chapter 3.

For many companies, an announcement that they’re buying back shares is an indication that they’re doing well financially and that the executives believe in their company’s growth prospects for the future. Because buybacks reduce the number of outstanding shares, a company can make its per-share numbers look better even though a fundamental change hasn’t occurred in the business’s operations.

If you see a big jump in earnings per share, look for an indication of share buyback in the financing-activities section of the statement of cash flows.

Paying dividends

Whenever a company pays dividends, it shows the amount paid to shareholders in the financing-activities section of the statement of cash flows. Companies aren’t required to pay dividends each year, but a company rarely stops paying dividends after the shareholders have become used to their dividend cheques.

If a company reneges on its decision to pay dividends, the market price of the share is sure to tumble. A company’s decision not to pay dividends after paying them in the previous quarter or previous year usually indicates that it’s having problems, and it raises a huge red flag.

Incurring new debt

When a company borrows money for the long term, this new debt is shown in the financing-activities section of the statement of cash flows. This type of new debt includes the issuance of bonds; notes; or other forms of long-term financing, such as a mortgage on a building.

When you read the statement of cash flows and see that the company has taken on new debt, be sure to look for explanations about how the company is using this debt in the Operating and Financial Review (OFR) and in the notes to the financial statements (see Chapter 9 for more information about the notes to the financial statements).

Paying off debt

Debt pay-off is usually a good sign, often indicating that a company is doing well. However, it may also be an indication that a company is simply rolling over existing debt into another type of debt instrument.

If you see that a company paid off one debt and took on another debt that costs about the same amount of money, this sign likely indicates that the company simply refinanced the original debt. Ideally, that refinancing involved lowering the company’s interest expenses. Look for a full explanation of the debt pay-off in the notes to the financial statement.

If you compare the financing activities of Tesco and Marks and Spencer (see Appendix A), you see that Tesco increased their long-term borrowing by £184 million but, on the other hand, bought back shares for £490 million and paid dividends of £467 million. Marks and Spencer paid down their long- term borrowings by £479 million as well as paying dividends of £261 million. Adding in the other smaller amounts in the financing section Tesco used £533 million of its cash for its financing activities, and Marks and Spencer used £876 million of its cash on hand for its financing activities.

When you look at the financing activities on a statement of cash flows for younger companies, you usually see financing activities that raise capital. Their statements include borrowing funds or issuing shares to raise cash. Older, more established companies begin paying off their debt when they’ve generated enough cash from operations.

Recognising Special Line Items

Sometimes you see line items on the statement of cash flows that appear unique to a specific company. Companies use these line items in special circumstances, such as the discontinuation of operations. Companies that have international operations use a line item that relates to exchanging cash among different countries, which is called foreign exchange.

Discontinued operations

If a company discontinues operations (stops the activities of a part of its business), you usually see a special line item on the statement of cash flows that shows whether the discontinued operations have increased or decreased the amount of cash a company takes in or distributes. Sometimes discontinued operations increase cash because the company no longer has to pay the salaries and other costs related to that operation.

Other times, discontinued operations can be a one-time hit to profits because the company has to make significant severance payments to laid-off employees and has to continue paying the costs of the manufacturing and other fixed costs related to those operations. For example, if a company leased space for the discontinued operations, the company is contractually obligated to continue paying for that space until the contract is up or the company finds someone to sublease the space.

Foreign currency exchange

Whenever a company has global operations, it’s certain to have some costs related to the cost of moving currency from one country to another. The pound, as well as currencies from other countries, can experience changes in currency exchange rates – sometimes 100 times a day or more.

Each time the exchange rate between two countries changes, moving currency between those two countries can result in a loss or a gain. Any losses or gains related to foreign currency exchanges are shown on a special line item on the statement of cash flows called ‘Effect of exchange rate changes’. Both Tesco and Marks and Spencer show the effects of currency exchange at the foot of their statements (see Appendix A). Tesco’s net cash reduced by £18 million, and Marks and Spencer’s reduced by £1.5 million.

Adding It All Up

This number is the big one, the highlight, the bottom line: ‘Cash and cash equivalents at end of year’. This number actually shows you how much cash or cash equivalents a company has on hand for continuing operations the next year.

Cash equivalents are any holdings that a company can easily change to cash, such as cash in current and deposit accounts, and money-market funds. Investments that can be converted to a known amount of cash within three months of acquisition are also included as cash equivalents. Investments in shares are excluded from cash equivalents since their realisable value may change.

The top line of the statement starts with cash flows from operating activities which is a figure derived from profit for the year. Adjustments are made to show the impact on cash from operations, investing activities, and financing. These adjustments result in the calculation of actual cash available for continuing operations. Remember that this is the cash on hand that the company can use to continue its activities the next year.

If you look at the statement of cash flows for Tesco and Marks and Spencer in Appendix A, you can see that Tesco had about £1 billion on hand at the end of February 2007 on profit for the year of about £1.9 billion. Marks and Spencer had only about £47 million in cash and cash equivalents at the end of March 2007 on profit for the year of £660 million. Both companies cash on hand actually decreased during the year.

In Part III, we delve more deeply into how the cash results of these two companies differed. We also show you how you can use the figures on the statement of cash flows and other statements in the financial reports to analyse the results and make judgements about a company’s financial position.