ACTG2010: Chapter 5 Notes

Miquela Gray (Fall 2014)

THE CASH CYCLE
The cash cycle is partially self-sustaining as the cash generated from customers finances purchases that will produce future
sales. Also, as per the cash cycle, an entity expends cash to purchase resources before it collects any cash from customers.

Cash can also enter the cycle by way of loans or equities. And it leaves to repay loans, buy capital assets or pay dividends.
The Cash Cycle: The cycle of investing cash in resources, providing goods or services to customers using those resources
and collecting cash from customers is called the cash cycle.
Cash Lag: The delay between the expenditure of cash and the receipt of cash collected
o Cash lag varies from business to business and is determined by various factors such as; average
inventory/service turnover time, debtor days and creditor days
Inventory Conversion Period: Average length of time between receiving inventory from a supplier and selling it to a
customer
Payables Deferral Period: Average number of days between receipt of goods or services from a supplier to payment
of the supplier
Receivables Conversion period: Average length of time between delivery of goods to a customer and receipt of cash
collected
Inventory Self-Financing Period: Average number of days between the date inventory is paid for by the entity and
the date it's paid for by a customer
Important Notes on Cash Cycles:
Cash and net income can be drastically different
Cash lag and the cash cycle are important concepts for understanding cash/liquidity positions of businesses
Internal and external circumstances can affect an entity's liquidity

THE CASH FLOW STATEMENT: OVERVIEW

Cash Flow Statement: The financial statement that shows how cash was obtained and used during a period and classifies
cash flows as operating, investing, or financing. (aka; Statement of Cash Flows or Statement of changes in financial position)
Necessary because:
o Income statement gives incomplete picture of an entity's resource flows because it only reports economic
flows and doesn't distinguish liquidity
o Income statement doesn't reflect financing transactions or investment in long-term assets
o Cash Flow statement provides information about changes in an entity's cash position
Cash and Cash Equivalents:
Cash on hand and in bank accounts
Short-term liquid investments (easily converted into cash, usually mature within 3 months, low risk)
Bank overdrafts (amount of money taken out of account that exceeds balance in account, high interest liability owed
to bank that is subtracted from cash/cash equivalents)
Cash flows are grouped into three categories in a cash flow statement:
1. Cash from Operations (CFO): The cash an entity generates or uses in its day-to-day business activities. It usually
includes;

2. Cash from Investing Activities: Cash spent on buying capital assets and other long-term assets and the cash received
from selling those assets. Activities include;

3. Cash from Financing Activities: Cash raised from and paid to owners and lenders. Activities include;

UNDERSTANDING THE CASH FLOW STATEMENT: SPECIFIC ACTIVITIES

Financing and Investing Activities
Financing Activities: Cash raised from and paid to owners and lenders; help entities meet cash needs that can't be met by
cash from operations. Transactions that affect the financing accounts on a balance sheet (i.e. all accounts on the liabilities
and equity side except those involving working capital) See above table for details.
Investing Activities: Cash spent on buying capital assets and other long-term assets, and the cash received from selling said
assets. This section is represented on the balance sheet by cash sections involving non-working capital accounts. (i.e. plant,
property + equipment, intangibles) Businesses spend cash on investing activities to promote growth or expansion or
upgrade.
Cash from Operations
Cash from Operations: Cash generated by an
entity's day-to-day operations and business
activities. It is the cash leftover after all cash
outflows pertaining to a business' daily
activities have been deducted from its
inflows. CFO provides cash to be used to
purchase capital assets, grow, retire debt,
pay dividends and reduces a firm's need to
use external sources of finance. Negative
CFO in the short-term can mean needing to
use cash reserves, draw from lines of credit,
or borrowing or raising equity capital; since
these sources of finance are not
inexhaustible, negative CFO in the long-run
is dangerous for a business. New businesses
usually have negative CFO as they are
rapidly expanding or in the growth phase.
CFO can be presented one of two ways on the Cash
Flow Statement:
1. Indirect Method: A method of
calculating/reporting CFO by reconciling from
net income to CFO by adjusting net income
for non-cash amounts that are included in the
calculation of net income and for operating
cash flows that are not included in the
calculation of net income.
2. Direct Method: A method of
calculating/reporting CFP by showing cash
collections and cash disbursements from
operations during the period.
The direct method is encouraged by IFRS but rarely
used in practice. It reports sources and amounts of
cash inflows and outflows and focuses on an
entity's cash flows. The indirect method highlights
the difference between income and cash flow and
allows stakeholders to see the impact of managerial
choices on net income.

Two types of adjustments can be made when reconciling CFO using the indirect method:
1. The first method removes all transactions and economic events that are included in the calculation of net income but
do not affect cash flow. (i.e. depreciation expense, which is subtracted in the calculation of net income, will need to
be added back to net income to find CFO.) When a non-cash item is subtracted when calculating net income it must
be added back to reconciling from net income to CFO and vice versa for non-cash items that are added when
calculating net income.

2. Second method adjusts revenues and expenses so only cash flows are reflected. When using the indirect method,
increases in working capital asset accounts such as accounts receivable, inventory, and prepaids are subtracted from
net income, and decreases are added back. Increases in working capital liability accounts such as accounts payable,
wages payable, and accrued liabilities are added to net income, and decreases are subtracted. When revenues and
expenses are recorded at different times than the associated cash flows, the difference appears on the balance sheet
as a non-cash working capital item.
a. Example: When cash from a credit sale (previously allocated to AR and recognized as revenue) is collected, AR
decreases but there is no income statement effect.

i.

ii.

b. Example: When wages are expensed and paid for the year.

i.

ii.

SUMMARY:

INTERPRETING AND USING THE CASH FLOW STATEMENT

CFO: Used for paying dividends, acquiring assets, paying off liabilities, financing expansion etc
Cash Collections = Revenue - Increase in AR + Increase in deferred revenue

Liquidity: A short-term concept that refers to the availability of cash or the ability to convert assets to cash. Important
assessment tool to evaluate how well an entity can meet its current obligations. (ex. of liquid assets: cash, shares, AR. Nonliquid assets: Land, buildings, equipment, intangibles)
Solvency: An entity's viability in the long-term, ability to pay its long-term debts. Entities are insolvent if they have liabilities
greater than its assets, or if they cannot pay their debts as they come due.
Other Issues
Operating Cash Flow Ratio: Since the Current Ratio is static and only based on balance sheet items, liquidity can often be
better evaluated by using the Operating Cash Flow Ratio. OCR that`s less than 1.0 may mean that the entity is unable to
meet its short-term responsibilities.

Free Cash Flow: The available cash after capital expenditures have been made. It is available for the acquisition of new
companies, expansion, debt reduction, or share purchase.

ASPE vs. IFRS and Cash Flow:

ASPE does not require a cash flow statement if the information on the CFS are available on other financial
statements. IFRS does.
ASPE requires interest paid and collected that's reported on the IS to be classified as CFO whereas IFRS allows entities
to classify interest payments as CFO or FA and interest received as IA.
ASPE requires dividends paid to be classified as FA whereas IFRS allows choice between FA and CFO. ASPE requires
dividends earned to be classified as CFO whereas IFRS allows choice between CFO and IA.

Cash Flow Patterns

There are eight different combinations of cash flows from operations, investing activities, and financing activities. They are
as follows: