Cash flow analysis
Firstly, we should analyse the structure of cash flow statement.
As known, cash flow statement is divided into three parts: operating cash flow, investing cash flow and financing cash flow. And in operating cash flow,
there're two methods to prepare it: the direct and indirect method of cash flow.
Secondly, when you're analysing the cash flow, you should note the cash requirements as the following:
1. Repayment of existing loans.
All loans to be repaid in the next couple of years should be considered, including any convertible loans.
2. Increase in working capital.
When the business is expanding, working captial will also need to increase. You should know the coefficient: (Inventory + receivables -
Suppose this is 30% ans sales are currently $1m, a 20% increase in sales requires finance of 0.06m(1m*20%*30%) to increase the working
3. Capital expenditure requirements.
It's necessary to consider whether the company will have sufficient cash to meet this capital expenditure.
4. Other commitments.
You should know the deadline.
5. Contingent liabilities.
If these liabilities are very high, their crystallisation could cause real problems for the company. Especially in list companies, guaranting
mutually is very dangerous.
6. Leasing commitments.
If these are material,they should be carefully monitored in relation to the cash available.
So you can know the cash situation of the company when you're analysing the cash flow. You should note the cash shortfall, after all, that many companies
go bankrupt is just because of cash break. Here, if you want to know more details, read Free Cash Flow: Seeing Through the Accounting Fog Machine to
Find Great Stocks (Wiley Finance)
1. Cash flow
Cash flow statement is a financial stuation changing statement according from the cash as the basic. It reflects the cash inflow and outflow within a certain
period. It shows the ability of gainning cash and cash equivalents. And controlling the cash flow more effeciently can improve the performance of
The cash flow can be classified into: operating cash flow, investing cash flow and financing cash flow.
Net cash flow from operating activities represents the net increase of decrease in cash form the operations. There are two methods to report the net cash
flow from operating activities: the direct and indirect method of cash flow. Net cash flow from investing activities includes: that paid and received for
property, plant and equipment and other non-current assets, interest and dividends received on investments. Net cash flow from financing activities
comprise receipts or repayments of principal from or to external providers of finance.
The cash flow statement is very important in the financial statements. Because the cash flow is very, very important in the company. As known, the
condition of bankrupt is not how much of your liabilities, but it's that you can redeem the liabilities or not on time. That means cash flow statement shows
your cash flow condition.
Here, there is a sample cash flow statement.
Cash flow statement is one of basic important financial statements. When you're learning how to prepare the cash flow statement, you should know how
to analyse the cash flow at the same time. You need analyse synthetically balance sheet, income statment, accounting policies and explanatory notes to
analyse the operational situation of the company. And you'll know how to control the finance of the company, how to improve the performance, the
operation efficiency and the management of the enterprise.
2. Operating cash flow
As known, profit before tax is using the accruals concept, but net cash flow from operating activities only records the cash inflows and outflows according
to the trading. Some operating activities impact profit before tax, but not operating cash flow, because of the the accruals concept.
The indirect method starts with profit before tax, and adjusts according to the depreciation, profit/loss on disposal of non-current asset, balance sheet
change in receivables, balance sheet change in inventories, and balance sheet change in payables.
Then you should understand the reconciliation between profit before tax and net cash flow from operating activities as the following:
Depreciation is a book write-off of capital expenditure. But please note that capital expenditure will be recorded into investing activities.
Therefore, the depreciation represents an addition to reported profit in deriving cash inflow.
2. Profit/loss on disposal of non-current asset.
If the profit or loss on the sale has been included in profit before tax, an adjustment is necessary in computing operating cash flow. A loss
means added to reported profit, a profit means deducted from the reported profit.
3. Balance sheet change in receivables.
The figure changed in receivables is using the accruals concept, the receivables mean that you haven't received it, but it can impact the
profit before tax. For example, there's a revenue in ledger, you haven't received the cash, but it'll generate the related tax. So you should
consider this part.
