Module 7: Case study the Cash Flow Statement

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1 Module 7: Case study the Cash Flow Statement Watch the cash flow video > Among the primary financial statements, the Cash Flow Statement always comes after the Income Statement and the Balance Sheet and these ancillary statements that have been developed to fill gaps between the two, the Statement of Comprehensive Income and the Statement of Changes in Equity. It is important not to ignore cash flow and believe that it can take care of itself we know this from personal financial experience and it applies equally to organisations. For small start-up companies, cash flow is the life blood and failure to manage it properly can undo a perfectly valid commercial proposition. As companies grow, management preoccupation shifts from the short-term imperative of ensuring that there is enough money to pay bills, towards ensuring continuity of financing for the medium term and how to use that finance most effectively to minimise costs. Because money costs and compounding cost is a slippery slope downwards whereas the road to wealth is partly about compounded income.

2 The Cash Flow Statement sets out some clear categories of cash flow starting with: Cash generated from operations The figure of million, roughly 10% of turnover, does not appear on the face of the Income Statement. It comes from Note 30 to the Financial Statements which starts with Profit before taxation and then strips out anything to do with the financing of the business interest income and costs and any non-cash items that are purely accounting adjustments. Having taken these items out, profit before taxation becomes a positive cash flow of million.

3 Changes in working capital Another activity which impacts operating cash flow is working capital management. This aims to: - Minimise the level of inventories through effective logistics and supply chain management - Encourage debtors to pay you quicker or even just to agreed terms - Negotiate additional credit from suppliers The difference between working capital levels at the beginning and end of each trading period has a direct impact on the cash generated. In this instance, it has helped generate another 5.0 million which in interest terms, at say 4%, is worth 200,000 a year. This serves as a reminder that attention to detail and the accumulated impact of small differences can make a big one.

4 Net cash flow from operating activities reflects adjustments for net Finance costs of 19.3 million and tax. The tax line shows a receipt of 1.0 million. Usually, organisations pay tax to the government, not the other way round. The answer is in the taxation note to the Financial Statements. Lease incentives received from landlords are capitalised as liabilities and then released to income time. The tax treatment of lease incentives mirrors the accounting treatment. However, a change in reporting framework by one of the group s principal subsidiaries from UK Generally Accepted Accounting Practice or GAAP to International Financial Reporting Standards (known by the acronym IFRS) has extended the life over which lease incentives are amortised, giving rise to an accounting adjustment. The tax consequence of this is a prior year tax credit that has resulted in a repayment. By way of comparison, tax paid in the previous year 2013/14 was 20.9 million. Cash flows from investing activities This section of the cash flow statement considers the money spent on the fixed capital element of the business. This is referred to as investment as it is intended to protect and increase future profits. In any event, it is an application of funds which will feed back into operating cash flows over time as extra profit. - Purchase of tangible assets property, plant and equipment cost 79.6 million during the year compared with million during the previous year. Depreciation of tangible assets was 87.7 million during the year. - - The level of expenditure suggests that investment is doing little more than maintaining the status quo, even though new replacement assets will more than likely cost more than those being depreciated. There are no hard and fast rules about what constitutes the right level of investment but the level of investment in new fixed assets can be a measure of corporate health. - By contrast, the investment in intangibles of 54.0 million is greater than in the previous year and exceeds the amortisation of intangibles of 16.5 million. It is clear that there is a strategy of upgrading and improving systems. The analysis suggests a commitment to the development of bespoke software in-house which is likely to be more expensive than simply adopting tried and tested industry standard software. Cash flow from financing activities - A vital component required to understand the finance of a business is insight into how it adds to the store of money that is available to it. This section of the Cash flow statement

5 shows that Debenhams has taken the opportunity of strong operating cash flow to repay some of its debt, in the form of its senior notes and its revolving credit facility. This will give rise to a significant reduction in interest costs and a resulting increase in profits. - This section also includes the dividends paid to shareholders of 41.7 million. Why are dividends shown here in financing activities and not in Net cash generated from activities which is where interest costs are shown? - The important difference about dividends is that they are discretionary. Unlike interest which is payable contractually and is a clear example of a business cost, dividends represent an appropriation of profit and such distributions need ratification by shareholders. The effect of all these inflows and outflows is the impact on the Net cash and cash equivalents and the figure at the foot of the Statement ties in with the figure that appears in the Consolidated Balance Sheet. The Consolidated Cash Flow Statement does not include a reconciliation of the group s net debt because the expression net debt is not one that appears in Primary Statements because it offsets assets (cash) and liabilities (borrowings). However, it is used by management within its preferred KPIs and by investors/analysts and commentators. It is included in the Report and Accounts at Note 31 Analysis of changes in net debt, which cross-refers to the Consolidated Balance Sheet. Management of net debt To reiterate, the management of cash flow is an important financial management activity which sits beside the management of net debt. The exploitation of a business net assets is the preoccupation of the executive management team in their pursuit of profit or value. They rely on Finance and in particular the Treasury function to manage cash flow and the financial liabilities within the Balance Sheet.

