Objectives of Financial Statements
2.1 Introduction to Cash Flow Statements and its Standards
Financial reporting is essential for every going concern and preparing statements is part of financial reporting. The main statements as part of the accounting standard are balance sheet, profit and loss statements, cash flow statement and the accompanying notes to explain the figures included in each of the statements (Bahnson, et al., 1996). Financial statements together with the analysis and reports of the directors and executives are included in the annual reports of the company to give a whole sole picture of the company to the investors and the interest groups regarding how well the company is doing. The reports are prepared to account for the profits and the losses incurred the investments and the existing assets and liabilities of the company and the inflow and outflow of cash. Financial statements have various purposes and come in use of the shareholders as well as the internal employees of the company and thus, following required standards set by the IFRS is important. Cash flow statements came to recognized as relevant for financial decision making during the 1980s when cash was considered as a separate element from revenues or net profit, which are accrued but cash is generally is what the company is left with at hand and this cash is generally used for the management of the current assets and liabilities. Thus, knowing what cash strength the company will be in the near future and presently is of high relevance. For this reason strong emphasis has been placed by the IFRS to include cash flow statements in the company’s annual accounts (Billings and Morton, 2002).
Cash flow statements are prepared on a month by month basis and give a clear picture regarding the cash generators and the cash consumers or absorbers. Based on such findings the decisions to reduce the cash absorbing activities and increase the cash generating activities are taken. The cash flow statements also show whether the main source of cash is the trading and selling activities of the business or other sources like selling of assets (Copeland, Koller and Murrin, 1991).
General Motors for example, during 2005 was generating 80% of its profit from its financial services rather than its main service offering, its cars. This though was a positive indication as the company was generating a high revenue but it soon became a source of serious concern as he debtors who took loan to finance their car expenditure failed to redeem he loans and he entire receivables or debtors account was declared as ‘bad debs’ and thus, a heavy loss was incurred and the amount that was reported as profit in the profit and loss statement was actually a loss! Thus, the amount of cash at hand at the end of and beginning of and during an accounting period determines the company’s actual strength because reporting profits and revenues only comes to effect when the company actually sees cash in bank and on the basis of which it positively predicts its future in the competitive business environment. For this reason FRS 1 and FRS 3 and IAS 7 have established that companies essentially need to report cash flows in their financial statements to allow the analysis and reporting of the cash generations and absorptions during the year and measure and account for the difference that exists between the reported profit and the cash at hand (Copeland, Koller and Murrin, 1991).
The Cash Flow statement is an important part of the financial reporting of the company whereby according to FRS 1 and 3 they have been established as a mandatory statement to be made part of the annual reports (Crabb, 1999).
According to FRS 1 large companies, i.e. limited companies are to prepare cash flow statements. Small businesses are also encouraged to prepare them for the sake of having a clear knowledge and accountability of cash transactions but it is no legally mandatory for them. The objective to be followed with regard to cash flow statement preparation is to report the cash generation and as well as absorption activities or sources. This allows the interpretation of the cash transactions to be more thorough and a direct disclosure of the inflows and outflows of cash within the accounting period. The cash flow statement allows the assessment of the current and acid liquidity of the company, provides relevant and useful information about the transactions that are part of each business activity within the company, provides a bird’s eye view of the sources that generate cash and areas which consume it within the company, allows future cash inflows and outflows to be predicted and forecasted and finally determines the sources which accounted for the major cash generations, either from trading sources or other profit centers (Farshadfar, Chew, and Brimble, 2008).
2.2 The Easy-to-Understand Interpretation of information by Cash Flow Statement Users
The users of cash flow statements are mainly concerned with how and where the cash comes from and where it goes to in a clear cut manner and the use this information to assess the company’s ability to finance its debt requirements, interest payments, dividend payments and capital expenditures and other cash expenses and then evaluate this information to interpret and forecast how in future the cash generation will take place and the return they will get from the activities of the company (Crabb, 1999). To analyse so much out of the cash flow statement, it is thus, necessary to use the format and terminology that is easily comprehendible by the users. This section explains the terms and establishes how easy to understand and clear and straight forward they are which makes the statement a fairly easy approach to understanding the cash income and expenditure of the company within the accounting period (Bahnson, et al., 1996).
2.2.1 Definitions of Major Terms in the Cash Flow Statement
Following are the common phrases and words used in the cash flow statements:
This element represents the cash that is present in the bank accounts of the company.
These are highly liquid assets of the company that can be quickly converted to cash when cash is needed.
These are incoming and outgoing cash and cash equivalents.
These activities are all those areas which are responsible for cash generation such as trading and selling of products.
Investments upon fixed and capital assets that are to be part of the company for a long term and the returns from their sale are included in this section.
These are linked with the capital of the owners of the company and those of stockholders. It shows the changes that occur to the share capital within the accounting period (Financial Accounting Standards Board, 2008).
2.2.2 Presentation of Cash Flow Statement
The following sections take form in the cash flow statements as per the FRS 1 requirements: operating activities, representing operating profit with adjustments for depreciation, payments from debtors and payments to creditors and the changes that take place in stocks; returns on investments and servicing of finance comprising the received interest/dividends and paid interest; taxation, representing the paid taxes; capital expenditure and financial investments, reflecting the net cash received from the fixed assets’ disposals; acquisitions and disposal; equity dividends paid, representing the paid dividends both interim and final; management of liquid resources, showing how the investments of current assets have moved in the accounting period and finally financing, showing the issuance of share capital and also the redemption of long term loans (Peasnell, 1982). As for other financial statements, notes are to be necessarily accompanied by cash flow statements, primarily relating to the calculation of ‘net debt’ and the changes that occur to it during the accounting period (Crabb, 1999).
IAS 7, which is an international accounting standard, establishes that the cash flow statement should provide the sources of differences that arise between the profit and the net cash flow. For this the statement needs to present the information of business activities that take on during the accounting period, the ability of the business to generate quickly available cash, i.e. its liquidity, the overview of the areas that and activities that contribute towards the generation of cash for the business, estimate of the cash flows to be expected from the future and the identification of the cash flows that are generated from the sales in contrast with the sale of assets or other non-trading sources of the business (Farshadfar, Chew, and Brimble, 2008).
IAS 7 requires cash flow statements to include the following three sections: operating activities, investing activities and financing activities, which mainly cover all of the activities that are part of the cash flow statements that follow the format defined by FRS 1 and 3. The format difference is the only difference but both standards establish one fact: that the relevance of cash flow statements for business decisions is immense as it shows the clear cut cash position as opposed to the profit position, which can directly be relied on the future prediction of cash revenues (Crabb, 1999).
Notes explaining the calculate figures of cash and equivalents in each of the sections of the cash flow statements are to be included in the notes following the statement in the annual report. More specifically, the following information is disclosed:
The borrowed amount that has not been drawn for financing of operational activities but is available for future use.
The notes are to differentiate the cash flows that increase from the operational activities from those that are required for the facilitation of the operating activities. This allows the understanding of how the cash is being generated and used in maintenance of the assets that are generating cash flows (Billings and Morton, 2002).
2.3 Business Decisions and their Cash Flow Information Requirements
To answer the question as to what extent does the provision of the statement of cash flows in published financial statements support the objectives of decision usefulness, it is first useful to understand what decisions are required and then match those with the format and components of the cash flows and the information that they provide and then determine the usefulness (Crabb, 1999). Based on general observation and management of business, the decisions taken by the business, which are linked with financial information, can be characterized under the following headings: investing decisions and financing decisions, marketing decisions, research and development decisions, supplier relations decisions, customer relations decisions, employee compensation decisions, operational decisions, growth and expansion decisions (Bahnson, et al., 1996).
Investing and Financing Decisions
These decisions are related with the money that is required by the company and how it can obtain that finance from several sources of finance such as banks, investors, etc. but the need to finance only arises when the financial statements give an indication that such a need is in place (Hung, Chan, and Yhi, 1993).
The diminishing working capital is an indication that the company needs to tap a source of short term finance to cover short term debts whilst make its way to reduce cash absorbing cost centres.
