Scenic Video Transcript Direct Cash Flow Statements Topics. Introduction. Purpose of cash flow statements. Level 1 analysis: major categories

Transcription

1 Cash Flow Statements» What Do I See?» Direct Cash Flow Statements» Scenic Video Scenic Video Transcript Direct Cash Flow Statements Topics Introduction Purpose of cash flow statements Level 1 analysis: major categories Level 2 analysis: line items o Financing cash flows o Investing cash flows o Operating cash flows Take-aways Transcript Introduction Welcome to the Direct Cash Flow Statements Scenic Route. This video will help you understand the purpose and structure of direct cash flow statements. Most IFRS and US GAAP companies don't report direct cash flow statements even though they are encouraged to do so by standard setters. Instead, they report the indirect statements discussed in the next scenic route. This raises two questions: Why don t companies use direct statements, and of course, why should you study direct statements if they're not used much? We'll explain the reasons most companies don t use direct statements when we go behind the numbers. Why should you study direct statements even though they're not used much? Because you can learn a great deal about indirect statements by studying direct ones. In fact, direct statements provide more information about cash flows than indirect statements. This means we can gain valuable insights about what's happening behind the numbers reported in indirect cash flow statements by studying direct cash flow statements. To this end we look to Australia, the one country where many, if not most, companies report direct cash flow statements. In fact, before Australia adopted IFRS in 2005, direct cash flow statements were required. Consistent with IFRS, Australian companies are now encouraged to report direct cash flow statements, but they can also use indirect statements just as companies can around the world. We begin with the primary purpose of direct cash flow statements, which we're going to connect to balance sheets. And by the way, that's also going to be the primary purpose of indirect cash flow statements. You may translate this work into your local language, as long as you credit G. Peter & Carolyn R. Wilson and respect the Creative Commons Attribution-Noncommercial-Share Alike United States license NavAcc LLC.

2 And then we'll do a Level 1 and Level 2 analysis similar to what we do with the balance sheet in the income statement starting at the highest level with three numbers and then working our way down into the line items. As we go through the Level 2 analysis which is line items, we'll talk about three sections of the cash flow statement: financing activities, investing activities, and operating activities; and then we'll end with some takeaways. So let's get started. Purpose of cash flow statements Even though we re talking about direct cash flow statements here, we're going to begin with the balance sheet, and we're going to be looking at Qantas' balance sheet. Recall Qantas is an Australian airline. As we look at the cash account and, cash and cash equivalents that is, we see that their beginning balance of their cash was around $3.7 B, the ending balance was around $3.5 B, and it changed this by about $208 M. You'll notice we've added a column to the balance sheet relative to what the company reported so we could easily see the change, just as we did earlier for the statement of changes in owners' equity. Now the question you might be asking yourself when you're looking at a balance sheet, cash went down by $200 M, why? And that's of course similar to the question you asked when we were looking at the statement of shareholders' equity. In that case, when we looked at the equity accounts on balance sheet we saw they changed and we went to the statement of changes in owners' equity, and that explained in much more detail why it changed. Well, we're going to do the same thing with the direct cash flow statement. We're going to look at the cash flow statement to get better insights about why cash changed on the balance sheet. In fact, that's the primary purpose of the cash flow statement. So, let's do that. Now the first thing I want to point out is that we look at this direct cash flow statement for Qantas is that we ve got one column here that we're going to focus on, and that s the column for Now there were two columns on the balance sheet that corresponded to this one column on the cash flow statement. Remember, there's a beginning balance and there's an ending balance on the balance sheet. And, the cash flow statement is going to focus on the period in between just as the income statement did. So the cash flow statement, obviously, is a flow statement rather than balance sheets, which are stock statements, measured at a point in time. So we're looking at the activity that happened during the period. How did cash change during the period and why? And that means one column on the cash flow statement corresponds to two columns on the balance sheet. If you wanted to find corresponding balance sheet numbers for the year before, well, you'd have to go back and look at the balance sheet change on the balance sheets that were reported the year before. So that's an important thing to keep in mind. Students often get that confused. So let's get started here and work our way down and see what the bottom line is on the direct cash flow statement. We begin by looking for some numbers we re already familiar with. So what was the cash balance at the beginning of the year? Well, here it is right here, $3,704, $3,704, $3,704, beginning balance, and that was reported on the balance sheet. And then at the end of the year on the balance sheet was $3,496. The difference on the balance sheet was $208. 2

