Slide 5.

Chapter 5 Measuring and reporting cash flows

LEARNING OUTCOMES
You should be able to

discuss the crucial importance of cash

to a business;

explain the nature of the cash flow statement and

discuss how it can be helpful in identifying cash
flow problems;

prepare a cash flow statement;

interpret a cash flow statement.

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.2

A definition of cash and cash equivalents (IAS 7)

Definitions:

Notes and coins in hand,

and deposits in banks and
Cash similar institutions that are
accessible on demand

Short-term, highly liquid

investments that are
Cash equivalents readily convertible to
known amounts of cash

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.3

The relationship between the balance sheet, the

income statement and the cash flow statement

Owner’s Income statement Owner’s

claim claim

Balance sheet Balance sheet

at the start of at the end of
the accounting the accounting
period period

Cash and Cash and

Cash flow
cash cash
statement
equivalents equivalents

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.4

Standard layout of the cash flow statement

Cash flow
from operating activities
plus or
minus

Cash flow
from investing activities
plus or
minus

Cash flow
from financing activities
equals

Net increase (or decrease) in

cash and cash equivalents over
the period
Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.5

Diagrammatical representation of the cash flow

statement

Cash and
Operating cash Investing
activities equivalent activities
balances

Financing
activities

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.6

Tesco plc
Summarised cash flow statement for the year ended 24 February 2007
£m
Net cash inflow from operating activities 2,611
Net cash used in investing activities (2,343)
Net cash used in financing activities (533)
Net (decrease)/increase in cash and cash equivalents (265)

Cash and cash equivalents at beginning of year 1,325

Effects of foreign exchange rate changes* (18)
Cash and cash equivalents at end of period 1,042

*This adjustment is required because transactions are undertaken

by the company in different currencies and movements in
exchange rates can lead to gains or losses arising.
Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.7

Deducing net cash inflows from operating activities

There are two methods

that can be used such as:

The direct method

The indirect method

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.8

The indirect method of deducing the net cash flows

from the operating activities
Net profit before taxation
plus
Depreciation expense
plus
Interest expense
plus or minus
Increase (minus) or decrease (plus) in
inventories
plus or minus
Increase (minus) or decrease (plus) in
receivables
plus or minus
Increase (plus) or decrease (minus) in
payables
less
Interest paid
less
Taxation paid
less
Dividend paid
equals

Net cash flows from operating activities

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.9

Example 5.3 Torbryan plc

Cash flow statement for the year ended 31 December 2008
£m
Cash flows from operating activities
Profit before taxation (after interest) 193

Adjustments for:
Depreciation 79
Interest receivable (17)
Interest payable 23
Increase in trade receivables (18)
Decrease in trade payables (1)
Decrease in inventories 3
Cash generated from operations 262
Interest paid (23)
Taxation paid (39)
Dividend paid (50)

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.10

Example 5.3 Torbryan plc (Continued)

Cash flow statement for the year ended 31 December 2008
£m

Net cash from operating activities 150

Cash flows from investing activities
Payments to acquire tangible non-current assets (95)
Interest received 17
Net cash used in investing activities (78)
Cash flows from financing activities
Repayments of loan notes (150)
Issue of ordinary shares 90
Net cash used in financing activities (60)
Net increase in cash and cash equivalents 12
Cash and cash equivalents at 1 January 2008 (68)
Cash and cash equivalents at 31 December 2008 (56)

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.11

Example 5.3 Torbryan plc (Continued)

Analysis of cash and cash equivalents during the year ended 31 December 2008

£m

Overdraft balance at 1 January 2008 (68)

Net cash inflow 12
Overdraft balance at 31 December 2008 (56)

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.12

Chapter 6 Analysing and interpreting financial statements

LEARNING OUTCOMES
You should be able to

identify the major categories of ratios

that can be used for analysis purposes;

calculate important ratios for accessing the financial

performance and position of a business;

explain the significance of the ratios calculated;

discuss the limitations of ratios as a tool of

financial analysis.
Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.13

Financial ratio classifications

Categories

Profitability

Efficiency

Liquidity

Financial gearing

Investment.

