CHAPTER

5
Financial Position and Cash Flows
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Financial Position and Cash Flows

Balance Sheet
Usefulness Limitations Classification Format Additional information Techniques of disclosure Terminology

Statement of Cash Flows

Purpose Content and format Preparation Usefulness Perspectives

IFRS / Private GAAP Comparison

Comparison chart Looking ahead

Balance Sheet: Usefulness (Appendix 5B, p.259, Balance Sheet)

Also known as Statement of Financial Position The balance sheet provides information:

for evaluating the capital structure and for computing rates of return on invested assets
It is also useful for assessing an enterprises:

Liquidity (time until asset is realized or liability has to be paid) Solvency (ability to pay debts and related interest) Financial flexibility (ability to respond to unexpected needs and opportunities)

Liquidity
Current Ratio Quick Ratio
CurrentAssets CurrentLiabilities
Cash, MarketableS ec urities, NetReceivables AverageCurrentLiabilities

Working Capital = Current Assets Current Liabilities

Combining with Statement of Cash Flow
Current Cash Debt Coverage Ratio = Net Cash Provided by Operating Activities Average Current Liabilities
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Solvency
Coverage Ratios: Debt to assets
TotalDebt TotalAssets
TotalDebt Shareholders ' Equity

Debt to equity

Flexibility
Combining with Statement of Cash Flow (1) Cash Debt Coverage Ratio =
Net Cash Provided by Operating Activities Average Total Liabilities

(2) Free cash flow

Calculated as net cash from operations less capital expenditures and dividends

Balance Sheet: Limitations

1 Many assets and liabilities are stated at historical cost Information presented is reliable, however Reporting at current fair value would result in more relevant information

Cash Short-Term (Temporary) Investments Receivables Inventories Prepaid Expenses Investments Property, plant and equipment Intangible assets

HC (FV equals to HC) FV NRV (net realizable value) LCM (lower of cost or market) HC Depends, FV or amortized HC Amortized HC
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Balance Sheet: Limitations

2. Judgement and estimates are used in determining many of the items reported on the Balance Sheet

Many soft numbers (estimates) are included which may be uncertain e.g. accounts receivable; inventory
3. The balance sheet does not report items that cannot be recorded objectively (e.g. internally generated goodwill)

Balance Sheet: Classification

Similar items are grouped together, with sub-total
Items with different characteristics are separated Individual balance sheet items should be: Reported separately, and in

Sufficient detail in order to:

Allow users to assess amounts, timing, and uncertainty of future cash flows Allow users to evaluate liquidity, financial flexibility, profitability, and risk Helps to calculate important ratios (e.g. current ratio to assess liquidity) More choice and flexibility is permitted under IFRS with respect to the format of the balance sheet (reverse order liquidity is more common).

Profitability
Return on assets
NetIncome AverageTotalAssets

Return on equity
NetIncome AverageCommonShareholders ' Equity
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Elements Of The Balance Sheet

Assets: Present economic benefits that the entity has rights or access to (and others do not) Liabilities: Present economic obligation/burden that is enforceable Equity (or net assets): The residual interest in assets after liabilities are deducted

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Balance Sheet: Classification

Assets
Current assets
Long-term investments Property, plant, and equipment

Liabilities and Equity

Current liabilities
Long-term debt Shareholders equity Capital shares Contributed surplus Retained earnings Accumulated other comprehensive income / other surplus

Intangible assets
Other assets

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Financial Instruments vs. Monetary Items

Financial instruments include three categories
(1) Cash (2) Strategic investments in other companies (3) Contractual rights to receive or contractual obligations to deliver cash or another financial instrument (examples: all receivables, payables, loans, passive investments in stocks, bonds, derivatives, etc.)

Classified into financial assets and financial liabilities Monetary items include category (1) and (3) only Classified into monetary assets and monetary liabilities Most are reported at FAIR VALUE

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Owners Equity
Capital Shares (also called contributed capital)
Outstanding shares: reported the amount at par

Contributed Surplus
Outstanding shares: reported the amount in excess of par (i.e., share premiums)

Retained Earnings
Net income made and retained in business

Accumulated Other Comprehensive Income

(AOCI) Beginning AOCI + OCI = Ending AOCI
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More Issues on Balance Sheet

Supplemental information
Contingencies Accounting policies Contractual situations Additional detail Subsequent events

Disclosure techniques

Notes, schedules, parenthetical explanations, cross references, etc.

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Statement of Cash Flows

Cash is the long-term indicator of a firms success or failure Statement of Cash Flows shows:
Where the cash came from: cash inflow What the cash was used for: cash outflow What was the change in the cash balance

Statement of Cash Flow divided cash flows into:

Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities

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Classifications of Cash Flows

Operating activities
Inflows: Collection of Revenues, including interest Outflows: Payment of Expenses, including interest

Investing activities
Inflows: Disposals of our land, building, equipment; Sale of securities; Collections of loans made to others Outflows: Purchases of land, building, equipment; Purchase of securities; Loans made to others

Financing activities
Inflows: Borrowing money from others, Contributions by owners (i.e., investments into the company) Outflows: Distributions to owners; Repayment of loans, but not interest; Reacquisition of capital stock 17

Statement of Cash Flows Presentation

Presentation methods
Direct method: includes specific cash inflows/outflows (e.g. Cash received from customers, cash paid to suppliers and employees, interest paid/received, taxes paid, etc) Indirect method: begins with net income and reconciles to cash (e.g. adds back non-cash charges deducted from net income, such as depreciation)

Both methods are acceptable

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Statement of Cash Flows Presentation

Illustration Text 5-16 to 5-19 (p.244-246): Indirect method to prepare for Statement of Cash Flow
Understand the impact of the change of each account (inventory, accounts receivable, etc.) on the cash flow (for example, the increase in accounts receivable would result in an increase or decrease in cash flow?)

Most extensive discussion is in Ch22 (adms3595)

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Usefulness of the Statement of Cash Flows

Cash is a companys lifeblood Provides creditors with useful information about a company, such as:
1. Companys ability to generate net cash from operating activities 2. Net cash flow trends or patterns from operating activities 3. Major reasons for positive or negative net cash from operating activities 4. Whether the cash flows are renewable or sustainable
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Usefulness of the Statement of Cash Flows

Provides insight into the following areas: Financial Liquidity
Current Cash Debt Coverage Ratio =
Net Cash Provided by Operating Activities Average Current Liabilities

Financial Flexibility

Cash Debt Coverage Ratio =

Net Cash Provided by Operating Activities Average Total Liabilities

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Usefulness of the Statement of Cash Flows

Cash Flow Patterns
There may be useful patterns identified of cash inflows and outflows from operating, investing and financing activities

Free Cash Flow

Calculated as net cash from operations less capital expenditures and dividends Answers questions such as,
What is the free cash left to invest or expand? Is the company able to pay dividend without seeking external financing? Will the company be able to maintain its needed capital investment if business operations decline?

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