Managing cash flows: Extract MANAGING CASH FLOWS EXTRACT

Transcription

1 Managing cash flows: Extract MANAGING CASH FLOWS EXTRACT CPA Australia Ltd

2 CONTENTS Course overview 1 Learning objectives 1 Course content 1 Knowledge assessment 2 Symbols 2 1. Managing cash flows overarching concepts Organisational discipline Factors influencing cash flows The role of cash flows in corporate collapses Financial statement classifications Creative accounting Financial statement manipulation Cash flow classifications Sourcing cash Financial mathematics Summary Managing cash balances Introduction Liquidity management Treasury function The benefits Cash management Ratios involving cash balances Current ratio, quick ratio and cash ratio Cash burn rate Months to burnout Summary Operating cash flow management Introduction Definition Management of working capital The operating cycle and cash cycle Inventory cycle Accounts receivable cycle Accounts payable cycle Reducing the cash cycle Summary Receivables management Provision for doubtful debts Debtor management policy Factoring of accounts receivable Evaluating debtor policies Inventory management Just in time (JIT) Economic order quantity (EOQ) Incremental analysis 37 2 CPA Australia Ltd 2014

3 3.7 Payables management Other operating cash flows Differences between accrual profit and operating cash The failings of EBITDA as a proxy for operating cash flow A sustainable level of recurrent cash flows Operations index Comparative cash flow spread sheet Normalising the cash flow statement Sustainable cash flow worksheet example Ratios involving operating cash flows Liquidity ratios Profitability ratios Financial stability ratios Summary Investing cash flow management Introduction Definition Improving cash flow through management of capital expenditure Lease versus buy decisions Comparing mutually exclusive projects with different lives Immediate versus deferred investment Cash flow for business valuation Improving cash flow through financial instruments Summary Financing cash flow management Introduction Definition Ways of improving financing cash flow Debt versus equity Sources of equity financing Share buybacks Dividend policy Sources of debt financing Managing long-term debt risk Summary Forecasting and budgeting cash flows Introduction Budgeting Important considerations Steps in cash flow budgeting Strategic issues affecting cash budgets Sensitivity analysis Forecasting Forecasting considerations Example: Cash budget preparation Summary Conclusion 86 Glossary 88 CPA Australia Ltd

4 References 89 Suggested answers 90 Appendices 110 Appendix 1: Financial mathematics 110 Appendix 2: Case studies 117 Case study 1: One.Tel and Telstra 117 Case study 2: Qantas Airways and Air New Zealand CPA Australia Ltd 2014

5 1. MANAGING CASH FLOWS OVERARCHING CONCEPTS Effective management of cash flows is crucial for the success of any organisation. KEY POINT 1.1 ORGANISATIONAL DISCIPLINE A key to effective management of cash flows is organisational discipline. By this, we mean that the organisation understands the importance of cash management, has written policies about how cash is managed, and tenaciously implements those policies throughout the organisation. Such policies may cover: cash flow forecasting and budgeting; cash reconciliations and controls; product pricing and volumes (sales growth and gross margins); working capital management (accounts receivable, accounts payable, inventory); operating expenses (selling, general and administrative); capital investment decisions; and funding management (cash, debt and equity). Instilling organisational discipline is something that requires strong leadership and a strong culture of cash management. Knowing what to do is one thing, but actually doing it is what will help your organisation survive the difficult times and thrive in good times. 1.2 FACTORS INFLUENCING CASH FLOWS While preparation of a cash flow statement is important in identifying the overall cash position of an organisation, it is a measure of past events. Effective cash management involves identification of the external and internal factors that influence these cash flows. External factors include interest rates, exchange rates, and global, national and industry economic performance. Often these factors are beyond the control of the organisation. However, the consequences of such factors can be influenced to a degree by effective management of key internal factors within the organisation areas over which it has control. These internal factors may include competitive strategies, organisational structures, working capital policies, investment decisions, and funding arrangements. Once these factors have been identified, and their likely impact assessed, the organisation can obtain a better understanding of future cash flows and be better prepared to manage them. TIP When analysing cash flows, it is sometimes helpful to apply Pareto s principle. Created by Italian economist Vilfredo Pareto in 1906 to explain the uneven distribution of wealth in his country, Pareto s principle states that 20% of the causes represent 80% of the effect. The principle highlights the need to pay close attention to the most important 20% of an organisation s cash balances and transactions, as they will likely determine 80% of the organisation s problems or benefits. CPA Australia Ltd

6 1.3 THE ROLE OF CASH FLOWS IN CORPORATE COLLAPSES Often financial statement users believe that as long as a company is profitable then the business is sound. A further misconception is that if assets on the balance sheet are growing, then the company is becoming stronger. Past corporate collapses have indicated that a company can fail even though it is profitable, and even though it may be large in size. Such cases reinforce the adage that Cash is King. The ability to manage and forecast organisational cash flow is important in that without it a business will not survive. History is littered with examples of organisations which have become insolvent because of a lack of cash flow. Recent corporate collapses can be attributable, to a large degree, to the failure to manage cash, in addition to other factors such as poor corporate governance. Read these two interesting quotes from Kerry Packer and James Packer regarding the high-profile collapse of One.Tel Ltd, which was largely attributable to the organisation s failure to manage cash flow. You ran out of cash with Imagineering, and it s going to happen again. Kerry Packer to Jodee Rich on the performance of One.Tel January 2001 (Barry, 2002 p. 275). Imagineering was a fast-growing company founded by Jodee Rich that collapsed in the late 1980s, largely due to lack of cash flow. What s going on? When am I meant to panic? 1.4 FINANCIAL STATEMENT CLASSIFICATIONS The executive chairman of Publishing & Broadcasting Limited, James Packer, in the NSW Supreme Court, on what he said to Jodee Rich, the founder of failed telecommunication company One.Tel, after reading a cash report in (BRW, July, 2005.) Organisations are now so diverse and complex that the transactions they enter into are often unique and can t be compared with those of other organisations. This, in turn, makes the financial statement classification of those transactions much harder. While a vast majority of organisations make genuine attempts to correctly classify transactions according to their true nature and form, a number of recent corporate collapses have revealed evidence of creative accounting, and even fraudulent accounting Creative accounting Creative accounting commonly involves manipulation of the financial statements through questionable transactions, classifications or disclosures. It involves distorting financial reality to suit the needs of the organisation (or its major stakeholders) and often occurs when transactions fall into grey areas whereby: they are not covered by particular accounting standards; or existing standards are not explicit about how a transaction is to be handled Financial statement manipulation The income statement and the balance sheet can be manipulated in numerous ways. Asset or revenue overstatement Capitalising costs (i.e. treat as an asset) rather than expensing costs (e.g. software development). Booking revenue before it should be recognised. Recognising revenue prior to the shipment of goods. Changing inventory valuation methods. Extending amortisation and depreciation periods for long-life assets. 6 CPA Australia Ltd 2014

7 Liability or expense understatement Delaying inventory write-down (obsolescence). Accruing operating expenses and creating liability accounts in good years, in order to reduce future years operating expenses in years where profit is not so good (i.e. cookie jar reserves). Failing to provide sufficiently for bad and doubtful debts. Disclosure of transactions or events Exploiting interpretation of materiality in terms of its impact on decisions. Exploiting use of professional judgment between the common 5% 10% materiality guidelines. Using misleading graphs and pictures. Conceptually speaking, you can therefore have two companies with exactly the same transactions but they will have different levels of profit, and different balances between debt and equity on the balance sheet, solely because of differences in accounting policy choice. 1.5 CASH FLOW CLASSIFICATIONS While income statements and balance sheets have been in existence in some way, shape or form for over 100 years, cash flow statements are the most recent of the three financial statements that are required of reporting and disclosing entities. However, these are often the most misunderstood and least used of the three statements. Data in cash flow statements arise solely through external transactions, unlike income statements and balance sheets which rely on accruals involving assumptions about revenue and expense allocation. Cash flow statements, however, are still subject to a creative element. The flexibility inherent in accounting standards means that certain cash flows can be classified under more than one of the three categories: operating, investing, or financing. AASB 107/IAS 7/IAS 7 Statement of Cash Flows is not an extensive standard, and offers some flexibility with respect to cash flow classification. Figure 1 Proceeds from sale of PPE INVESTING CASH FLOW Sale of investments Purchase of investments Purchase of PPE Proceeds from borrowings Repayment of borrowings FINANCING CASH FLOW Share buyback Proceeds from share issue Proceeds from sale and leaseback transactions Loans to joint venture entities Interest received and paid Taxes paid Dividends received Sale of receivables Dividends paid Software development/ R&D costs Oil exploration costs Customer/ subscriber acquisition costs Proceeds from customers Payment to suppliers of goods OPERATING CASH FLOW Payment to suppliers of services CPA Australia Ltd

8 Read these examples involving software development and interest, dividends and taxes. They provide a sample of how flexible organisations can be in disclosing cash flow. Flexibility should not be encouraged, however, because it is important that there be consistency in the application of a particular accounting policy from year to year to ensure comparability, and that items capitalised and placed in investing activities do in fact satisfy the definition of an asset they will generate future economic benefits. EXAMPLE Software development Before a software application becomes technically feasible, software development costs are expensed, and are usually classified as operating cash flows. Once feasibility is achieved and the organisation expects that future revenues will be generated from the software project, then subsequent costs can be capitalised, and consequently classified in the statement of cash flows as investing activities. However, it is likely that some organisations have expensed such development costs in the income statement and classified them as investing activities in the cash flow statement. This can result in a mismatch between operating cash flows and the operating profit. A similar approach has been taken for research and development and for oil exploration costs. EXAMPLE Interest, dividends and taxes Interest can also be capitalised or expensed. Interest incurred as part of the construction of a qualifying asset is capitalised and can be included as an investing outflow. Likewise, interest can be the cost of obtaining financial resources and classified as a financing outflow. Dividends received can be classified as operating cash flows as they can be part of the revenue-producing activities of the organisation, or they can be investing cash flows if seen as a return on investment. Dividends paid are typically classified as a financing cash flow as they represent a cost of funding. However, they may instead be classified as an operating cash flow in order to help assess the ability of the organisation to pay out dividends from operating cash flows. Taxes paid are operating cash flows if related to income tax, GST or fringe benefits, but are investing cash flows if related to capital gains tax payable on the sale of a non-current asset. 1.6 SOURCING CASH Sourcing cash from operating activities is a positive sign that a company has a sustainable level of recurrent cash flows. That is, the company sells products/services for more than they cost, and promptly collects the cash from those sales. This is in contrast to a company that, for example, borrows funds to pay for operating expenses or to make dividend payments. Cash from operating activities is a cash-based measure of operating profit after income tax. This section is the most critical of the three sections of a Statement of Cash Flows as, if a company cannot produce sustainable cash flows from operations, then cash flows generated by investing or financing activities will be of no real benefit. Sourcing cash from investing activities might indicate that productive assets are being sold (or might indicate dividend received from investments). This may be good if the asset being sold is itself not adding sustainable cash flows to the organisation. However, sourcing cash from investing activities in order to fund a shortfall in operating cash flows is a negative sign. 8 CPA Australia Ltd 2014

9 Sourcing cash from financing activities indicates that the business is expanding. This can be a positive sign if the organisation s balance sheet is not over-geared. However, excessive debt may place the company at a risk of default if there is a downturn in the business or interest rates rise significantly. Sourcing cash from shareholders can lead to lower returns on equity if those funds are not put to productive use. 1.7 FINANCIAL MATHEMATICS When managing and forecasting cash flows, knowledge of relevant financial concepts and formulas is critical. Financial concepts include compound interest, nominal and effective interest rates, geometric rates of return, present and future values, net present values and annuities. A core component of these financial concepts is the time value of money. Knowledge of financial mathematics is assumed in this course. An overview of the relevant financial mathematics concepts can be found in Appendix 1. APPENDIX CPA Australia Ltd