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.14

Main users of financial information

Owners Customers Competitors

Employees
Managers and their
representatives

Business
organisation

Lenders Government

Investment Community
Suppliers
analysis representatives

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.15

Ratio benchmarks

Ratios may be compared with

the following:

past periods

similar businesses during

the same period

planned performance.

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.16

Profitability ratios
Return on ordinary shareholders’ funds

Profit for the year (net profit) – any preference dividend

x 100
Ordinary share capital + Reserves

Return on capital employed

Operating profit x 100

Share capital + Reserves + Non-current liabilities

Operating profit margin

Operating profit
x 100
Sales revenue

Gross profit margin

Gross profit
x 100
Sales revenue
Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.17

Efficiency ratios

Formulas

Average inventories Average inventories held x 365

turnover period =
Cost of sales

Average settlement period Average trade receivables x 365

=
for trade receivables Credit sales revenue

Average settlement period Average trade payables x 365

for trade payables =
Credit purchases

Sales revenue to capital Sales revenue________________

=
employed Share capital + reserves + non-current liabilities

Sales revenue per = Sales revenue

employee Number of employees

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.18

The main elements comprising the ROCE ratio

Operating profit
Sales revenue
multiplied
by

Sales revenue
Long-term capital employed

equals

Return on capital employed

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.19

Liquidity ratios

Formula:

Current assets
Current ratio =
Current liabilities

Current assets (excluding inventories)

Acid test ratio =
Current liabilities

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.20

Gearing ratios

Formula:

Gearing Long-term (non-current) liabilities x 100

=
ratio Share capital + Reserves + Long-term (non-current) liabilities

Interest cover = Operating profit

ratio Interest payable

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.21

The effect of financial gearing

Operating profit

Returns
to ordinary

shareholders

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.22

%/times The effect of financial gearing at Tesco plc (2000 – 2007)

26

24 ROSF (%)
22

20 Interest cover
(times)
18

16

14

12 ROCE (%)
10

0
2000 2001 2002 2003 2004 2005 2006 2007
Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.23

Investment ratios

Formula

Dividend payout = Dividends announced for the year x 100

ratio Profit for the year

Dividend yield Dividend per share/(1 – t) x 100

=
ratio Market value per share

Earnings per = Profit for the year

share Number of ordinary shares in issue

Price/earnings = Market value per share

ratio (P/E) Earnings per share

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.24

Average dividend yield ratios for businesses

in a range of industries
5
4.43
%
4
3.24 3.21
3.09
2.95 2.83
3
2.40

Exchange listed businesses

2.08 1.99 2.10
2 1.96 Pharmaceuticals and 1.86
1.68

Average for all Stock

Travel and leisure
Construction and

Life insurance
Food and drug
biotechnology
engineering

1
Oil and gas

Electricity
Chemicals

Industrial

Tobacco
materials

retailers

Banks
Media
0

Source: Constructed from data appearing in the Financial Times, 6 October 2007

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.25

Average price/earnings ratios for businesses

in a range of industries

30

% 25.68
25

20.42
19.82
20 18.00 18.15
17.63

14.65 13.59
15 13.09 12.87
11.67 12.19
9.81
10
and biotechnology

Average for all SE

Travel and leisure

listed businesses
Pharmaceuticals

Food and drug

Life insurance
and materials

engineering
Construction
Oil and gas

Chemicals

Electricity
5
Industrial

Tobacco

retailers

Banks
Media
0

Source: Constructed from data appearing in the Financial Times, 6 October 2007

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.26

Graph plotting current ratio against time

0.9 J. Sainsbury plc
Current ratio

0.8

0.7

William Morrison plc

0.6

0.5
Tesco plc
0.4

0.3

0.2

0.1

2000 2001 2002 2003 2004 2005 2006

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008
Slide 5.27

Limitations of ratio analysis

The quality of underlying financial

statements

Inflation

Restricted vision of ratios

The basis for comparison

Balance sheet ratios

Drs. E. J. Galama Peter Atrill and Eddie McLaney, Accounting and Finance for Non-Specialists, 6th Edition, © Pearson Education Limited 2008