Topic 8 - Cashflow Statements (2): Indirect Method

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This article is a topic within the subject Accounting 1B.

Contents

Required Reading

Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 581-587.

Direct Vs. Indirect Method

There are 2 ways to report cash flows from operations (CFO). The direct method involves reporting the major classes of operating cash receipts (inflows) & payments (outflows) to derive CFO (info obtained from T accounts & accounting records). The indirect method involves adjusting/reconciling net profit after tax to CFO’s, clearly showing why the 2 figures are different. Reconciliation is mandatory in the notes.

The Indirect Method

[1]

  • Start With NPAT
  • Adjustments
    • Permanent Differences – effects that will not reverse over time e.g. depreciation, disposals
    • Timing Differences – effects that will reverse over time (accruals vs. cash basis) e.g. credit sales
  • Reconciled to CFO’s

Adjusting For Timing Differences

[2] Only current assets & liabilities (excluding financing (e.g. dividends or loans) & investing activities) should be looked at.

  • Increases (decreases) in current assets are subtracted from (added to) NPAT
    • An increase in accounts receivable, would reduce CFO’s in comparison to NPAT as NPAT recognises credit sales
  • Increases (decreases) in current liabilities are added to (subtracted from) NPAT
    • An increase in accounts payable, increases CFO’s in comparison to NPAT as NPAT does not recognises credit purchases as expenses

Decision Usefulness of Cash Flows

[3] It is important to know where the cash flows are coming from (sources), where it is going to (uses) and why (purpose). Is the cash flow recurring? When will other cash flows occur? These are some questions that should be answered. We can use the statement to assess a firm’s ability to

  • Generate future cash flows
  • Continue to meet its financial obligations
  • Pay future dividends

Analysing the Cash Flow Statement

[4]

Relate the Cash Flow Statement to the Income Statement & Balance Sheet

E.g. if accounts receivable rise (BS) & sales are steady, something may be wrong (customers aren’t paying – lower OCF’s) E.g. if accounts payable rises (BS) & inventory is falling/steady, the company is delaying payments to suppliers (struggling?).

If the company is improving its management of inventory & receivables collection, inventory & AR should fall. Sales should be close to cash from customers & COGS should be close to cash paid from suppliers.

Examining CFO’s & Total Cash Flows

If a firm has negative OCF’s over an extended period of time it will be in serious trouble – it won’t be able to repay financiers or invest in productive assets. If a firm has positive OCF’s it can pay off debt, pay dividends or invest (buying non-current assets or securities)

Relating Operating, Investing & Financing Cash Flows

[5] This analysis can indicate which period of the life cycle the firm fits into

  • Start Up / Growth – young firms, seeking capital to invest, operations not established – low OCF’s
  • Maturity / Stability – new investment slows, repays financing, generates large OCF’s
  • Decline – Loses profitability & OCF’s, selling projects to raise funds to repay financing

Free Cash Flow (FCF) = OCF – Capital Expenditure (Maintenance). If FCF > 0 the firm can invest in new opportunities.

Calculating Cash Flow Ratios

ACCT151181.jpg

Lecture Example: JNT Limited

ACCT151182.jpg

End

This is the end of this topic. Click Accounting 1B to go back to the main subject page for Accounting 1B

References

Textbook refers to Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning

  1. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 581-587
  2. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 581-587
  3. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 585-587
  4. Trotman, K. and Gibbins, M. (2009) Financial Accounting: An Integrated Approach, 4th edition, Nelson Thomson Learning, pp. 585-587
  5. ASB, UNSW
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