Issues In Cash Flow Statement, Holmes Institute, Australia

HI5020 Corporate Accounting

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Question 1: Do the relevant research to critically examine the relative information content of the income statement and statement of cash flows. Why do investors find both income statement and statement of cash flows useful?

Answer: Under most accounting standards listed firms prepare threefinancial statementwhichincludes the balance sheet and the income statement and supplemented by the cash flow statement. While the balance sheet is that statement which provides a sneak peak into the amount ofassets and liability position of a firm on a particular date (year-end) , the income statement provides a sneak peak into the profitabilityposition of the firm. The income statement is one of the most read and discussed statement among the three statements as most of the users are concentrated on knowing the profitability positions to secure their positions. However the additions of the cash flow statement to the other two statements makes it possible make a comparison of how the forms cash inflows have occurred and how the management has spent the cash in the form outflows. The statement not only shows the movement and change of cash balances but also they are able to demonstrate the net changes made to the cash position.

Cash balances are an integral part of the management being able to run a business uninterruptedly. At all times a minimum required cash balance is needed and also the firm must generate enough cash to meet the day to day expenses including payments to the suppliers and salaries and other expenses. However the cash flow statement is not a standalone financial statement prepared but it is a statement which gets prepared form the other two financial statements. Once the firms management is finished with the preparation of the income statement and the balance sheet the cash flow statement would be prepared.

The income statement prepared to show the revenue generated for a given period that is the fiscal year and the flow of expenses which includes the cost of sales and all other operating expenses and fiancé costs etc. the important items which is deciphered from the incomesstatement are the net revenue, grossmargin ofprofit, operating profits and PBT/PAT. How much expenses in the formof income taxes would be needed is also showed at the bottom of the statement. The bottom line is also known as the net profit after taxes. This provides a lot of information to the users as to whether the users have been able to generate enough profits for growth oriented needs. However the cash flow statement it must be remembered that begins with where the income statement is finished (Horngren, et al., 2014).

The importance of the cash flow as a statement can be gauged form the fact that not all the profitable companies generate or end up having the same amount of cash and not all the companies whose cash balances are good generates good profitability. For most of the companies the net profit position is quite different form the net cash position and this is why the reconciliation of profits with cash in the form of cash flow statement is necessary. The cash flow statement further sub divides the whole activities into three different parts namely the operating and financing/investing. Of the three the operating activity deals with cash generated from operations. For calculating the cash flow from operations the non-cash expenses like depreciation and amortized expenses are added back and the net changes in working capital is either added or subtracted depending on whether it has increased or declined. Because there are many other things that happens in the course of business other than just selling goods and receiving cash such as purchasing of assets and paying of dividends etc. most of the companies end up having entirely different amount of cash balances at the end of the year (David, et al., 2013).

While the operating activity demonstrates the cash from operations for the year , the investing section finds the cash used or generated from investing in long term assets. Financing sections includes new stock issues and dividend payments and issue of debts etc. it is important for users to know if he operating cash flow covers all the cash outflows in investing and financing sections. If the addition of the three cash flow activities derived is negative then the closing cash balances would go down where as if the addition of the three cash flow activities derived is negative then the closing cash balances would go down (Deegan, 2015).

An efficient management and monitoring of the cash flows occurring in the period under analysis would have many benefits. The CFS provides a compelling view of the net cash position to the management and the stockholders. This knowledge as to where the money is spent and how the same can be maximized would let the managers plan these cash flows better and take better and more effective steps for rationalization of credit policy of the firm. The CFS also makes it possible to assess the further investing needs and how external funds can be used more effectively and how debts can be minimized to lower financial risks (Carl S Warren, 2011).

Thus from the above discussion its quite apparent that the analysis of the cashflow is not fully understood and practical without making an analysis of the income statement. This is why income statement is one of the most suitable starting points for making profitability assessment and also doubles up as the first step of estimation of cash flows. Users would learn many intriguing things by studying the cash flow statements along with the income statement and be able to fully understand the business operations and its capital structure components.

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Question 2: 1. For each of the three years on the Statement of Cash Flows:

a) What are the major sources of cash for each firm? What are the major uses of cash for each firm?

Answer: Some of the major cash sources for all the three firms listed are as follows:

1. Payments which were received by theses companies form the customers

2. New stocks and debts were issued for cash inflows

3. Dividends were also a major source of cash

Some of the major cash uses for all the three firms listed are as follows:

1. Significantly larger payments were made by all the three firms to suppliers and also the wages of the employees.

2. Larger payments were also made of buying long term assets like ppe

3. Oil and gas resources were bought and exploration costs incurred.

4. Repayment of the long term debts are one of the bigger cash uses.

b) What was the trend in cash flow from (continuing) operations for each firm?

Answer: Funtastic limited cash flows were bigger in size but the company has not been able to generate positive operating cash flows in any of the years. The difference between the cash sources and cash uses were also increasing making it worse. As compared to the fantastic cash flows, BHP limited is quite well placed as it has been creating positive cash flows in operating and the same is also showing signs of improvement. Santos is also has done quite better as it has been creating positive cash flows in operating and the same is also showing signs of improvement.

c) Was cash flow from operations greater than or less than net income? Explain in detail the major reasons for the difference between these two figures.

Answer: In all the three years for which the analysis is made the cash flows form operations for the BHP limited is much higher than the net income generated. This is because f different adjustments made to the net income to derive the cash flow and the same have a positive impact on the company's cash flows:

i) Non cash expense such as amortization of assets and depreciation has been significantly higher in size and has been added back. These expenses together was found to be bigger than $6 billion in each year.

ii) There were significant impairment costs related to the BHP limited PPE and the same is adjusted by adding them to net income.

iii) The changes in working capital for the years have also been adjusted in all the years.

iv) Positive adjustments were also made to the net income in the form of receipts of interest revenue and dividend revenue etc.

v) The cash flow is negatively adjusted on account of the annual payment of taxes and the same has negatively affected the cash flow from operations.

vi) BHP limited has also added significant cash inflows in the form of cash flows from operations which were discontinued by the firm and the same has increased the OCF.

d) Was the firm able to generate enough cash from operations to pay for all of its capital expenditures?

Answer: The operating cash flows which were generated by the operations of the BHP limited in the analysis period has been found to be much higher than those of the company's capital expenditures. The same is compared and presented in the following table:

The above figure provides an indicationthat for making capital expenditures the management of the BHP were not dependent upon external funds. 

e) Did the cash flow from operations cover both the capital expenditures and the dividend payments made by the firm (if any)?

Answer:

As can be seen from the above table presented the total cash used for capex and dividend payments were lower than the OCF is2017and 2018 but the same was higher thanthe OCFin2016. This is because while the OCF was much smallerin size in 2016, the Capex was comparatively much bigger (Belverd E. Needles, 2012).

f) If the firm has generated excess cash from operations, how did the firm invest the excess cash? If not, what were the sources of cash the firm used to pay for the capital expenditures and/or dividends?

Answer: BHP limited has generated excess OCF in 2017and 2018. And the same was used to repay a larger part of the company's existing debts. However in 2016, the BHP limited has been forced to issue new long term debts to the tune of over $7288 million for bridge he shortfall (ANTHONY A ATKINSON, 2012).

g) Did the firm use the working capital (current asset and current liability) accounts other than cash and cash equivalents as sources of cash, or uses of cash?

Answer: All the firms for which the analysis is being done has actually used a number of current assets and current liabilities apart from cash and cash equivalent items. Items such as the payables and receivables have been sued to finance the working capital and the same is adjusted in the OCF as changes in Working capital:

i) The BHP limited has made use of the trade receivables as part of working capital and the increase in the receivables has been deducted and decrease in the receivables has been added back to the net income for finding the OCF.

ii) The BHP limited has made use of the trade payables as part of working capital and the decrease in the payables has bene deducted and increase has been added back to the net income for finding the OCF.

iii) The BHP limited has made use of the inventory as part of working capital and the decrease in the inventory has bene added and increase in the inventory has been deducted to the net income for finding the OCF.

h) What other major items affected cash flows?

Answer: Apart from the major items which were listed in question 1 the following items were quite important as well:

For Santos limited:

• Major cash use items were related to new explorations and undertaking of seismic studies.

• Finance costs paid was an influencing item in all the three years.

• Royalty amount paid was a significant expenditure as well.

For BHP limited:

a) Finance costs paid was an influencing item in all the three years.

b) Gains and losses made from equity investment was another major item.

c) Expenses incurred on new explorations were a big item present in each of the three years.

d) BHP limited continually paid more long term debts and new issues were smaller as compared to the previous year.

For Fantastic limited:

a) Issue of new stocks were a constant item of cash source (2016 and 2018).

b) Acquisition of the assets categorized as intangibles were significant items of cash use.

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i) What was the trend in capital expenditures for each firm?

Answer: The following table shows the company wise capex for the three year period:

While BHP capex was higher in 2016 , the same was coincided by a larger debt issue and the same has clearly led to the management slowed down new Capex in both 2017 and2018 and the management concentrated on paying off the debts. However as the company paid the debts off , the capex showed signs of increase in 2018.

A growing pattern of capex was also seen in the case of Santos limited. As years progressed and Santos was able to generate higher OCF the capex has significantly gone up for the Santos limited as the company is a growing company and needs toinvest heavily in the new assets.

For Funtastic limited the trend in capex is that of slower and slower capex as the company was fighting lower net income (losses) and OCF was continually negative and getting bigger (negatives) and it is increasingly becoming tougher for the management o to get more funds for new investments(ANTHONY A ATKINSON, 2012).

j) What was the trend in dividends for each firm?

