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What Do I See on Cash Flow Statements
Topics
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Introduction
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Direct cash flow statements
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Indirect cash flow statements
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Take-aways
Transcript
Introduction
Welcome to the Express Route of the “What Do I See on Cash Flow Statements” module.
This video introduces and compares and contrasts two cash flow statements -- the direct
format statement and indirect format statement. Both formats are permitted under IFRS and
US GAAP, but the direct method is encouraged by standard setters. Nevertheless, most
companies outside Australia report indirect rather than direct statements even though direct
statements are encouraged by standard setters.
Australia required direct statements prior to adopting IFRS in 2005 and many, if not most,
Australian companies continue to use this format. Why should you study direct statements if
you aren't planning on analyzing Australian companies? Two reasons. First, the IASB and
FASB are considering requiring them. Second, and more importantly, direct statements
provide more information about cash flows than indirect statements, which means you can
learn a great deal about what's behind indirect statements, the ones you're going to be
looking at, by studying direct ones. So let's get started.
Direct cash flow statements
So here are some things you need to know about direct cash flow statements. First of all,
direct cash flow statements explain balance sheet changes in cash. Second, direct cash flow
statements report two years under IFRS and three years under US GAAP. We're going to
look at Qantas's direct cash flow statement and here we see two years.
Now, what do we mean by direct cash flow statements explain the balance sheet change in
cash? Well, we're going to go down to the bottom of the statement to figure out exactly what
that means. The very bottom line on Qantas's statement says “Cash and cash equivalents at
the end of the year,” $3,496. That's around $3.5 B was the ending cash balance and that was
reported on the balance sheet at the most recent balance sheet date, so that's just a stock
number as opposed to a flow number which the cash flow statement obviously measures,
and in that case, it's similar to income statements.
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So if we look at the year, here we have the beginning balance. Here we have the ending
balance. On the balance sheet, the ending balance is this number right here and the
beginning balance is right here, and we're looking at the change in cash over the period. So
that's where we're trying to get at. This is cash and cash equivalents at the beginning of the
year. So here we expanded it, beginning of the year, end of the year. If you take the
difference between those two, you get -$208 M. The purpose of the cash flow statement is to
explain how cash changed on the balance sheet. So you're looking at a balance sheet and
you say, "Hey, cash changed. I wonder why?" You go to the cash flow statement, much as
you did, by the way, when we looked at the equity accounts, and, you say, "Why did the
equity accounts change on the balance sheet?" Well, we went to the statement of changes in
owners’ equity, same idea here.
Now, if we take that -$208 M, which is the change on the balance sheet, we're going to break
it up in two parts. One is going to be -$188 M and the other is going to be -$20 M. Now, the
-$188 M, well, it pertains to cash flows that are up above here. Here for example, proceeds
from borrowings. It's a positive number because they went out and they borrowed some
cash. If they borrowed cash, that's cash coming in, so it's positively signed.
And here's a negatively signed cash flow, which is repayments of borrowings. Again, those
are intuitive. They're direct, one of the reasons it's called a direct cash flow statement. It all
has to do with cash coming in and cash going out. We're going to add all these cash flows up
above mathematically and when we do, we're going to get -$188 M, which means cash
changed because of flows in and out of the company by $188 M.
You see this $20 M here is not really a cash flow in or out of the company. You know what a
cash flow is. If you pay a bill, well, that's a cash outflow. If your employer pays you, well,
that's a cash inflow. But what about this $20 M? Well, it has to do with the fact that Qantas,
like many global companies, deals in many countries, and in particular, it deals in foreign
currencies. And, at the end of the year, it has to convert all the numbers into Australian
dollars.
And, when it does that, exchange rates can vary. So it may have a bank account for
example, in euros, and that bank account may lose value against the Australian dollar and
they'll have to adjust the Australian dollar balance for the changes in the euro currency
against the Australian currency, and that's way beyond this chapter, but we thought you
should know about it. Again, that's just an adjustment for currency exchange rate differences
and we're not going to be worrying about that.
Here is the number we want to focus on- what about those cash inflows and cash outflows?
But it is important for you to realize when you're looking at a company, cash inflows and
outflows plus the exchange rate, well, they explain the entire change on the balance sheet.
Once you know that, forget about foreign exchange rates for a while.
Now, let's continue to think about things you want to know about direct cash flow statements.
First of all, the balance sheet change in cash, that -$188 M, we're going to break it up into
about four parts. One is going to be the net cash inflows from operating activities. That's
going to be a classification on the cash flow statement. And then, plus the net cash inflows or
outflows from investing activities. So we'll add inflows and we'll subtract outflows. But
mathematically, we'll add them as long as we're careful with the signs. Plus, the net cash
inflows (outflows) from financing activities.
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So we got three categories -- operating, investing, and financing-- and we're going to add
those up and that's going to give us the -$188 M, and then we're going to have plus or minus
adjustments for exchange rate variations, and that's our -$20 M. Put those all together, we
got -$208 M. We'll see here shortly exactly where those come from.
And, these are IASB definitions for financing, investing, and operating. They are fairly
straightforward and we're going to give you the definitions here and look at a few examples.
And, if you want more examples, well, you can learn those in Scenic Route 1 on direct cash
flow statements.
So financing activities, what are they? They result in changes in the size and composition of
the contributed equity. Now, that sounds kind of complicated. All that means is you look to
your shareholders, did they give you some cash, for example, in exchange for stock? Did you
give them cash to repurchase shares or pay a dividend? All cash transactions with
shareholders and their roles as owners, and in borrowings of the entities, so the same idea
with debt holders. Under IASB, all cash flows that have to do with transactions with debt
holders can be classified, can be classified as financing transactions.
Now, all principal debt cash flows, so borrowing money, paying back principal, that has to be
classified as financing. But under IFRS, you have the option of taking interest payments and
putting them up in operations. So you can have it in operations or in financing. Under US
GAAP, everything is the same as IASB except that interest payments must, must be
classified as operating rather than financing.
What about investing activities? Well, investing activities are just what they sound like, buying
or selling long-term assets. And, it also includes buying or selling investment securities that
are current assets or investment securities that are long-term assets.
And then, what are operating activities? Principal revenue producing activities, the kind of
things you do every day and other activities that are not included above. And, we’re going to
see a few examples of those in a minute, tax payments for example, and under US GAAP,
interest payments or interest received, dividends received, things like that. Under IFRS, as
we just said a while ago, interest payments can go down below in financing or up in
operations, and interest received on investments for example, or dividends, well, those can
go in operations or in investing. A company has a choice but they must disclose it.
So let's go down and see how to get this -$188 M. We are going to focus first of all on these
three numbers, because when you add those together, you're going to get that -$188. So this
up here is roughly $1.8 B net cash from operating activities. So cash receipts in the course of
operations is $15 B. That's cash coming in from selling airline tickets, for example, to
passengers or receiving cash for having shipped freight for various companies. And then, we
got cash payments on the normal course of operations, so, paying employees, paying for
other resources they needed, and then we see interest received, interest paid.
So these are the kind of things we talked about earlier and they are all cash flows. Now, that
sounds crazy. You might be saying, "Well, of course they are all cash flows." No. When we
get to the indirect method, one of the distinguishing features is we're not going to have cash
flows up here in the operating section until we get to the cash from operations.
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So one of the reasons you really want to study cash flow statements are direct is you get
intuition about what's going into the cash from operations, that intuition you can't get studying
indirect. So when you net all those together, that's running your company and you are
generating cash from operations, and you better do that in the long run or you're in big
trouble because that's the real source of cash.
And then, what Qantas did during the years, it went out and invested around $2.5 B. Now, if
you look at that, you say, well, right away they have invested more money than they brought
in, and that's okay. That can be for growth. That can be because there was a downturn in the
economy. We're still in a bit of an economic crisis here. Lots of reasons. So in the short term,
that's fine. You can't have that in the long term, but in the short term that's fine. And so what
do we have? Well, we’ve got a little bit of a deficit going for us here, but they're going to
cover a lot of that deficit by going out and getting some money from debt holders and
shareholders.
So let's go back up and look at what investing activities are. Remember, it's buying long-term
assets, selling long-term assets.
Here is a great example, payments for property, plant and equipment. That's fairly common
and intangible assets, both long-term assets, $2.5 B going out for that. You can imagine
buying airplanes or whatever. And then they are selling property, plant and equipment. So
this is cash going out. You are buying plants for example. Here you are selling something
relatively small for $86 M, and it's cash coming in. Again, inflows and outflows, well, they
make common sense. And, you can go to the scenic route and get a little more information
about these cash flows. But we think they're pretty intuitive. If you just read these captions
and then look at what's happening to the cash going in or out, I think you’re going to be all
right without going to scenic route. But, if you find having difficulty with some of these line
items that you don't understand, you might want to go look at the scenic route to get a little
more information.
That's investing cash flows. So again, just to summarize, they brought in $1.8 B, they spent
$2.5 B, and then they went out and raised some cash. Remember financing activities,
transactions with shareholders, transactions with debt holders, largely. So payments for
treasury shares, that's repurchasing shares. That's just a synonym for repurchasing shares.