These above were financing decisions. Next come the investing decisions, which are taken to allow the company to expand its operations, fulfill demand of the customers through establishing larger plants, to enter into a new market or to relocate to a more profitable location, each of which require heavy capital expenditure which can only be generated internally when there is a high amount of retained earnings reserved for future investments or when future investments can be planned based on a stagnant inflow of cash from sales revenue (Farshadfar, Chew, and Brimble, 2008).
Investors such as banks and stockholders are looking for clear insights of the company that provide an indication of the expected profitability in future based on the investment they make. These indications are provided by cash flow returns ratios and other profitability ratios that allow investors to assess the ability of the company to generate cash inflows from capital investments in the future and feel safe in spending money on the company as they know they will be getting returns in future (Crabb, 1999).
Thus, both internal and external investment decisions are based on the analysis of financial statements such as cash flow statements.
Marketing activities are by far the most finance absorbing due to their massive implications across the company-wide success and as the marketing activities are the main business drivers, managers willingly spend to support the marketing strategy implementations as they know that it will only generate a massive pool of sales revenue in return. But the call to spend on marketing activities becomes a dilemma when the company is short of cash or anticipates a fall in cash revenues in future and thus, fears to spend on a risky marketing project which will make it lose its retained earnings. Management, having a ‘safe play’ attitude will also be reluctant to spend heavily in implementing marketing plans which make use of the element of the ‘out of the box’ thinking. Also, the fear of managers for marketing investments are that it only keeps rising, even if the product is successful as there are so many brand management activities that follow the launch of the product in the market to continually assure that the product becomes a brand and then stays on top among the competitors with fine segmentation and effective positioning. For this market research is put in place prior to, during and after the launch and is continually invested in to keep track of the progress of the brand with regard to the consumers. The challenge and the fear of losing money arises when the element of ‘human’ comes to the picture, that is from the perspective of the consumers whose behavior can not every be purely predicted and managers fear that if they spend so much on consumer research and marketing campaigns, the high rate of revenues is not definite and with scarce financial resources of the company, this will only worsen the situation rather than curing it. The classic case of ‘new Coke’ is a good example to quote here where Coca Cola, which is among the top 10 companies in the Fortune 500 as declared by the 2010’s list, launched the New Coke after spending heavily upon marketing research and product testing activities which provided positive results. The company based on these finding spent heavily in the launch which met a massive failure as the consumers failed to accept it as a replacement to the old classic coke with which they were emotionally attached to. Therefore, the assurance those managers yearn for in making financing decisions for marketing activities is the fact that the product for which the expenditure is being carried out for has the potential to generate cash and due to lack of marketing and awareness the sales revenue is low (Kotler, 2005). Falling sales figures is the basic indicator of the need to spend in marketing activities but it may also be an indicator that the product be taken out of the market. The month by month and quarter by quarter assessment of the cash generation by the sales of the product give a more clear idea that whether the product has cash generation potential for future or not. If returns are only showing a diminishing and declining pattern then spending on marketing activities would be foolish unless repositioning activities are to be taken on but only if funds are available and if the product has not become technologically obsolete (Crabb, 1999).
Research and Development Decisions
Research and development require an extensive amount of capital expenditure but it has its returns for the business. Research and development allows companies like BMW, Sony Ericsson, P&G to prosper in the global business environment using innovation which is a product of this heavy capital expenditure. But to invest in research and development activities a company needs to have sufficient funds available. A large number of companies across the world though having sufficient understanding of the need to have internal research and development activities, do not attempt to incorporate those in the organisation due to having limitations of funds (Crabb, 1999).
Supplier Relations Decisions
Managers also have to make decisions regarding which suppliers to pursue to receive the cost advantage and an edge over the competitors, with respect to quality and time issues. When more cash is out flowing to suppliers as opposed to the cash inflow from sales revenues, managers have to make a call to reduce the cost of suppliers (Billings and Morton, 2002).
Customer Relations Decisions
Often companies have credit policies for customers for 30 to 40 days after the purchases which often extends beyond the credit limit and the company has to claim the amount as bed debt and thus lose hope of receiving money of the sales revenue. With a rise in debtors, just like in the example of General Motors, the smart decision is to demolish the credit policy and deal with only cash transactions like most retailers and FMCG companies do to avoid uncertainties in payment collections (Hung, Chan, and Yhi, 1993).
