Managerial and Financial Accounting - Term Paper Example

Cash Flow MANAGERIAL AND FINANCIAL ACCOUNTING Managerial and Financial Accounting Academia Research The fundamental of a Cash Flow ment comes from the concept of Management Accounting. Hence, let us first understand what Management Accounting is. The term Management Accounting refers to accounting for the management. It provides the management the necessary information so that it can function properly in the way of planning, organizing, directing and controlling the business. Hence, it has a two pronged activity: 1. Completing the accounting results 2. Controlling the business by the management From the above noted details one can understand that a Cash Flow statement plays an important role while formulating a company’s plan of action. A Cash Flow statement shows the incoming and outgoing money during a particular period of time. The period can vary according to the requirement of the company, from monthly to quarterly to yearly. The statement acts as an analytical tool to determine the short-term viability of a company. The cash flow statement is dealt in the International Accounting Standard 7. The cash flow statement is very different from the income statements and the balance sheet, because it does not include the amount of future incoming and outgoing of cash, Cash Flow 2 but rather looks at the present status of the cash of a company. Hence, no credit is included in the cash flow statement. It is primarily determined basis three components by which the cash enters and leaves a company: core operations, investing and financing. Cash flow is determined by looking at three components by which cash enters and leaves a company: core operations, investing and financing. The Cash flow of a company is calculated by making certain addition and subtraction to the net income. These include the revenue, expenses and credit transactions, which appears in the balance sheet and the income statement. This is done because not all transactions are in cash. Example: depreciation is not a cash item and it does not actually results in the outflow of cash for the company, hence it is added back to the net income to get the actual picture of the cash flow statement. The cash flow statement shows the cash generated or expended during a specified time interval and its heading mentions the time frame. Example: "For the Three Months Ended September 30, 2006" or "The Fiscal Year Ended March 31, 2007". A cash flow statement organizes and reports the cash generated and expended and is used in the following categories: 1. Operating activities – It converts the items reported on the income statement from the accrual basis of accounting to cash. 2. Investing activities – Reports the purchase and sale of long-term investments and that of property, plant and equipment. Cash Flow 3 3. Financing activities – Shows the issuance and repurchase of the companys own bonds and stock and the payment of dividends. 4. Ancillary information – It reports the exchange of significant items that did not involve cash and also reports the amount of income taxes paid and interest paid. Now let us understand what is the use of a cash flow? 1. The cash from operating activities is compared to the companys net income. If it is calculated that the cash the cash from operating activities is greater than the net income, it is inferred that the companys net income or earnings are stable and of great standard. However, if the result is the other way round, then it can be deduced that the income of the company is converting into cash and the company may go into a red situation. 2. To a lot of investors or shareholders “cash is king”. To them the cash flow statement holds a key in understanding the financial performance of the company. If the company is able to generate more cash than what it is expending, then company is in a good shape. 3. Some financial models, which are used by the company to understand its financial situation, are based upon the cash flow statement. Now, that we know what is a cash flow statement, then let us understand how we can prepare a cash flow statement, or rather understand the sources from where we can get the necessary information to calculate a cash flow statement. Cash Flow 4 The sources of inflow of cash can be both internal and external. Internal Sources: Cash from operation is the main internal source. The net profit will have to be adjusted for non-cash items for finding out the cash from operations. The major internal sources are: - 1. Depreciation: Deprecation does not result in the outflow of cash, hence the net profit have to be increased by the amount of the depreciation 2. Amortization of intangible assets: Goodwill, preliminary expenses when written off against profits, reduces the net profit, without