So they bought back some of their shares, $65 M going out.
And then “Proceeds from borrowing.” “Proceeds” is a word that means cash coming in. What
did we receive? Around $1.4 B. We started out with $1.8 B, we spend $2.5 B in investing, we
generate $508 M net out of financing, and we're left with a deficit from all of these activities
up here of -$188 M.
Well, you can't have a negative cash balance, so something must have happened. Well, of
course, it did. That's what we saw earlier. We have more cash to start the year with than we
did to end of the year. So we used up some of our excess balance, and, of course, then we
have that foreign exchange thing we talked about earlier. So that's really how the cash flow
statement works, and if you understand this, you can probably go straight to the exercises
and you will be fine.
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Indirect cash flow statements
What about the indirect statement? We want to start by showing you some things it has in
common with the direct statement because by studying the direct statement, you've learned
a lot about the indirect statement. First of all, they both have two years of data, not surprising.
And we're looking at Qantas's actual cash flow statement and we created a hypothetical
Qantas indirect cash flow statement, and that's very easy to do from the data they provide in
footnotes. It's the exact indirect statement they would have reported if they chose to report an
indirect statement.
What's similar and what's different? Well, first of all, all the cash flows starting with
operations, well, all of these cash flows, everyone of the investing, the financing, the foreign
exchange rate, the ending balances, all that is exactly the same. So the only difference is
going to be up here in the operating sections.
One of the things that we want to understand is what's going on over here in the operating
section of the indirect statement, because it's really different, and that's where you're going to
be focusing a lot of your energy.
Indirect cash flow statements reconcile net income to net cash from operations. We see for
the most recent year, statutory profit for the year was around $249 M and then net cash from
operations, we've already seen was $1,782. That can't change. That's got to be the same as
it was over here. So when you are looking at an indirect statement, you don't get much
intuition about what went into this cash from operations. You have to have in the back of your
mind all these inflows and outflows over here because the purpose over here on the
reconciliation, well, the purpose is to explain why income differs from cash.
And you might be saying, "Well, why do they do that? Why not just use the direct? I mean it
looks more direct." Absolutely, it does. Well, there's a couple of reasons and they are
explained in Scenic Route 2, but let me just give you a broad overview of what you can learn
from this reconciliation.
Now, we start with income and we end with cash from operations. And, what we're trying to
do here is we're trying to tell our shareholders, "Look, here's what we had for profit for the
year and here's what we had for cash for the year." Now, why might those differ? An investor
is going to care about that. And why would they care? Well, let's think about it. What does
profit measure? Profit measures the result of a lot of judgments. We saw accruals. We saw
deferrals. We saw lots of decisions requiring accounting judgment, for better or for worse, so
a company can show his private information and show what's going on in the company by
making an accrual or a deferral entry, and those were really important to getting information
about cash flows that are in the future or tying activities today to cash flows in the past. We
studied that in great deal on the income statement, but it gets us a different number for
income than cash from operations.
And, in between are lots of judgments. Now, these judgments can be good or bad. So if you
are an investor looking at a company and you are saying, "Well, I wonder how they are doing
their judgments. Are they being honest? Are they helping me get a better understanding of
the business?" Well, a good deal of that understanding comes from right in here and that's
called the reconciliation adjustments. To reconcile something is to explain it. So those are the
explanations for why income differs from cash. If you are an investor, you care a great deal
about those; and for more on that see Scenic Route 2.
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Take-aways
So where are we heading? Well, the challenging aspect of indirect cash flow statements is
interpreting the reconciliation adjustments. How do they explain why net income differs from
cash from operations? This is going to take a while to do, but we're going to get really good
at it by the time we get through with what's behind the numbers and even better in later
chapters. What do they tell us about the underlying business activities?
You know it's one thing to say you add these two things together and, guess what? You get
from income to cash. That's the math. What do we really learn about what's going on in the
business by studying these adjustments? And we can learn a great deal. Because
remember, management has got loads of judgment involved in these adjustments.
Under what circumstances are they useful to outsiders? The answer to these questions, we
got to go behind the numbers in the next module?
What should you do next? Well, as we always say, accounting is not a spectator sport so
you’ve got to get in the game. You’ve got to practice. So tackle the exercise. They are pretty
straightforward. They're just going to have you classify cash flows and learn various
synonyms that companies use on their line names on the cash flow statements. And then,
check your solutions and then identify things you don't know and then take corrective actions.
We think you're going to be able to do that from express route without going to the scenic
routes. But if you find you're having difficulty, go check out the scenic routes. Here is their
menus, pretty much the stuff we talked about here but in more detail.
Well, hope you enjoyed this video. See you in the next one.