Accounting Business Reporting for Decision Making

CHAPTER 7 Statement of cash flows 293

VALUE TO BUSINESS

•   ‘Cash’ is defined as cash on hand and cash equivalents.

•   The statement of cash flows classifies an entity’s cash flows into operating, financing or investing

activities.

•   To prepare the statement of cash flows adjustments need to be made to convert the accrual

statements (statement of profit or loss and balance sheet) to a cash basis.

•   The direct method and the indirect method are two approaches that can be used to prepare and

present the statement of cash flows.

In the past, the statement of profit or loss and the balance sheet have taken centre stage when

assessing future earnings. However, it is now becoming widely recognised in the investment commu-

nity that the management of earnings can result in some accounting manipulations in the statement of

profit or loss. This heightened recognition has led to an increase in the reliance on the statement of

cash flows for extra information about the earnings potential of an entity. The comparison of profit or

loss with the cash flow from operating activities can highlight how an entity is managing its working

capital requirements.

The lending world is also showing interest in the statement of cash flows. It is argued that lenders can

use the statement of cash flows to answer questions about the performance of an organisation’s manage-

ment, or whether an organisation has generated or can generate sufficient cash. On the other hand, enti-

ties can manipulate items on the statement of cash flows just as easily as they can on the statement of

profit or loss or balance sheet to make performance appear more favourable.

7.4 Analysing the statement of cash flows

LEARNING OBJECTIVE 7.4 Evaluate an entity’s performance using a statement of cash flows.

The purpose of preparing financial statements is to allow users to evaluate an entity’s operations and

financial performance. Understanding how the statements are prepared helps in the evaluation. The pre-

vious sections highlighted that the statement of cash flows helps to evaluate the cash generated by the

operating activities in order to service the needs of the investing and financing activities.

For JB Hi-Fi Ltd, the following general observations for 2015 can be made from the statement of cash

flows (see figure 7.2).

• Net cash flows from operating activities were $180 million, which was slightly higher than profit of

$136.5 million. Profit includes an amount for depreciation and amortisation so, as a general rule, the

cash from operating activities should be higher.

• The reconciliation (which is produced in note 32 of the financial statements and reproduced in

figure 7.2) reveals increases and decreases in current assets and current liabilities. This illustrates

the heart of working capital management (the cycle of cash, inventory, accounts receivable and

accounts payable). A build-up of inventory and the delayed collection of debts mean that a company

has to finance the increase in its working capital requirements. The level and management of cash

in working capital are vital business factors. Many entities have failed from poor cash management

rather than poor profitability. The reconciliation of profit to net cash from the operating activities of

JB Hi-Fi Ltd shows a slight increase in receivables. This could indicate that the accounts receivable

collection process has slackened; however, given that sales increased marginally, a slight increase

would be expected. It is imperative that businesses keep a close eye on their accounts receivable

balances. The reconciliation also shows an increase in the inventory balance between 2014 and

2015, although the increase is less than the increase of the previous year. Too much inventory can

tie up cash unnecessarily. Given that JB Hi-Fi Ltd opened new stores and improved its online sales,

it would seem reasonable that inventory levels would increase. There is also a significant increase