changing the cash balance, hence it should be added back to the net profit to calculate the cash from operations 3. Loss on sale of fixed assets: This should be added back, since it does not result on the actual outflow of cash 4. Gains from sale of fixed assets: This should be deducted from the net profit as this is not the actual cash from the operation of the business 5. Creation of reserves: Any reserve created out of the gross profit should be added back to the net profit as this does not result in the outflow of cash External Sources: The external source of cash can occur from the following major areas of the business: - 1. Issue of new shares: If new shares are issued in the market, then cash received, after deducting the expenses in issue of shares, will be taken as a source of cash 2. Sale of fixed assets or investments: Since this sale leads to an inflow of cash, it is considered as a source of cash Cash Flow 5 3. Short-term borrowings: This is considered as an inflow of cash 4. Raising long-term loans: By the issuance of debentures, and taking long-term loans are the additional external sources of funds Similar to the sources we need to understand the application or rather the outflow of cash as well. The application of cash primarily occurs in the following ways: 1. Purchase of fixed assets: This reduces the cash balance and hence, considered as an outflow of cash 2. Payment of long term loans: Any payment towards the loans taken from the banks and financial institutions results in the outflow of cash 3. Loss on account of operation: The loss incurred during the normal course of business is an outflow of cash 4. Payment of tax: Paying the different set of taxes, results in the decrease of the cash balance 5. Payment of dividend: This is payment though beneficial for the shareholders, but it results in the outflow of the company’s cash balance. While calculating the cash flow statement, it should be kept in mind that the decrease in any current assets is considered as an external source of cash, while the increase will result in an outflow of cash. The same rule applies to current liabilities as well, where the decrease is considered as an outflow of cash and an increase results in an inflow of cash funds. Hereafter, let’s get into a real life situation. We are going to consider two of UK’s retail majors, Tesco Plc. and J Sainsbury Plc. Cash Flow 6 Tesco Plc. Summary Group cash flow statement 2006 2005 Year ended 25 February 2006* £m £m Cash generated from operations 3,412 3,009 Interest paid -364 -350 Corporation tax paid -429 -483 Net cash from operating activities 2,619 2,176 Net cash used in investing activities -1,962 -1,501 Cash flows from financing activities     Dividends paid -441 -448 Other net cash flows on financing activities -51 -203 Net cash used in financing activities -492 -651 Net increase in cash and cash equivalents 165 24 Cash outflow from decrease in debt     and lease financing 115 206 Loans and finance leases acquired     with subsidiaries - -17 Net debt included within disposal group 55 - Other non-cash changes -357 11 Decrease in net debt in the period before     the impact of IAS 32 and IAS 39 -22 224 IAS 32 and IAS 39 adjustments to net debt -588 - (Increase)/decrease in net debt -610 224 Opening net debt at beginning of period -3,899 -4,123 Closing net debt at end of period -4,509 -3,899 With presence in UK, Rest of Europe and Asia; Tesco is a growing company in a rapid expansion mode for its food and non-food retailing service. The cash flow statement as mentioned above is for Tesco, showing the change from 2005 to 2006. In the above cash flow statement we can see an increase of 13% in cash from operations. But at the same time the Interest paid has shown an increase as well, which is due to the increase in debt Cash Flow 7 up to ₤610 million. There has been a reduction in the corporation tax. The company has paid a marginally less dividend in 2006 as compared to 2005. Hence, from the operations and financing activities, Tesco Plc has improved its cash balance to a robust ₤165 million, an increase of about 560%. The increase is primarily due to improved sales and consolidation of debts. But the correction was done by the increase in current assets and non-current assets and also because the total debts has increased. For J Sainsbury Plc, the market comprises of its Sainsbury Supermarkets, Sainsbury Bank and Sainsbury Online and is based only in UK. But, it has seen a major turnaround, from a loss of ₤238 million to a whooping profit of ₤104 million in 2006, though there is no major change in the total sales. The diversification into non-food segment and changes in the prices and operations has resulted in such a dramatic change. However, the improvement in the cash flow was due to fact, that it issued secured debt valuing ₤2.1 billion. With this it purchased its outstanding unsecured bonds totaling ₤1.7 billion. The cash flow from operations has shown a decrease of about 18% and the interest payable has also increased two folds. With fewer purchase of fixed assets and increase in the long-term borrowings the cash inflow has improved. However, with repayment of short-term borrowings and fewer sales of fixed assets the cash flow has been adjusted. This debt restructuring has helped the company to stabilize its financial position and it can now concentrate more on improving its sales and operation. Cash Flow 8 J Sainsbury Plc Summary cash flow statement 2006 2005 Year ended 25 March 2006 £m £m Net interest -156 -83 Taxation 3 -71 Cash flow before appropriations 627 792 Purchase of fixed assets/operations -561 -823 Sale of fixed asset/operations 151 1,383 Bond buy back costs -22 - Proceeds from issue of shares 22 5 Dividends paid -131 -254 B share dividends paid - -113 Repayment of short-term borrowings -299 -130 Increase/(repayment) of long-term borrowings 364 -176 Capital redemption -9 -549 Net increase in cash and cash equivalents 142 135 (Increase)/decrease in debt -65 306 Loans and finance leases disposed with subsidiaries - 230 Movement in underlying net debt 77 671 Closing IAS 32 and IAS 39 adjustments -51 - Foreign exchange adjustments - -24 Movement in net debt 26 647 Opening net debt -1,441 -2,088 Closing net debt -1,415 -1,441 We can also analyze a company by its various financial ratios. The foremost three that can help us to understand the company better are 1. :Debt-Equity ratio = Total debt / Total equity 2. Total assets turnover ratio = Net Sales / Total assets 3. Profitability ratio = Net profit / Capital employed x 100 Cash Flow 9 For Tesco Plc. we have: 2006 2005 ₤ m ₤ m Total Debt 5821 5601 Total Equity 9380 8603 Net Sales 39454 33866 Total Assets 9444 8603 Net Profit 1576 1347 Basis the above figures: Debt-Equity ratio - 0.62 0.65 Total assets turnover ratio - 4.17 3.91 Profitability ratio - 10.36 9.48 For J Sainsbury Plc. we have: 2006 2005 ₤ m ₤ m Total Debt 1415 1441 Total Equity 3965 4112 Net Sales 16061 15202 Total Assets 12747 11618 Net Profit 58 188 Basis the above figures: Debt-Equity ratio - 0.36 0.35 Cash Flow 10 Total assets turnover ratio - 1.26 1.30 Profitability ratio - 1.07 3.38 Here, in this example we have a company with robust performance and a company which is in the path of restructuring and stabilizing. In comparing the two companies’, Tesco Plc. and J Sainsbury Plc. one can clearly deduce the effect of cash inflow, irrespective of the size of the company or its status in terms of turnover and profit. Also, for Tesco Plc. the Debt-Equity ratio has decreased which is a positive sign, because it is less dependent on debt. The assets are also performing better with increased sales for Tesco, which is evident from its Total assets turnover ratio and profitability ratio. However, for j Sainsbury Plc. the story is not so. It is presently depending more on debts which is more or less same for both 2005 and 2006. Due to sales of some assets the Total assets turnover ratio has shown a decline. The profitability ratio shows that the company has made less profit but it will stabilize itself due to sufficient funds availability. Financial statements contain a wealth of information which if analyzed properly and interpreted, can provide valuable insights into a firms performance and position. Analysis of financial statements is of interest to lenders (short-term as well as long term), investors, security analysts, managers and others. Financial statement analysis may be done for a variety of purpose and may range from simple analysis of short-term liquidity position of the firm to a comprehensive assessment of the strengths and weaknesses of the company in various areas. The different ratios that are calculated in Financial Statement Analysis help to find out the firms true value. Cash Flow 11 Based upon the above mentioned facts and figures and the analysis it can be deduced that a cash flow statement can be used to predict the future cash flow, which will help the company to budget its expenditure. For the investors, the cash flow is the reflection of the company’s financial well being. But, in some cases, even a negative cash flow result can help the company to strategies its expansion. Just by adjusting the earnings, revenues, assets and liabilities, an investor can get a very clear picture about how much cash the company generates and, more specifically, how much of that cash is generated from the company’s core operation. REFERENCES 1. Fundamentals of Financial Management, Second Edition, Prasanna Chandra 2. Management Accounting, S.N. Maheswari, 96-97 3. JSainsbury Plc.Annual Report 06, Tesco Annual Report 06 Read More