Employee Compensation Decisions
When cash payout to employees is high compared with their productivity and low sales volume, the indication that mangers get is to reduce the compensation given to employees. Financial statements such as cash flow statements allow the managers to assess the cash flowing out to employees, as an expense and weight the expense against additional performance measures to justify the expense (Copeland, Koller and Murrin, 1991).
Share Issuance Decisions
The limited companies issue shares to raise more finance and the financial statement analysis by the end of the accounting period allow the mangers to recognize that it is time to finance the business’s dire need of finance through private or public issue of shares. But investors can only be attracted if the profitability of the company is high otherwise the shares receive a high risk, junk bond status which does not do well for the company in terms of raising finance from issuing shares (Farshadfar, Chew, and Brimble, 2008).
2.4 Decision Usefulness of Cash Flow Statements and Future Predictions
Compared with what is required by the financial statements’ users for making important business decisions, the cash flow statement incorporates each of these business dimensions into its format and heading to disclose the functional areas of operations, investments and finance to draw attention to key information regarding the business activities, earnings and cash at hand and its overall movements during the accounting period (Kay, 1976). The most eye catching and concern driving aspect of the cash flow statement for the decision makers is the area of cash flow from operations, which actually comes under much of the financial analysis as it shows the sources of earning. Ratios applied to cash flows allow future cash flows to be predicted which are useful for potential investors in assessing the feasibility of investment in the company (Billings and Morton, 2002).
2.4.1 Cost Coverage
One objective of the cash flow statement is assessing the ability of the enterprise to conduct pay outs in the form of dividends and supplier costs. This assessment is done through analysis of the ability t generate short term and quick cash. Cash interest coverage, cash debt coverage and cash dividend coverage are three ratios which are applied to the findings of the cash flow statements to allow a clear picture of the cash standing of the company and the ability it possess to meet operating expenses and costs. Each of these ratios is explained below (Hung, Chan, and Yhi, 1993).
Cash Interest Coverage Ratio
The objective of the cash interest coverage ratio is to compliment the conventional interest which communicates to the investors the amount of time that the company is able to cover its interest expenses with the cash it has (Farshadfar, Chew, and Brimble, 2008).Comparing the ratio result with that of the industry on average points the weakness or strength of the company and the position of its liquidity which gives way to a future direction that investors are looking for to either accept the share issue or reject it. The investors get the knowledge of the company’s ability in meeting its commitments for payments and in due time and thus, establish a certain dependent level assurance with the company (Bahnson, et al., 1996).
As opposed to the conventional accrued based interest coverage ratio which was based on the accrued figures shown by the profit and loss statements where only non-cash items were included, the cash based interest coverage ratio delivers the accurate information regarding the coverage as it is the whole sole function of the cash at hand of the company to cover the expenses and the ability to meet the short term expenses and debt covering and not accrued figures and earnings which are not currently in the hands of the company and thus are not reflecting the true working capital of the company (Billings and Morton, 2002).
With the inclusion of cash flow statements in the annual financial reporting, the interest coverage ratio now incorporates the cash flows to accurately describe the company’s liquidity and its ability to cover its commitments for expenses (Copeland, Koller and Murrin, 1991).
Cash Debt Coverage Ratio
This ratio shows the ability of the company to repay its debts which indicates its financial strength in both long term and short term. Investors or bankers will be reluctant to invest in a company which has a weak cash flow and has insufficient cash inflows to repay its debts (Ohlson, 1995). Two ratios are used to determine the debt repayment strength of the company: retained operating cash flow over total debt ratio and retained operating cash flow over current maturities of debt ratio. The first ratio allows the investors to assess the ability of the company to reinvest using available cash. It is found out by subtracting dividend payments from cash flow from operations. The objective of both of the cash debt coverage ratios is to highlight the time period of the debt repayment and the cash retained by the company to cover the debts in time. The second ratio focuses more on the long term debts (Farshadfar, Chew, and Brimble, 2008).
An alternative approach to the liquidity ratio analysis is using cash and cash equivalents together with the operating cash flow to determine the debt and interest coverage. On the other hand, using current liabilities to incorporate in the debt portion of the ratio is also an option. Other variations also exist to the ratio to cover debt in order to foresee the future commitment meeting abilities of the company (Hung, Chan, and Yhi, 1993).
Cash Dividend Coverage Ratio
An important cash absorbent of the company is the dividend payout which is the key area of interest for the shareholders or potential investors looking to be a part of the company in future. They need to know whether the company in future has the ability to meet their dividend payment requirements or would be left empty handed due to the poor financial standing of the company owing to low profitability (Ohlson, 1991). This ratio allows measuring the ability of the company to cover dividend payments to common stockholders. The ratio entails the division of cash flow from operations over total dividend payments. The definition of dividend payouts can be done so in different ways which are dependent on the current or future analysis of dividend cover (Copeland, Koller and Murrin, 1991).
2.4.2 Income Quality
Another major objective of cash flow statements is to show where and how the difference arises between the cash net flows and the profit. The reasons why the differences emerge determine the quality of the income generated in the accounting period. Cash flows allow a more reliable measure of income as it is currently in hand. the amount of cash at hand at the end of and beginning of and during an accounting period determines the company’s actual strength because reporting profits and revenues only comes to effect when the company actually sees cash in bank and on the basis of which it positively predicts its future in the competitive business environment and actually assesses that this is the income it has obtained in real terms. The following ratios are sued to analyse the quality of income: cash quality of sales and the cash quality of income (Farshadfar, Chew, and Brimble, 2008).
Cash Quality of Sales Ratio
The direct method of reporting cash flows allows evaluation of cash revenues easily where the profit and loss statement items such as gross sales, costs of goods sold and expenses can be taken into account (Farshadfar, Chew, and Brimble, 2008).
Cash Quality of Income Ratio
The comparison of cash flows from operations with the operating income allows the cash quality of income ratio to be calculated. This analysis provides the amount of variance between the reported income and the cash in hand. The reason for the deviation of the reported income from the cash earnings is the inclusion of credit sales, expenses and non-cash item of depreciation. This produces a substantial impact upon the cash in hand which shows a relatively low figure. But this cash figure is the one which actually will be used to cover current debts (Copeland, Koller and Murrin, 1991).
The cash income ratio measures this deviation. An alternative approach to measuring the ratio is using the cash flow from operations (before subtraction of interest and taxes) and dividing this amount by the income (before subtraction of interest, taxes and depreciation). This results in the exclusion of various non-cash items and brings the net income amount in less distance from the cash income amount (Farshadfar, Chew, and Brimble, 2008).
2.4.3 Capital Expenditures
Capital expenditures that the company entails only reflect its ability to maintain its competitive edge over time periods. Capital expenditures require a heavy amount of financing capital and the company is able to meet those when the cash inflow is stagnant and high in a time period (Jupe and Rutherford, 1997). The users of the cash flow statements use the information presented in the cash flow statement to measure the company’s ability to meet its capital expenditure financing requirements which are shown in the balance sheet. The cash flow statement for this purpose discloses the cash spent on plant, property, machinery and other equipment. Complete details are included in the notes accompanying the statement as required by FASB Statement no 14. Such disclosures as well as the cash inflows represent the extent to which the company has the ability to finance its expenditures on fixed assets using internal sources of finance (Farshadfar, Chew, and Brimble, 2008). Two main ratios that are used to assess the financing and strength of the company are capital acquisitions ratio and the investment/finance ratio, each of which are discussed as follows (Hung, Chan, and Yhi, 1993).
Capital Acquisitions Ratio
The ratio reflects the capability of the company to invest in fixed assets and other capital expenditures like research and developments and entrance into new markets. The ratio incorporates the retained operating cash flows and the amount spent on acquisitions. The ratio is calculated by dividing the amount spent on acquisitions by the retained operating cash flow which is the amount left after dividend payments are left which is used for capital expenditures (Jupe and Rutherford, 1997). The main problem that arises herein in the calculation of capital expenditures is the exclusion of other investments than the property and plant, such as research and development and major marketing campaigns that consume an immense amount of finance and have long term profitability impacts on the company and are not done so quite regularly. Because of not including other major capital expenditures in measuring this ratio, a misleading figure is obtained. Therefore it is important to first define what activities constitute as capital expenditures within an accounting period to be included in the cash flow statement (Hung, Chan, and Yhi, 1993).
