Chapter 03 cash flow management

Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU
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Chapter 3 – Outline (1)
• Introduction – The cash flow statement
• Usefulness of cash flow information
• Cash flow cycles
• Format and structure of the cash flow statement
• Cash flow from operating activities
• Cash flows from investing and financing activities
• Direct and indirect method for operating cash flows
• Constructing a cash flow statement
• Disposal of fixed assets
• Presentational differences

• A cash flow statement presents information about
the cash flows associated with the company’s main
operations and those associated with its investing
and financing activities of the period.
• A cash flow statement functions in conjunction with
both the income statement (performance dimension)
and the balance sheet (financial position)
• IAS 7 Cash Flow Statements
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Cash Flow Statement

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Usefulness of cash flow information
• Ability to generate adequate cash flows is a
significant performance dimension
• Cash flow information clarifies the dynamics of
short-term liquidity and long-term solvency
• Cash flow information is an essential input for
economic decision models

Cash flow versus profit
• Cash flow and profit are different economic phenomena
 But linked through the mechanisms of accrual
accounting!
• Cash flows are factual details of incoming and outgoing
flows of cash, while the balance sheet and income statement
emanate from professional judgement and are not a direct
projection of objective economic data
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Liquidity/solvency and cash flows
• Liquidity
- Relates to “nearness to cash” of the structure of assets
- Determined by capacity to convert current assets into cash
• Solvency
- Relates to future availability of cash in order to settle financial
liabilities on due date
- Determined by timing and uncertainty of expected future cash
payments and cash receipts
• Liquidity and solvency ratios are determined on
static financial position data, while cash flows
reflect changes in financial position

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Relationship with BS and IS
• Spontaneous Financing
 Firm will also always have minimum level of Accounts
Payable—in effect, money you have borrowed
• Accounts Payable (and Accruals) are generated spontaneously
• Arise automatically with inventory and expenses
• Offset the funding required to support current assets
Income statement
BS at start Cash flow BS at end
A cash flow statement reflects both “profit related” and “non-
profit related” activities (investing and financing) with an impact
on available cash over the period covered in the income statement

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Related questions????
1. From which sources did the company raise cash last year? How was
this cash used?
2. Were the normal operating activities capable of satisfying its need
for cash during the year?
3. If not, is the shortage of cash compensated by new borrowings,
issuing new share capital or by selling fixed assets?
4. Is a surplus of cash used for repayment of debt, for investments or
for distribution of dividends?
5. Why has the balance of cash available decreased, knowing that the
company’s operations have been profitable?

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Cash conversion cycles
• Cash flows through the company continuously in a
series of short-term and long-term conversion cycles
• The ST - cash conversion cycle (operating cycle)
relates to the main business
operations
 = OPERATING ACTIVITIES

Cash conversion cycles Continues 2
• The LT- cash conversion cycles relate to the
acquisition, renewal and disposal of intangible and
tangible infrastructure and the long-term sourcing of
funds
 Productive capacity acquired for cash and subsequently
consumed during several ST-operating cycles
 Acquisition and disposal of infrastructure =
INVESTING ACTIVITIES
 External sourcing of funds = FINANCING ACTIVITIES
• .
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•
Fig. 3.1 Long-term and short-term cash
flow cycles
•Inventory
•Work in Progress •Sales
•Receipts•Payments
•Procurement
•Current payables •Inventory •Current receivables
•Cash and cash
equivalents
•Main operations
•External financing
•Investing/ Productive
infrastructure

• Cash flows from operating activities
• + Cash flows from investing activities
• + Cash flows from financing activities
• Net change in cash during period
• + Beginning cash balance
• Ending cash balance
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Format and structure of the cash flow
statement

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Format and structure of the cash flow
statement

Cash flows from operating activities
• Operating activities are primarily
the revenue-generating activities
of a company
• “Operating cash flow” is conceptually most near to “net profit”
• Main differences:
1. Non-cash expenses and non-cash revenues (f.i. depreciation
expense)
2. Non-operating items (f.i. gain on disposal of tangible fixed assets)
3. Timing differences between net profit and underlying cash flow (f.i.
changes in the level of inventories, receivables, creditors, etc.)
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Operating cash flows: Examples
• Receipts from sale of goods and rendering of services (cashing in of receivables
included)
• Receipts from taxes on sales and VAT
• Receipts from royalties, fees, commissions,…
• Payments to suppliers (payment of creditors included)
• Payments to employees
• Payments of taxes, VAT, fines, …

Operating cash flows –
Direct versus indirect method
 2 methods for identifying and presenting the operating cash flow:
• Direct method: engenders the presentation of the most important
categories of gross operating cash inflows and cash outflows
• Indirect method: net operating cash flow is determined by adjusting
the (net) profit figure for the 3 types of differences
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Direct method - Example
•
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Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from main operations 2,550
Income taxes paid (1170)
Net cash flow from operating activities 1,380

Indirect method - Example

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Net profit before tax 3,350
Adjustments for:
Depreciation 490
Investment income (100)
3,740
Working capital changes:
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from main operations 2,550
Income taxes paid
Net cash flow from operating activities
(1170)
1,380