Answer: Funtastic did not pay any dividend at all in any of the three yearsunder analysis. This is because the company has had a negative OCF in all the years. Santos limited on the other hand has paid dividends in 2016and 2018. But there was no dividend in 2017. The dividend amount was $43 million in 2016 and $73 in 2018 which points towards the fact that divined payment are growing. However the BHP limited has proceeded to pay dividend in each of the three years. While the company has paid a dividend of $4130 million in 2016 the same in 2017 was 2921 million and $5220 m in 2018. The trend is definitely towards a growing dividend but the same is slightly interrupted in 2017 because of growing funding needs in investing category and for repayment of debts (Beams, 2012).

k) What was the trend in net borrowing (proceeds from borrowing fewer payments of short- and long-term debt) for each firm?

Answer: Santos Limited did not make any debts in 2016 but as the company made larger capex in 2017 and 2018, management of the company was compelled to issue debts for financing the growing capex. Its capex requirement was highest in 2018 and as a result of which the debt issue was also highest in 2018.

BHP limited made a huge debt issue of approx. $7,239 million in 2016 as its OCF was not enough to account for Capex and dividend payments. However in subsequent years the company's net borrowing position improved as debts declined by $5,537 million and $3,660 million. It also spent lower on dividend payments in2017. The emphasis was to reduce debts and related interest costs(Belverd E. Needles, 2012).

Funtastic Limited on the other hand made new issues of debts in all the three years amounting to $8457 million in 2016, $3,747 million in 2017 and $2,630 million in 2018 as the company's was faced with negative OCF and was bound to issue debts to compensate for lack of operating cash generation.

l) What was the trend in working capital accounts?

Answer: The following trends were observed in the working capital of the BHP limited:

The net changes in working capital was (1198.00 million) and as a result of which the same was able to increase the OCF in 2016. While Receivables declined and inventory, there was visible increases in trade payables and other liabilities. In 2017 the working capital needs declined by 241 million and the same also increased the OCF. However the OCF was negatively affected in 2018 as the changes in working capital was positive 320.00 million and OCF declined as a result.

2. Critically evaluate the financial strength of each of the three companies based on the evidence presented in the Statement of Cash Flows.

Answer: Funtastic Limited's cash receipts form the sales or from credit sales taken together has declined so rapidly that the same has almost halved in three years. Operating expenses have increases as a proportion. As a result of which the OCF has declined and is increasingly negative. It is so bad that the management would need to borrow to meet even the operating costs.

BHP limited on the other hand has been able to grow the operating cash flows on a year on basis and has provided cover for the capex and dividend expenses well. The situation has improved consistently from 2016 when the company's management had to resort to borrowings to meet dividend payment needs as OCF was insufficient. OCF increase has led the management to reduce financial leverage by paying off the debts in both 2017 and 2018 and lower financial risks(Carl S Warren, 2011).

As far as Santos limited is concerned it has been good cash from operations and covering for increased investing in long term assets. To meet its growing needs the management of the Santos firm has decided to use new issue of shares and net issue bonds etc. as the size of the form is very small as compared to BHP and Fantastic , the management is relying on external funding for meeting growing investing needs and to maintain better working capital(Atrill, 2013).

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3. If you are asked to evaluate these three companies for lending purposes, which of the three companies you will select for lending? Explain Why.

Answer: BHP limited is quite well placed as it has been creating positive cash flows in operating and the same is also showing signs of improvement. To begin with BHP limited has been forced to issue new long term debts to the tune of over $7,288 million for bridge the shortfall in capex and other expenses (ANTHONY A ATKINSON, 2012). In the next two years BHP limited has generated excess OCF and the same was used to repay a larger part of the company's existing debts.

BHP limited has been able to grow the operating cash flows on a year on basis and has provided cover for the capex and dividend expenses well. The situation has improved consistently from 2016 when the company's management had to resort to borrowings to meet dividend payment needs as Operating Cash Flow was insufficient. Operating Cash Flow increase has led the management to reduce financial leverage by paying off the debts in both 2017 and 2018 and lower financial risks(Carl S Warren, 2011). The operating cash flows of BHP was not only sufficient to cover for Debt repayments but also for capex and dividend payments. Its operating profit was also large enough to cover for the interest expenses in all the three years(Horngren, et al., 2014).

Keeping all the above points in mind, would decide to extend new interest bearing debts to the BHPlimited solely because it has improved its OCF by leaps and bounds and also managed to improve the net debt position considerably. Apart from the fact that it being a larger company has the leverage in the financial market to refinance debts and make timely repayments. Among the three companies BHP limited is most suited to further grow the operating cash flows as the company's product mix is huge and the company is well placed increase revenue in the coming years as the metals and mineral prices has been slowly and steadily making a rebound(Deegan, 2015).

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