3 Now how does this statement give us more insights about that? Well, first of all, there's this number -$188, $188 M decrease. Now, that's not the same as the $208 decrease. And why is that? Well, it's because of foreign currency effects right here, which are $20 M more. I'll come back and explain all that, but let's first of all go back and figure out where does $188 M decrease come from? It comes from up here. That is the direct cash flow statement. All the numbers above, they net to -$188 M. And that s what the statement is doing. It s explaining the changes in cash in terms of what happened during the period with cash inflows and outflows, and we ll see that in just a second. What about this $20 M? What does it do? Well, the $188 M is really cash flows. Now, what does that mean? Well, you know what cash flows are. If you spend money to pay your electric bill, well that s a cash outflow. If someone gives you cash, perhaps an employer, well that s a cash inflow. So the $188 M is all going to be inflows or outflows, and you can see that right here. Inflows are positive numbers; outflows are negative numbers. What about this $20 M that has to do with foreign exchange rates? Well, that number is a little different. You see, cash didn t actually flow in that situation but rather Qantas has operations in other countries. And because it has operations in other countries, it deals in foreign currencies in other countries. Well, the cash balances at the end of the year have to be translated into Australian dollars because that s the way they re reporting their numbers. And when they do that translation, there can be exchange rate differences between the currency they re translating from to the Australian dollar, and that gives rise to these exchange rate adjustments to the cash account. Otherwise, it wouldn t balance in Australian dollars. Now, you need not worry about that at this point. You just need to know that if you want to explain the entire change on the balance sheet, well part of that is going to be due to currency exchanges and part of that to cash flows in and out of the company. And that s where our focus is going to be primarily going forward. Level 1 analysis: major categories Now, let s break down that $188 M and get more insights about it. And we'll do that, first of all, with a Level 1 analysis. When you first look at a cash flow statement, you ought to look down at the bottom, and sometimes, by the way, these beginning balances and any balances are in different places on the statement and say, well how much did it change? And then try to break it down and get to this $188 M and say, well, that s what I d like to get more insights about. And, the very first thing you want to do is, say, there's three numbers I want to look at that go into that $188 M. And, the first number is cash from operations. Now, we ll be breaking down operations in just a minute, but for right now it s kind of intuitive. Operations has to do with things that happen frequently over and over again in the business and they tend to happen within an operating cycle. So we got $1.8 B for Qantas coming in from operations. And if we look at the net cash from investing activities, it s around $2.5 B. Now, notice that s a net cash flow. Some cash went out, some cash came in, but on net it was around $2.5 B. And we will be looking at these cash flows in detail in just a minute. So what are investing cash flows? Well, that s buying long-term assets or something like that. So here is what we have so far. From operations, Qantas generates $1.8 B roughly, and 3

4 they ve used about $2.5 B to grow the business going forward. Now, where are they getting the money from? Well, then we look in the financing activities. We see from their financing activities they generated $508 M. Now, what are financing activities? Again, we ll look at it more in detail shortly, but for right now financing activities are just shareholders giving cash to the company or getting cash from the company, debt holders giving cash to the company or getting cash from the company. So what do we have so far? We see if you add those numbers up mathematically, you get the -$188 M. Now, you can t end up with -$188 M of cash, so the cash balance had to decrease by that amount. Of course, that s ignoring the foreign currency effects which we will ignore going forward because it s largely outside the scope of this chapter. Let s see if we can get some more insights about these three different types of cash flows. Level 2 analysis: line items Financing cash flows We begin with financing cash flows. And the reason we start with financing rather than operating, by the way, is operating cash flows, as we will see, are defined to be everything else when you have defined investing and financing cash flows. And there s another reason. When a company starts its business, well it starts with financing cash flows. You have to go out and raise some money before you can buy property, plant and equipment, for example, and before you can start operating that property, plant and and equipment. So it's kind of logical to start with financing even though it s typically at the bottom of the cash flow statement. There s a formal definition here, but I d rather we focus on the examples to give you some insights and then look at the line items that are reported. What do we tend to find when we look at the financing section of a direct cash flow statement which, by the way, is the same as an indirect cash flow statement as we ll see shortly. Well, first of all, all transactions with owners in their role as owners, so we re talking about events that we ve looked at in the past like issuing stock, buying back stock, paying dividends. Those are the big transactions with owners, all those cash flows go in the financing section. Now, what about debt holders? Well, under US GAAP, all cash transactions with debt holders except interest payments are classified as financing activities. Interest payments under US GAAP are classified as operating cash flows. Now, what about IFRS? Under IFRS, all transactions with debt holders can be classified as financing activities, but they have the option of putting interest, like US GAAP companies, up in the operating section. Let s look at some line items in the financing section of Qantas' cash flow statement. We see Payments for treasury shares. Now, what are treasury shares? This is basically a stock repurchase, so the company buying back its shares. So when you buy back your own shares, we say you have treasury shares. Now, here is the key thing we want you to know at this point, it's a cash outflow. So Qantas spends $65 M to buy back some of its shares. What about Proceeds from borrowings? Well, proceeds means cash received. So how much cash did Qantas receive when it borrowed money from debt holders? Well, $1.4 B roughly. And then how much did they repay in principal for borrowings? $784 M. 4

5 So look at the signs and they make logical sense, and that is why it s called a direct cash flow statement because when cash is coming in, when you borrow money, well it's positive. And when it's going out, it's negative. And, this is a really important thing to see right up front. And, the other thing to see is once we explain some of what these words mean, they re kind of logical. Once we know what proceeds are, we can think of, oh, that's money coming in because we went and got money from a debt holder just like you would get money from, say, a bank to go to college. Now, here we have (Payments)/ proceeds from swaps. Well, that one is out of bounds, okay. We won t worry about that, but look it's only a million dollars. And then we get the Net receipts from aircraft security deposits, and that's not even there for this year. And then Dividends paid to non-controlling interests. So they didn t pay dividends to their controlling interest shareholders, their major shareholders, but they did do a non-controlling interest and again it's a small number. So the big numbers focus on the big issues we talked about up here -- transactions with shareholders, transactions with debt holders, and those transactions primarily with debt holders and share holders that involve issuing shares, repurchasing shares, issuing debt, paying off debt, or things like that. We also noticed right away that their interest is not here because they have interest on their debt, and they have not included it in their financing activities. So we'll find it up in the operating activities, which again is an option they have. The key takeaway here is that financing activities are really intuitive once you get the hang of them, and they tend to look fairly similar across companies except for synonyms. Sometimes you have to worry about companies describing the same thing differently. Investing cash flows Now, let s look at the investing section of the cash flow statement, and again some examples will help us out tremendously here. Investing generally deals with buying or selling long-term assets. So buying property, plant and equipment or selling it, buying a business with cash or selling one for cash, buying financial assets with cash or selling them for cash. And this is the one exception to the long-term assets because if you, for example, buy US government bonds, often those will be classified as investing activities because you are buying securities, but they might be classified on your balance sheet as current rather than non-current. So most investing activities center on long-term assets, buying or selling them, but securities which are foremost financial assets are current and yet are classified often as investing activities. So let s look at some of these. Payments for property, plant and equipment, and again notice $2.4 B going out. Interest paid and capitalized on qualifying assets, well, that s one we don t want you to worry about right now. And then we have, Proceeds from disposal of property, plant and equipment; proceeds, that s cash received, so they got $86 M; Proceeds from the sale and leaseback of non-current assets, $30 M, and that means they sold an asset and then turn around and leased it back. So when they sold it they got $30 M for it. And we could go on. Most of these are fairly logical. Sometimes you have to understand the underlying business issues, but once you understand the underlying business issues and the vocabulary, they are straightforward. Operating cash flows Now we turn to operating cash flows. It s basically everything else that wasn't included in financing and investing. And some of these things make sense we think about what 5