Cash flows from investing activities
• Investing activities relate to the acquisition and disposal of long-term
tangible and intangible assets and other investments
• Cash flows from investing activities are an indication of the expansion
or downsizing of operating capacity
• Examples:
 Payments for newly acquired equipment
 Receipts from the disposal of a building
 Payments for new
investments
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Cash flows from financing activities
• Financing activities relate to changes in the size and composition of
contributed capital and financial debt of the company
• Examples:
 Receipts from issuing new shares or bonds
 Receipts from new bank loan
 Payments for buy-back of shares
 Repayments of loans
 Payments of interest and
dividend

1. Determine the net change in cash
 Compare beginning and ending balance
2. Identify all transactions of the period leading to a change in cash
 Direct: analyze movements in the accounts of cash
(equivalents) transaction by transaction
 Indirect: explain net change of cash by analyzing all other
accounts, knowing that each transaction with an impact on
cash also affects a non-cash account
3. Use the information (of step 1 and 2) to construct a cash flow
statement according to the formal rules
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Constructing a cash flow statement

Applying step 2
• Information for operating cash flow is primarily derived
from balances in the IS, while information for the two other
principal categories comes from the Balance Sheet (and
details in the Notes)
• Movements in the accounts indicate a change in financial
position and further examination is needed to determine if
they had a cash impact
• Check if balances have been impacted by “accrual-based
adjustments” or other “non-cash activities”
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Fig. Classifying balance sheet movements
as inflows or outflows of cash
•
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Assets Equity/
Liability
Increase Out flow Inflow
Decrease Inflow Out flow

Matching approach to asset financing
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
•Capital

Conservative approach to asset financing
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•Fixed Assets
•Total Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital

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•Fixed Assets
•Total Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital
Aggressive approach to asset financing

FACTORS DETERMINING WORKING CAPITAL
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1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle
•13. Credit control
14. Inflation or Price level changes
15. Profit planning and control
16. Repayment ability
17. Cash reserves
18. Operation efficiency
19. Change in Technology
20. Firm’s finance and dividend policy
21. Attitude towards Risk

EXCESS OR INADEQUATE WORKING CAPITAL
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Every business concern should have adequate working capital to run
its business operations. It should have neither redundant or excess
working capital nor inadequate or shortage of working capital.
Both excess as well as shortage of working capital situations are bad
for any business. However, out of the two, inadequacy or shortage of
working capital is more dangerous from the point of view of the
firm.

Disadvantages of Redundant or Excess
Working Capital
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Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories
over required level
Excessive debtors and defective credit policy, higher
incidence of B/D.
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness
suffers
Due to low rate of return on investments, the market value
of shares may fall

Disadvantages of Inadequate Working
Capital
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 Can’t pay off its short-term liabilities in time.
 Economies of scale are not possible.
 Difficult for the firm to exploit favourable market situations
 Day-to-day liquidity worsens
 Improper utilization the fixed assets and ROA/ROI falls sharply

Management Of Working Capital ( WCM )
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Management of working capital is concerned with the problems
that arise in attempting to manage the current assets, the current
liabilities and the inter-relationship that exists between them. In
other words, it refers to all aspects of administration of CA and
CL.
Working Capital Management Policies of a firm have a great
effect on its profitability, liquidity and structural health of the
organization.

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3D Nature of Working Capital Management
•Dimension I
•Profitability,
•Risk, & Liquidity

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Principles Of Working Capital
Management
•PRINCIPLES OF
WORKING CAPITAL
MANAGEMENT
•Principle
of Risk
Variation
•Principle
of Cost of
Capital
•Principle
of Equity
Position
•Principle of
Maturity of
Payment

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Maturity Matching Principle
• Maturity (due date) of financing should roughly
match duration (life) of asset being financed
 Then financing /asset combination becomes self-
liquidating
• Cash inflows from asset can be used to pay off loan

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Financing Net Working Capital
• According to maturity matching principle
 Temporary (seasonal) should be financed with short-
term borrowing
 Permanent working capital should be financed with
long-term sources, such as long-term debt and/or equity
• In practice, firms may use more or less short-term
funds to finance working capital

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Figure 3.7(a):
Working Capital Financing Policies

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Figure 3.7(b):
Working Capital Financing Policies

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Short-Term vs. Long-Term Financing
• The mix of short- or long-term working capital
financing is a matter of policy
 Use of long-term funds is a conservative policy
 Use of short-term funds is an aggressive policy

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• Short-term financing
 Cheap but risky
• Cheap—short-term rates generally lower than long-term rates
• Risky—because you are continually entering marketplace to
borrow
• Borrower will face changing conditions (ex; higher interest rates and
tight money)

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• Long-term financing
 Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher than short-term
rates

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Working Capital Policy
• Firm must set policy on following issues:
 How much working capital is used
 Extent to which working capital is supported by short-
vs. long-term financing
 How each component of working capital is managed
 The nature/source of any short-term financing used

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Chapter 03 cash flow management

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