On the other hand, capital disposals also create a problem in the accuracy of this measure of the company to finance its capital expenditure. These are to be added to the retained cash flows or are to be written off against capital expenditures. The sale of fixed assets is to generate cash inflow and this inflow is then used to finance other capital expenditures thus, since they are cash revenues they are to be made part of the cash flows from operations (Farshadfar, Chew, and Brimble, 2008).
Major property and plant acquisitions are taken on using debt financing which directly does not impact upon the cash at hand. Therefore the amount of cash spent on capital expenditures varies from time to time. What really happens is that the cash outflows in the form of repayment of debt which was originally taken to acquire property and plant or other major capital expenditure. This cash payment to cover debt is made part of the financing activities section of the cash flow statement and not in the investing activities section. Cash, then, as not reflected as being used to invest in assets but used to cover debt only. Therefore, it is more useful to conduct a comparison ratio of operating cash outflows with the average gross capital expenditures to provide a more adequate cash flow on capital expenditures figure (Hung, Chan, and Yhi, 1993).
This ratio incorporates the use of net operating cash flows, investing cash flows and financing cash flows to establish a relationship among them to explain the financing activities of capital expenditures. The ratio measures the amount of funds required to invest in capital assets and compares it with the funds that can be generated from sources of finance available (Kousenidis, Negakis and Floropulos, 1998). The alternative method is also available which uses cash flows for investment activities to compare with the cash flows from financing and cash flows from operating activities to measure the amount available to finance investment activities (Copeland, Koller and Murrin, 1991).
2.4.4 Cash Flow Returns
Finally, cash flow ratios are quite useful in reflecting the returns obtained from the assets in possession of the company. The profitability of the company and the ability to pay high returns to investors reflects the strength of the company in terms of cash generation within an accounting period. Assessing the cash flows of the past spread across years and month allow forecasting the expected cash flows in the future (Jupe and Rutherford, 1997). Cash flow returns on investments are measured to spread the cost of the capital expenditure over future cash flows. They are not profitability ratios and are to used with caution as they make no provision to replace assets or other future expense requirements. The smart action is to use cash flow ratios alongside profitability accrued ratios to represent a more accurate picture of the expected returns from the investment in the company. But it is important to note that the cash flow per share ratio is one of the most frequently used ratios by the financial analysts (Farshadfar, Chew, and Brimble, 2008).
Cash Flow per Share Ratio
Stockholders are concerned with the cash that is available in the company to pay returns to them. This ratio measures just that and divides the cash available by the common shares outstanding to give the amount of cash flow per share. Investors also calculate the cash payout to stockholders through the comparison of cash dividend coverage ratio with the cash flow per share ratio. This ratio, thus, provides a clear cut comparison of the amount of cash that is available per share with the amount is actually paid as dividends to stockholders (Hung, Chan, and Yhi, 1993).
Return on Investment Ratio
Even a more refine ratio than the cash flow per share is the return on investment ratio which measures the amount of cash that is received in return for the investment undertaken. There are three alternative ways of measuring it, by either using return on total assets, return on debt and equity or return on the equity of stockholders (Jupe and Rutherford, 1997). The cash return on total assets ratio is calculated using the amount of cash flows that is present before deductions of taxes and interest. This ratio is thus, equivalent to the return on the capital expenditure. This ratio has been taken by analysts as one of the profitability ratios as it allows a calculation of the cash-creating ability of the capital assets of the company which gives investors a clear idea of the potential of the company to raise cash internally and cover its capital expenditures through future cash flows from the same assets. They then expect future cash returns based on the ratio’s results. These ratios give the company an edge over the competitors when they are higher than the industry average and attract more investors as a result (Farshadfar, Chew, and Brimble, 2008).
Chapter Three: Methodology
Chapter Four: Data Collection
Chapter Five: Results and Analysis
Chapter Six: Conclusion and Recommendations
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