Chapter 5: Financial Position and Cash Flows

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1 Chapter 5: Financial Position and Cash Flows Balance Sheet: Usefulness Also known as Statement of Financial Position The balance sheet provides information: for evaluating the capital structure and for computing rates of return on invested assets It is also useful for assessing an enterprise s: o Liquidity (time until asset is realized or liability has to be paid) o Solvency (ability to pay debts and related interest) o Financial flexibility (ability to respond to unexpected needs and opportunities) Liquidity Current Ratio: CurrentAssets CurrentLiabilities Quick Ratio Cash, MarketableS ec urities, NetReceivables AverageCurrentLiabilities Working Capital = Current Assets Current Liabilities Combining with Statement of Cash Flow Current Cash Debt Coverage Ratio = Average Current Liabilities Solvency Coverage Ratios: TotalDebt Debt to assets: TotalAssets Debt to equity: TotalDebt Shareholders ' Equity Flexibility Combining with Statement of Cash Flow o Cash Debt Coverage Ratio = Average Total Liabilities 1. Free cash flow

2 Calculated as net cash from operations less capital expenditures and dividends Balance Sheet: Limitations 1. Many assets and liabilities are stated at historical cost o Information presented is reliable, however o Reporting at current fair value would result in more relevant information 2. Judgement and estimates are used in determining many of the items reported on the Balance Sheet o Many soft numbers (estimates) are included which may be uncertain o e.g. accounts receivable; inventory 3. The balance sheet does not report items that cannot be recorded objectively (e.g. internally generated goodwill) Balance Sheet: Classification Similar items are grouped together, with sub-total Items with different characteristics are separated Individual balance sheet items should be: Reported separately, and in Sufficient detail in order to: Allow users to assess amounts, timing, and uncertainty of future cash flows Allow users to evaluate liquidity, financial flexibility, profitability, and risk Helps to calculate important ratios (e.g. current ratio to assess liquidity) More choice and flexibility is permitted under IFRS with respect to the format of the balance sheet (reverse order liquidity is more common). Profitability Return on assets: Return on equity: NetIncome AverageTotalAssets NetIncome AverageCommonShareholders ' Equity Elements Of The Balance Sheet Assets: Present economic benefits that the entity has rights or access to (and others do not) Liabilities: Present economic obligation/burden that is enforceable Equity (or net assets): The residual interest in assets after liabilities are deducted Balance Sheet: Classification Assets: Current assets

3 Long-term investments Property, plant, and equipment Intangible assets Other assets Liabilities and Equity: Current liabilities Long-term debt Shareholders equity o Capital shares o Contributed surplus o Retained earnings o Accumulated other comprehensive income / other surplus Financial Instruments vs. Monetary Items Financial instruments o include three categories 1. Cash 2. Strategic investments in other companies 3. Contractual rights to receive or contractual obligations to deliver cash or another financial instrument (examples: all receivables, payables, loans, passive investments in stocks, bonds, derivatives, etc.) Classified into financial assets and financial liabilities Monetary items include category (1) and (3) only Classified into monetary assets and monetary liabilities Most are reported at FAIR VALUE Owners Equity Capital Shares (also called contributed capital) Outstanding shares: reported the amount at par Contributed Surplus Outstanding shares: reported the amount in excess of par (i.e., share premiums) Retained Earnings Net income made and retained in business Accumulated Other Comprehensive Income (AOCI) Beginning AOCI + OCI = Ending AOCI More Issues on Balance Sheet Supplemental information Contingencies Accounting policies Contractual situations Additional detail Subsequent events

4 Disclosure techniques Notes, schedules, parenthetical explanations, cross references, etc. Statement of Cash Flows Cash is the long-term indicator of a firm s success or failure Statement of Cash Flows shows: o Where the cash came from: cash inflow o What the cash was used for: cash outflow o What was the change in the cash balance Statement of Cash Flow divided cash flows into: o Cash flow from operating activities o Cash flow from investing activities o Cash flow from financing activities Classifications of Cash Flows Operating activities o Inflows: Collection of Revenues, including interest o Outflows: Payment of Expenses, including interest Investing activities o Inflows: Disposals of our land, building, equipment; Sale of securities; Collections of loans made to others o Outflows: Purchases of land, building, equipment; Purchase of securities; Loans made to others Financing activities o Inflows: Borrowing money from others, Contributions by owners (i.e., investments into the company) o Outflows: Distributions to owners; Repayment of loans, but not interest; Reacquisition of capital stock Statement of Cash Flows Presentation Presentation methods o Direct method: includes specific cash inflows/outflows (e.g. Cash received from customers, cash paid to suppliers and employees, interest paid/received, taxes paid, etc) o Indirect method: begins with net income and reconciles to cash (e.g. adds back non-cash charges deducted from net income, such as depreciation) Both methods are acceptable Statement of Cash Flows Presentation Illustration Text 5-16 to 5-19 (p ): Indirect method to prepare for Statement of Cash Flow Understand the impact of the change of each account (inventory, accounts receivable, etc.) on the cash flow (for example, the increase in accounts receivable would result in an increase or decrease in cash flow?) Most extensive discussion is in Ch22 (adms3595)

5 Usefulness of the Statement of Cash Flows Cash is a company s lifeblood Provides creditors with useful information about a company, such as: 1. Company s ability to generate net cash from operating activities 2. Net cash flow trends or patterns from operating activities 3. Major reasons for positive or negative net cash from operating activities 4. Whether the cash flows are renewable or sustainable Provides insight into the following areas: o Financial Liquidity Current Cash Debt Coverage Ratio = Average Current Liabilities o Financial Flexibility Cash Debt Coverage Ratio = Average Total Liabilities Cash Flow Patterns o There may be useful patterns identified of cash inflows and outflows from operating, investing and financing activities Free Cash Flow o Calculated as net cash from operations less capital expenditures and dividends o Answers questions such as, What is the free cash left to invest or expand? Is the company able to pay dividend without seeking external financing? Will the company be able to maintain its needed capital investment if business operations decline?

Name of business Statement of cash flows for the financial year end 31 December 20X1 (DIRECT METHOD) Inflow /(outflow)

Name of business Statement of cash flows for the financial year end 31 December 201 (DIRECT METHOD) Calc Notes Inflow /(outflow) CASH FLOWS FROM OPERATING ACTIVITIES Cash receipts from customers C1 Cash