6 The componentss of net debt are: - Cash (in the bank) and cash equivalents (such as bank or money market deposits) - Bank overdrafts - Borrowings split between Senior Notes and the Revolving Credit Facility - Finance lease obligations Senior notes are IOU s issued to lenders for a fixed period of time at a fixed rate of interest. Notes to the value of 225 million were issued in July 2014 repayable in The group bought back 25 million of these notes during the year. The revolving credit facility of 425 million was also arranged at the same time although 75 million was cancelled during the year, reducing the facility to 350 million. This credit facility gives the company flexibility to draw as and when it requires funds for varying short term periods. It is therefore effectively variable rate financing. It does not have to be fully drawn and it is available to suit the borrower. For this discretionary right to draw down, Debenhams will pay a commitment fee for the undrawn element. This is because the funding bank will have to reserve part of its capital to cover its commitment to Debenhams and this has a cost. The facility expires in October 2018, although there is an option to extend the borrowing to There appears to have been a concerted effort to reduce the reliance on traditional bank funding and diversify the sources of financing available to Debenhams. But within a relatively short period of time, the scale of financial flexibility has been reduced by 100 million suggesting a change in the group s investment ambitions. It suggests a lack of clarity in the corporate strategy or a deferral of expansion plans in the face of continuing difficulties with the UK economic environment. It also reflects the recent arrival of a new finance director, Matt Smith, who is more focussed on improvements in profitability and stronger operational cash flow. Financial risk management So how does a Treasurer determine what mix of these different components is optimal. Why not simply borrow money from a bank and just deposit any surplus money until it is needed? The Treasurer is first and foremost a risk manager. In the majority of cases, corporate treasuries are not profit centres, that is to say, they do not operate like a bank. The business and its needs come first and the Treasurer s role is to address the following: Liquidity The need for cash to pay bills as they fall due and collect revenue from customers efficiently is a clear priority, so day-to-day cash management comes first. In addition is the need to ensure that when debts fall due to be

7 repaid there are funds available. The Treasurer needs to be conscious of the debt repayment profile and ensure that he is prepared. A spread of maturities avoids the possibility that at precisely the moment when he needs to borrow, the market doesn t turn round and say I m sorry, not now. Security Applies particularly to investments. Historically Treasurers relied upon their relationship banks to be deposit takers if they had surplus funds. But banks creditworthiness has changed since 2008 and the UK government s deposit protection scheme only covers about 85,000 these days. So the creditworthiness of counter-parties requires regular review to ensure safety. Equally no Treasurer wants to arrange a credit facility with a counter-party is unable to renew when repayment comes around; Credit How does an organisation ensure that people with money will be happy to lend to it? Through prudent financial management, a decent credit rating for any public debt, and transparency over its performance and its financial structures; Cost The Treasurer needs to balance the need to be cost effective when borrowing and try and obtain competitive rates when borrowing. In a classic market, short-term rates are lower than long term rates as the longer you want to borrow, the more the market will factor in the risk of non-repayment and charge a higher rate. If you borrow too short term there is a risk of being caught out by sudden increases in interest rates. So a balance is needed between debt that is variable in its cost and that which has a fixed cost depending on: - your view on the future course of interest rates - your pain threshold if rates do suddenly increase unexpectedly Typically the higher the debt the more the Treasurer will want the peace of mind of knowing what the cost of funds is. But fixing the cost ten years ago might have proved a costly mistake as interest rates plummeted after 2008 with a consequence of comparatively high cost of funds in a slowing or static operating environment. And this would have constrained profit margins and profit growth.

8 Summary The effective control of an organisation s cash flow is a critical challenge for management in terms of its ability to carry on its business and invest for the future at a reasonable cost. Cash flows can be distinguished between: - Operating cash flows; - Investing activities; and - Financing activities The Treasurer has to be clear where an organisation s pain threshold is and make decisions about: the optimal level of indebtedness for the organisation i.e. what is a safe level of debt; an acceptable level of cost for the required financial security; the repayment profile that suits its projected cash flows; and gives it a degree of flexibility against the unexpected. To access related learning and development practice notes for in-house lawyers, sign up for a free trial of LexisPSL and discover the full portfolio of bespoke resources that LexisNexis has to offer for in-house lawyers.

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