4. Balance sheet change in inventories.
The inventories will impact the cash flow, because cash was spent on its purchase or a payable incurred, it represent an actual or potential
cash outflow. A corresponding adjustment would be made to payables to the extent that the expense relating to such payables will not have
been charged in the income statement. The practical difficulties is to determine how much inventory has not been paid for at the balance
5. Balance sheet change in payables.
It does not represent a cash outflow until paid. An increase in payables between two balance sheet dates is an addition to reported profit, a
decrease means a deduction from reported profit. If the purchase doesn't result in charge to the income statement in the current year, the
corresponding payable is not included in the reconciliation of profit to net cash inflow. For example, a payable in respect of non-current asset
is not included.
As the direct method, you should know:
1. the sales to derive cash received from customers
2. the purchases to derive cash payments to suppliers
3. the wages to derive cash paid to and on behalf of employees.
And interest paid is shown as part of operating activeites, but dividends paid are shown as part of financing activities. Cash flow arising from taxes on
income should be separately disclosed as part of operating activities unless they can be specifically identified with financing and investing activities.
3.Investing cash flow
Net cash flow from investing activities includes: that paid and received for property, plant and equipment and other non-current assets, interest and
dividends received on investments. Through it, you can know the resources transferred in order to obtain the earning in the future and cash flow, and the
cash inflows arising from the resources transferred previously.
1. cash paid for property, plant and equipment an dother non-current assets
2. cash received on the sale fo property, plant and equipment and other non-current assets
3. cash paid for investments in or loans to other enterprises
4. cash received for the sale of investments or the repayment of loans to other enterprises
5. interest received on investments or loans
6. dividends received on investments.
According to these items, you should analyse the cash flow is whether enough for investing or not.
4. Financing cash flow
Net cash flow from financing activities comprise receipts or repayments of principal from or to external providers of finance. It can help the investors and
creditors estimate the claim for the cash flow of the company in the future, and the price to obtain the cash inflows previously.
Financing cash inflows include:
1. receipts form issuing shares or other equity instruments
2. receipts for missuing debentures, loans, notes and bonds and from other long-term and short-term borrowings, but not including overdrafts,
which are included in cash and cash equivalents.
Financing cash outflows include:
1. repayments of amounts borrowed, but not including overdrafts
2. the capital element of finance lease rental payments
3. payments to reacquire or redeem the entity's shares.
You should measure the price of financing cash flow and the earnings when you're financing the cash flow.
5. The direct and indirect method of cash flow
Net cash flow from operating activities represents the net increase or decrease in cash form the operations. There are two methods: the direct and indirect
method of cash flow. The direct and indirect method of cash flow from operating activities can be used to prepare the cash flow statement, the direct and
indirect method have their advantages and disadvantages.
The direct method shows operating cash receipts and payments, including: cash receipts from customers, cash payments to suppliers and cash payments
and on behalf of employees. The advantage of the direct method is that it shows operating cash receipts and payments. The disadvantage is the significant
cost that there may be in preparing the information.
The indirect method starts with profit before tax and adjusts it for non-cash charges and credits to reconcile it to the net cash flow from operating
activities. The advantage of the indirect method is that it highlights the differences between reported profit and net cash flow from operating activities.
The disadvantage is the lack of information on the significant elements of trading cash flows.
The cash flow statement format using the indirect method starts with the calculation of operating cash flow form the profit before tax.
Journals and ledger accounts
We know, the route by which transactions are recorded is: Transactions --> Journals --> Ledger accounts --> Financial statements.
But what's the difference of journals and ledger accounts?
Journals record the transactions of each day.
A ledger account (or called 'T' account) is where all transactions of a similar type are recorded. Ledger accounts are pages in a book with a separate page
reserved for transactions of the same type. Each aspect is recorded in the relevant ledger account. In fact, there're a large number of ledger accounts, but
each has their meaning and each transaction will be relevant to the corresponding ledger account.
So, journals record the transactions, and ledger accounts take these Journals into the 'T' account.
Each 'T' account has two sides: the debit side and the credit side. This means we must master the double entry.
When you record all the transactions based on double entry in an accounting period, you'll receive the trial balance, it's the basic of preparing financial
statements. As known, the difficulty is how to prepare the correct journals, and how to take the transactions into the correct ledger accounts. Because
there're a large number of ledger accounts, and each insteads the result of the business behavior.
When you are ready to prepare financial statements (including balance sheet, income statement and cash flow), you should know clearly and master how
to do it right.