Analysing a statement of cash flows (2024)

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

Introduction

As an expert in financial reporting and analysis, I have a deep understanding of the concepts and principles involved in analyzing financial statements. I have extensive experience in interpreting financial data and drawing meaningful insights from it. I can help you understand the key concepts discussed in the article you provided.

Analyzing the Statement of Cash Flows

The statement of cash flows is a crucial financial statement that provides insights into the cash inflows and outflows of an entity. It helps assess the entity's ability to generate cash, meet its financial obligations, and fund its operations. Let's explore the key concepts discussed in the article:

1. Overall Movement in Total Cash and Cash Equivalents

  • Merely commenting on the overall movement in the total cash and cash equivalents figure for a year is not sufficient to evaluate an entity's performance.
  • An increase in this figure does not necessarily indicate that the entity has performed well.
  • For example, an entity may sell its owned properties and lease them back to generate cash in the short term. This may temporarily increase the overall cash position but does not reflect sustainable performance.
  • It is essential to understand the reasons behind the movement in the cash and cash equivalents figure.

2. Cash Flows from Operating Activities

  • Cash generated from operations is a key figure to assess an entity's ability to generate cash from its core activities.
  • It represents the cash profit from operations and should be compared to the profit from operations reported in the statement of profit or loss.
  • The closer these two figures are, the better the quality of profit.
  • If the profit from operations is significantly larger than the cash generated from operations, it indicates that the business is not effectively converting profit into cash, which may lead to short-term liquidity problems.
  • Analyzing the movements in working capital, such as receivables and inventories, is crucial to understanding the cash flow implications.

3. Cash Flows from Investing Activities

  • This section focuses on the cash flows related to non-current assets.
  • Selling assets can be positive if they are being replaced, but if assets are sold to manage short-term liquidity requirements, it weakens the financial position of the entity.
  • Banks may be less willing to lend if there are fewer assets to secure a loan against.
  • Selling assets to finance the operating side of the business or pay dividends is poor cash management and indicates a shrinking rather than growing company.

4. Cash Flows from Financing Activities

  • It is important to consider the sources of financing for any increases in assets.
  • Financing through operations is ideal, as it demonstrates that the company generates significant levels of surplus cash.
  • Long-term sources such as loans or shares are also appropriate for funding long-term assets.
  • However, it is crucial to consider the future consequences of raising long-term finance, such as higher interest charges and increased risk due to higher levels of debt.
  • Issuing shares may not lead to interest payments but can result in more shareholders and potentially higher dividend payments in the future.

5. Thorough Analysis of the Statement of Cash Flows

  • A well-rounded analysis of the statement of cash flows involves absorbing all the information it provides.
  • Candidates who can thoroughly discuss an entity's performance based on the statement of cash flows are more likely to demonstrate a deeper understanding than those who focus solely on the overall cash balance.
  • It is important to consider the reasons behind the movement in cash flows, the quality of profit, working capital movements, and the implications of financing activities.
  • This comprehensive analysis provides valuable insights into an entity's financial performance.

Conclusion

Analyzing the statement of cash flows is a critical skill for financial reporting candidates. By understanding the different sections of the statement and their implications for the business, candidates can provide a thorough evaluation of an entity's performance. It is essential to go beyond the overall cash balance and consider factors such as cash generated from operations, investing activities, and financing activities. This comprehensive analysis allows for a deeper understanding of an entity's financial health and performance.

Analysing a statement of cash flows (2024)

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