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Corporate Finance ­FIN 622
VU
Lesson 25
CASH FLOW STATEMENT & WORKING CAPITAL MANAGEMENT
The following topics will be discussed in this lecture.
Cash flow statement
Direct method
Indirect method
Working capital management
Cash and operating cycle
Cash Flow Statement
The cash flow statement analyses changes in cash and cash equivalents during a period. Cash and cash
equivalents comprise cash on hand and demand deposits, together with short-term, highly liquid
investments that are readily convertible to a known amount of cash, and that are subject to an insignificant
risk of changes in value. Guidance notes indicate that an investment normally meets the definition of a cash
equivalent when it has a maturity of three months or less from the date of acquisition. Equity investments
are normally excluded, unless they are in substance a cash equivalent (e.g. preferred shares acquired within
three months of their specified redemption date). Bank overdrafts which are repayable on demand and
which form an integral part of an enterprise's cash management are also included as a component of cash
and cash equivalents. [IAS 7.7-8]
Presentation of the Cash Flow Statement:
Cash flows must be analyzed between operating, investing and financing activities. [IAS 7.10]
Key principles specified by IAS 7 for the preparation of a cash flow statement are as follows:
·  Operating Activities are the main revenue-producing activities of the enterprise that are not
investing or financing activities, so operating cash flows include cash received from customers and
cash paid to suppliers and employees [IAS 7.14]
·  Investing Activities are the acquisition and disposal of long-term assets and other investments
that are not considered to be cash equivalents [IAS 7.6]
·  Financing Activities are activities that alter the equity capital and borrowing structure of the
enterprise [IAS 7.6]
·  interest and dividends received and paid may be classified as operating, investing, or financing cash
flows, provided that they are classified consistently from period to period [IAS 7.31]
·  cash flows arising from taxes on income are normally classified as operating, unless they can be
specifically identified with financing or investing activities [IAS 7.35]
·  for operating cash flows, the direct method of presentation is encouraged, but the indirect method
is acceptable [IAS 7.18]
The direct method shows each major class of gross cash receipts and gross cash payments. The
operating cash flows section of the cash flow statement under the direct method would appear
something like this:
Cash receipts from customers
xx,xxx
Cash paid to suppliers
xx,xxx
Cash paid to employees
xx,xxx
Cash paid for other operating expenses
xx,xxx
Interest paid
xx,xxx
Income taxes paid
xx,xxx
Net cash from operating activities
xx,xxx
The indirect method adjusts accrual basis net profit or loss for the effects of non-cash
transactions. The operating cash flows section of the cash flow statement under the indirect
method would appear something like this:
Profit before interest and income taxes
xx,xxx
Add back depreciation
xx,xxx
Add back amortization of goodwill
xx,xxx
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Corporate Finance ­FIN 622
VU
Increase in receivables
xx,xxx
Decrease in inventories
xx,xxx
Increase in trade payables
xx,xxx
Interest expense
xx,xxx
Less Interest accrued but not yet paid
xx,xxx
Interest paid
xx,xxx
Income taxes paid
xx,xxx
Net cash from operating activities
xx,xxx
·
Cash flows relating to extraordinary items should be classified as operating, investing or financing
as appropriate and should be separately disclosed [IAS 7.29]
·  The exchange rate used for translation of transactions denominated in a foreign currency and the
cash flows of a foreign subsidiary should be the rate in effect at the date of the cash flows [IAS
7.25]
·  Cash flows of foreign subsidiaries should be translated at the exchange rates prevailing when the
cash flows took place [IAS 7.26]
·  As regards the cash flows of associates and joint ventures, where the equity method is used, the
cash flow statement should report only cash flows between the investor and the investee; where
proportionate consolidation is used, the cash flow statement should include the venturer's share of
the cash flows of the investee [IAS 7.37-38]
·  Aggregate cash flows relating to acquisitions and disposals of subsidiaries and other business units
should be presented separately and classified as investing activities, with specified additional
disclosures. The aggregate cash paid or received as consideration should be reported net of cash
and cash equivalents acquired or disposed of [IAS 7.39]
·  Cash flows from investing and financing activities should be reported gross by major class of cash
receipts and major class of cash payments except for the following cases, which may be reported on
a net basis: [IAS 7.22-24]
cash receipts and payments on behalf of customers (for example, receipt and repayment
of demand deposits by banks, and receipts collected on behalf of and paid over to the
owner of a property)
cash receipts and payments for items in which the turnover is quick, the amounts are
large, and the maturities are short, generally less than three months (for example, charges
and collections from credit card customers, and purchase and sale of investments)
cash receipts and payments relating to fixed maturity deposits
cash advances and loans made to customers and repayments thereof
·  investing and financing transactions which do not require the use of cash should be excluded from
the cash flow statement, but they should be separately disclosed elsewhere in the financial
statements [IAS 7.43]
·  the components of cash and cash equivalents should be disclosed, and a reconciliation presented to
amounts reported in the balance sheet [IAS 7.45]
·  the amount of cash and cash equivalents held by the enterprise that is not available for use by the
group should be disclosed, together with a commentary by management [IAS 7.48]
Defining Working Capital
The term working capital refers to the amount of capital which is readily available to an organization. That
is, working capital is the difference between resources in cash or readily convertible into cash (Current
Assets) and organizational commitments for which cash will soon be required (Current Liabilities).
Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course
of business".
Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of
business".
Thus:
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
In a department's Statement of Financial Position, these components of working capital are reported under
the following headings:
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Corporate Finance ­FIN 622
VU
Current Assets
·  Liquid Assets (cash and bank deposits)
·  Inventory
·  Debtors and Receivables
Current Liabilities
·  Bank Overdraft
·  Creditors and Payables
·  Other Short Term Liabilities
The Importance of Good Working Capital Management
Working capital constitutes part of the Crown's investment in a department. Associated with this is an
opportunity cost to the Crown. (Money invested in one area may "cost" opportunities for investment in
other areas.) If a department is operating with more working capital than is necessary, this over-investment
represents an unnecessary cost to the Crown.
From a department's point of view, excess working capital means operating inefficiencies. In addition,
unnecessary working capital increases the amount of the capital charge which departments are required to
meet from 1 July 1991.
Approaches to Working Capital Management
The objective of working capital management is to maintain the optimum balance of each of the working
capital components. This includes making sure that funds are held as cash in bank deposits for as long as
and in the largest amounts possible, thereby maximizing the interest earned. However, such cash may more
appropriately be "invested" in other assets or in reducing other liabilities.
Working capital management takes place on two levels:
·  Ratio analysis can be used to monitor overall trends in working capital and to identify areas
requiring closer management (see Chapter Three).
·  The individual components of working capital can be effectively managed by using various
techniques and strategies (see Chapter Four).
When considering these techniques and strategies, departments need to recognize that each department has
a unique mix of working capital components. The emphasis that needs to be placed on each component
varies according to department. For example, some departments have significant inventory levels; others
have little if any inventory.
Furthermore, working capital management is not an end in itself. It is an integral part of the department's
overall management. The needs of efficient working capital management must be considered in relation to
other aspects of the department's financial and non-financial performance.
Cash Operating Cycle
Cash Conversion Cycle, also known as the asset conversion cycle, net operating cycle, working capital
cycle or just cash cycle, is used in the financial analysis of a business. The higher the number, the longer a
firm's money is tied up in business operations and unavailable for other activities such as investing. The
cash conversion cycle is the number of days between paying for raw materials and receiving cash from
selling goods made from that raw material.
·  Cash Conversion Cycle = Average Stockholding Period (in days) + Average Receivables Processing
Period (in days) - Average Payables Processing Period (in days)
with:
·  Average Stockholding Period (in days) = Closing Stock / Average Daily Purchases
·  Average Receivables Processing Period (in days) = Accounts Receivable / Average Daily Credit
Sales
·  Average Payable Processing Period (in days) = Accounts Payable / Average Daily Credit Purchases
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Corporate Finance ­FIN 622
VU
A short cash conversion cycle indicates good working capital management. Conversely, a long cash
conversion cycle suggests that capital is tied up while the business waits for customers to pay.
It is possible for a business to have a negative cash conversion cycle, i.e. receiving customer payments
before having to pay suppliers. Examples are typically companies that employ Just in Time practices such as
Dell, and companies that buy on extended credit terms and sell for cash, such as Tesco.
The longer the production process, the more cash the firm must keep tied up in inventories. Similarly, the
longer it takes customers to pay their bills, the higher the value of accounts receivable. On the other hand, if
a firm can delay paying for its own materials, it may reduce the amount of cash it needs. In other words,
accounts payable reduce net working capital.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk