How to Manage Cash Flow in Businesses

How to Manage Cash Flow in Businesses

Sunday, February 12, 2017 7:41 pm

Dada Adefolami

By Dada Adefolami

Cash flow management is the process of monitoring, analyzing, and adjusting your business’s cash flows,creating a reliable cash flow system is vital to the success of any business.

In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business.

The objective of IAS 7 is to require the presentation of information about the historical changes in cash and. cash equivalents of an entity. IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an integral part of its primary financial statements

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, limited period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company’s value and situation. Cash flow can be used, for example, for calculating parameters: it discloses cash movements over the period. to determine a project’s rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return and net present valueto determine problems with a business’s liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable. as an alternative measure of a business’s profits when it is believed that accrual accounting concepts do not represent economic realities. For instance, a company may be notionally profitable but generating little operational cash. In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance.

Income is the consumption and savings opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. However, for households and individuals, “income is the sum of all the wages, salaries, profits, interests payments, rents, and other forms of earnings received… in a given period of time.”

In finance, an asset–liability mismatch occurs when the financial terms of an institution’s assets and liabilities do not correspond. Several types of mismatches are possible. For example, a bank that chose to borrow entirely in US dollars and lend in Nigeria Naira would have a significant currency mismatch: if the value of the Naira were to fall dramatically, the bank would lose money.

IAS 7, Statement of Cash flows, was first published in 1992 and has barely changed since that date. It allows users of financial statements to assess how different types of activity affect a company’s financial position by classifying cash flows as operating, investing and financing activities. 

By requiring companies to consider transactions this way, the cash flow statement is thought to support various methods of analyzing the present value of future cash flows and of making company comparisons. However, there are issues with the current standard. Example, cash flows from the same transaction may be classified differently. A loan repayment would see the interest classified as operating or financing activities, whereas the principal will be classified as a financing activity.

The operating activities in the cash flow statement can be presented in one of two ways: the direct method or the indirect method. The direct method is occasionally used, as it displays major classes of gross cash receipts and payments.

Companies’ systems often do not collect this type of data in an easily accessible form. Basically, the direct method of accounting tracks cash changes from the bottom up to arrive at net income, rather than starting with net income and making adjustments. 

The indirect method is more commonly used to present operating activities. Under this method, a statement reconciling profit or loss with operating cash flows is shown, instead of a statement of cash inflows and outflows. This reconciliation allows users to determine the effect of accruals of profit or loss items and to obtain an indication of ‘earnings quality’. 

For example, if an entity’s net income is higher than its operating cashflow, a user would seek further explanations as to the reasons for this occurrence. A reason could be an accounting policy choice, for example. The presentation of operating profit under the indirect method of the cash flow statement can start with either profit or loss before or after tax. A user’s ability to make comparisons may be affected if different starting points are presented in the reconciliation by entities.

Free cash flow is used by analysts in various valuation models and is thought to be a better measure than using the figure for operating cash flow. Free cash flow is often taken as the excess of a company’s operating cash flows over its capital expenditure, which essentially reflects the cash flows available to owners. Entities have been encouraged to disclose cash flows that increase operating capacity and the cash flows required to maintain it. This information can be used as an indicator of the financial strength of an entity.

There are concerns over the current classification of items in the statement of cashflows. For example, dividends and interest paid can be classified as either operating or financing activities. As a result, users have to make appropriate adjustments when comparing different entities, particularly when calculating free cash flow for valuation purposes. Additionally, when a user is assessing an entity’s ability to service debt, interest paid would be reclassified from operating activities to financing activities. 

Research and development expenditure is classified as cash from operating activities, but is often considered to be a long-term investment. Some argue that such cash outflows should be included within investing activities, because they relate to items that are intended to generate future income and cash flows. IAS 7 takes the view that to be classified as an investing cash outflow; the expenditure must result in an asset being recognized in the statement of financial position.

Some items of property, plant and equipment are purchased from suppliers on similar credit terms to those for inventory and for amounts payable to other creditors. As a result, transactions for property, plant and equipment may be incorrectly included within changes in accounts payable for operating items. 

Consequently, unless payments for property, plant and equipment are separated from other payments relating to operating activities, they can be allocated incorrectly to operating activities.

There are currently different views as to how to show lessee cash flows in the statement of cash flows. Some users would like the statement of cash flows to reflect lessee cash outflows in a way that is comparable to those of a financed purchase where the entity buys an asset and separately finances the purchase. Other users take the view that lease cash payments are similar in nature to capital expenditure and should be classified within investing activities in the statement of cash flows. Some users would like all lease cash outflows to be included within the free cash flow measure, which would require lease cash flows to be classified within either operating or investing activities. 

Indeed, there is concern about the current lack of comparability under International Financial Reporting Standards (IFRS) because of the choice of treatment currently allowed. A lessee can classify interest payments within operating activities or within financing activities.

Many issuers recognize that current cash flow disclosures are inadequate, as they give an incomplete picture. Investors and analysts need a better understanding of the economics of their business and so voluntarily supplement the cash flow information required by IAS 7. In addition, some issuers provide a reconciliation of net debt from the end of one accounting period to the end of the subsequent period. The net debt reconciliation discloses information such as acquired debt and the inception of finance leases, as well as any fair value adjustments made to debt and the impact of foreign exchange movements.

Partly as a result of the above practices, the International Accounting Standards Board (IASB) published an exposure draft (ED) in December 2014 that proposes amendments to IAS 7. The main objective of the ED is to improve information about changes in an entity’s liabilities that relate to financing activities and the availability of cash and cash equivalents, including any restrictions on their use. 

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