A key part of the Financial Reporting (FR) exam is the ability to analyse a set of financial statements. The statement of cash flows is one of the primary financial statements, and FRcandidates must be able to explain the performance of an entity based on all the financial statements including the statement of cash flows. To do this, candidates must understand the different sections of the statement and the implications for the business.
One of the first things to note is to not simply comment on the overall movement in the total cash and cash equivalents figure in the year. An increase in this figure does not necessarily mean that the entity has performed well in the year. A situation could easily arise where an entity is struggling to generate cash in a period and is forced to sell its owned properties and lease them back in order to continue. This may mean that the entity’s overall cash position increases in the period, but is clearly not a sign that the entity has performed well. This would be a significant concern, as the entity cannot simply sell its properties again in the future. There will also be fewer assets owned by the entity in the future, meaning that its ability to secure future borrowing may be limited. Any candidate simply commenting that the entity has performed well as the overall cash figure has increased is unlikely to score any marks, as they have not really understood the reasons behind the movement.
A good analysis will examine the statement of cash flows in detail and look for the reasons behind the movement, commenting on how the entity has performed. The statement of cash flows contains three sections: cash flows from operating activities, investing activities and financing activities. Each of these sections gives us useful information about an entity’s performance.
Operating activities
The first key figure to address is likely to be cash generated from operations. This shows how much cash the business can generate from its core activities, before looking at one-off items such as asset purchases/sales and raising money through debt or equity. The cash generated from operations figure is effectively the cash profit from operations. The cash generated from operations figure should be compared to the profit from operations per the statement of profit or loss to show the quality of the profit.
The closer these two are together, the better the quality of profit. If the profit from operations is significantly larger than the cash generated from operations, it shows that the business is not able to turn that profit into cash, which could lead to problems with short-term liquidity.
When examining cash generated from operations, examine the movements in working capital which have led to this figure. Large increases in receivables and inventories could mean problems for the cash flow of the business and should be avoided if possible. The company may have potential irrecoverable debts or a large customer with increased payment terms may have been taken on. Either way, the company needs to have enough cash to pay the payables on time.
Look for large increases in payables. If a company has positive cash generated from operations, but a significant increase in the payables balance compared to everything else, it may be that the company is delaying paying its suppliers in order to improve its cash flow position at the end of the year.
The cash generated from operations figure should be a positive figure. This ensures that the business generates enough cash to cover the day to day running of the company. The cash generated from operations should also be sufficient to cover the interest and tax payments, as the company should be able to cover these core payments without taking on extra debt, issuing shares or selling assets.
Any cash left over after paying the tax and interest liabilities is thought of as ‘free cash’, and attention should be paid as to how this is spent. Ideally, a dividend would be paid out of this free cash, so that a firm does not have to take out longer sources of finance to make regular payments to its shareholders. Other good ways of using this free cash would be to invest in non-current assets (as this should generate returns in the future) and paying back loans (as this will reduce further interest payments).
Investing activities
This section of the statement of cash flows focuses on the cash flows relating to non-current assets.
For example, sales of assets can be a good thing if those assets are being replaced. However, as stated earlier, if a company is simply selling off assets to manage short-term liquidity requirements, this makes the financial position significantly weaker, and banks will be less willing to lend as there are less assets to secure a loan against.
The sale of assets should not be used to finance the operating side of the business or to pay dividends. This is poor cash management, as a company will not be able to continue selling assets in order to survive. This is an indication that a company is shrinking and not growing.
Whilst purchases or sales of non-current assets may be relatively irregular transactions, the presence of interest received, or dividends received may well be recurring cash flows arising from investments the entity holds.
Financing activities
The sources of financing any increases in assets should also be considered. If this can be financed out of operations, then this is the best scenario as it shows the company is generating significant levels of surplus cash. Funding these out of long-term sources (ie loans or shares) is also fine, as long-term finances are appropriate to use for long term assets.
However, when raising long-term finance, it is also useful to consider the future consequences. For example, taking out loans will lead to higher interest charges going forward. Higher levels of debt will also increase the level of gearing in the entity, meaning that finance providers may charge higher interest rates due to the increased risk. It may also mean that loan providers are reluctant to provide further finance if the entity already has significant levels of debt.
Raising funds from issuing shares will not lead to interest payments and will not increase the level of risk associated with the entity. However, issuing shares will lead to more shareholders and possibly higher total dividend payments in the future.
In summary, a well-rounded answer will absorb all the information contained within a statement of cash flows, using this to produce a thorough discussion of an entity’s performance. Candidates who can do this should perform well on these tasks and are more likely to have demonstrated a much greater understanding of performance than simply commenting on whether the overall cash balance has gone up or down.
Written by a member of the Financial Reporting examining team