6 operations are. We tend to think of Customers' collections. So Qantas collecting cash from people who are flying the airlines or from delivering freight for other parties, Payments to resource providers, like paying employees, for example. But we generally don t think of Income tax payments as having to do with operations, but they are considered part of operations because they don t fit into investing and financing. And then here we have Interest and dividends received. And again, we don t typically think of that as operations. Certainly, interest income on the income statement is generally not classified as an operating event, and that is an important distinction to understand. Often, events that deal with operations on the income statement are not classified the same on the cash flow statement. When you re classifying cash flows, they fall under these three categories and they ve been very clearly classified by the standard setters. The same is not true for the income statement in general and there is some inconsistency there. So just have a heads up on that. And then we see Interest paid. As we indicated earlier, that s an option and Qantas chose to put it up here. So if we look at this, we see cash receipts in the course of operations, $15 B; cash payments in the course of operations, $13,727. Some companies would break this down into cash paid to employees, cash paid to suppliers, whatever. But this is all a company really has to do under the direct statement -- interest received, interest paid, dividends received, income tax refunds. So they didn t pay taxes. They actually got a refund this year. And then importantly, the net cash is going to be $1,782. Now, when you look at the net cash, it s obviously a much smaller number because we net the large numbers with the small numbers, positives and negatives, and that s the number we re going to see on the indirect cash flow statement later. And what s really important about direct cash flow statements is that you learn to look at all these components that are in operations and get an intuitive feel for what s behind net cash from operations because when we get to the indirect, as the name suggests, you re not going to see these numbers up here but they re still going to be going into net cash from operating activities, which you will get to see on an indirect statement. That s just a little preview for you. Take-aways So what should you take away by now? Well, first of all and most importantly, how the cash flow statement tends to work. At Level 1 analysis, what do we see? Well, we see that if we take operating cash flows and add mathematically, that is taking into account the negative sign, the investing cash flows, and add the financing cash flows, we get the change in cash related to inflows and outflows. And then we have to adjust for foreign currency at the end of the year, which don t relate to cash going in or out but just the way we value the cash as we convert it from a foreign currency. And that gets us to the change in the balance sheet, and that s the purpose of the statement. And then we can drill down deeper into the line items. So where are we heading? Well, IFRS encourages companies to report direct cash flow statements. Most companies report the indirect cash flow statement studied in the next scenic route. That s interesting, right? Not only IFRS, by the way, but US GAAP companies both encourage direct statements. Yet, most companies use indirect statements. Except for their operating sections, direct and indirect cash flow statements are identical. The operating sections of indirect cash flow statements explain why income differs from cash from operations, reconcile, explains, and that s going to be our big focus when we go to the next scenic route and the large part of what we do when we go behind the numbers. 6

7 7 Most of the reported line items explain differences in net income and net cash from operations on indirect statements, and they re not cash flows. And that surprises students when they first look at it. It s called a cash flow statement. Yet, when we look at these reconciling items that explain why income difference from cash, generally those aren t cash flows. You ll understand that when we go behind the numbers. This contrasts with direct cash flow statements where all line items are cash flows. So everything we looked at so far is a cash flow. Companies that report direct cash flow statements, like in Australia, typically reconcile net income to net cash from operations in their footnotes. So they essentially do an indirect statement anyway. It s going to be really important that we understand the indirect statement, but it was also important that we start it with the direct to give you some insights that are going to be behind the numbers when we look at the indirect statement that we're not going to get to see. Well, I hope you enjoyed this video. See you next time.