Lecture 7 notes

Question 1

What will we learn today?

Answer 1

Sources of financing - loans The need for a cash flow statement Sources and uses of cash Preparing the cash flow statement ( indirect method) Interpreting cash flow statement

Question 2

What are the main sources of finance?

Answer 2

Owners equity

Loans/borrowings

Question 3

What are long term finances in a limited company?

Answer 3

Share issues

Retained earnings ( internally generated profits)

Long term loans.

Question 4

What are 4 types of long term borrowings?

Answer 4

Bank loans ( secured e.g. mortgage or unsecured)

Bonds

Debentures

Finance leasing

Question 5

What does a secured bank loan mean?

Answer 5

“Secured” means that the lender would have the right, should the company fail to meet its interest and/or capital repayment obligations, to seize a specified asset of the business (probably some land) and use it to raise the sums involved.

Question 6

What is another word for a specified asset of a business?

Answer 6

Collateral

Question 7

What is a unsecured loan?

Answer 7

regular loans, you don’t have to give asset, the amount of loan given is usually lower than secured.

Question 8

How are bonds a source of long term borrowings?

Answer 8

They can be converted into actual shares within the money. e.g. lets say we want to raise 2 million, individuals pay 2 million, in return they get a piece of paper saying you are owner of some bond, in the stock market, they get dividends and can resale their shares, in the bond market, also you get interest.

Question 9

How are debentures a source of long term borrowing?

Answer 9

TBA

Question 10

Give an example of financial leasing?

Answer 10

for example, a company wants to buy a large asset, when a airline company wants to buy an aeroplane, it doesn’t buy an aeroplane outright, there is a 3rd party company which buys the aeroplane, the airline company pays financial leases to this third party company, and can put this aeroplane as a non-current asset on their balance sheet. This is because these assets are expensive, it makes yearly payments to finance these.

Question 11

What are 3 advantages of issuing loans instead of shares?

Answer 11

• Shareholders’ control is not affected
• Interest on loan is deductible for tax purposes; dividends on shares are not
• Earnings per share (EPS) may be higher (lower cost of debt)

Question 12

What does it mean that shareholders control is not affected?

Answer 12

When you sell shares you bring in more owners but if you sell bonds or take loans then shareholder control not lost.

Question 13

What does it mean that interest on loan is deductible for tax purposes, dividends on shares are not?

Answer 13

If you pay 10000 as interest of loan the amount is not taxed, so you can reduce it from tax amount.

Question 14

What does it mean Earnings per share (EPS) may be higher (lower cost of debt)?

Answer 14

cost of debt means that the returns that people who issue loans except, typically loans are cheaper to take than shares, as shareholders except firm to do really well, hence higher shares.

Question 15

What are 3 disadvantages of Long term loans?

Answer 15

o Interest must be paid on a periodic basis.

o The principal value of the loan must be paid at maturity. ( if you fail to pay this then you are forced to declare bankruptcy)

o A company with volatile earnings and a relatively weak cash position (e.g. weak liquidity) may face great difficulties making interest payments when earnings are low.

Question 16

Assume ABC takes up a 5 year loan of £100000 with an interest rate of 5% . What is the double entry for this?

Answer 16

Dr Cash £100000

Cr Loans £100000

Question 17

Repayment By the 31st of December 2010, ABC has made a repayment of 22,000, (repayment of principal £15,000, interest £7,000). What is the double entry for this transaction?

Answer 17

Dr interest expense - 7000

Dr loan - 15000

Cr Cash £22000

Question 18

As an investor why would you pick bonds?

Answer 18

1) Interest is a legal obligation, and loans have priority in repayment ( even if they go bankrupt they get their money)

Question 19

As an investor has I know that i will always get my money back and interest what does this mean about returns?

Answer 19

The returns are lower than shares and less risk.

Question 20

As a investor why would you pick buying shares?

Answer 20

Despite dividends not being a legal requirement and if their is any residual profit left they get their contribution last, they get the benefit that if the value of the share goes up and sell their share. Thus ordinary shares are more risky form of investment but could lead to higher returns.

Question 21

Why do companies issue Equity ( shares)

Answer 21

1) When issuing equity ( this signals that you have a higher quality company, as you are allowing investors to judge your company).
2) Shareholders have residual claim on cash flows
3) Dividends are not a legal requirement and principal amount has to be paid)

Question 22

So conclude why do companies issue equity?

Answer 22

It offers a more flexible form of financing.

Question 23

So how does a firm choose whether to issue debt or equity?

Answer 23

Depending on current situation, firms will evaluate which one is better for them, e.g. firm is not doing well, they will choose to issue shares as they will not be able to repay loan amounts, if firm is doing well, then they might take some amount of loans.

Question 24

What does the cash flow statement denote?

Answer 24

From where did the cash come in How did we use the cash Where did the cash go out How much cash remains in firm, at the end of the period.

Question 25

What is the SOFP and I/S prepared on?

Answer 25

It is prepared on accruals basis, ( you don't track cash, what you track is the revenue when earned and costs when they are incurred.) meaning net profit from income statement is not the same as the final balance of a cash flow statement.

Question 26

What are 3 categories of a Cash flow statement?

Answer 26

Cash flow from operating activates Plus or minus Cash flow from investing activities Plus or minus Cash flows from financing activates = Net increase or decrease in cash and cash equivalents over the period of time.

Question 27

What is Cash from operating activities

Answer 27

These are revenue producing activities of entity ( profit or loss statement)

Question 28

What is Cash from investing activities?

Answer 28

Cash collected from acquiring or disposing non- current assets. ( Assets of the balance sheet)

Question 29

What is Cash from financing activities?

Answer 29

Transactions related to creditors ( give loans) and owners ( issuing shares). basically how the company is funded and how they pay debts. transactions involving long-term liabilities, owner’s equity and changes to short-term borrowings.

Question 30

What is share buyback?

Answer 30

company buying back its own shares, because they think the market is undervaluing their shares or they want greater control

Question 31

What are royalities?

Answer 31

A royalty is a legally binding payment made to an individual or company for the ongoing use of their assets

Question 32

Where would interest and dividends received and paid classified as?

Answer 32

It can be classified as any but it makes sense to put it in cash flow for financing activities but firms needs to be consistent.

Question 33

For cash flow for start up explain the life cycle of it This is a new company making a pill for grey hairs,

Answer 33

This is a new company making a pill for grey hairs, not many people know about it. Not enough people are buying it. But to produce it they still need to pay their suppliers etc, meaning negative cash flow from operations They know however there is a big market for this pill so they invest heavily in expanding facilities. As your operations are not generating cash, you have to borrow, or bonds or share, so you have a positive cash flow from fiancing activites.

Question 34

For a cash flow of growth what is the life cycle for this?

Answer 34

It has been selling for a few years, there is word of mouth, they are investing etc, so this means a lot more people are buying, hence positive cash flow from operating cash flow. The company notes it can expand product range from blue to black etc, there is a bigger market, so they continue to invest in the future. So still huge cash outflow for investing activites It is not mature yet to use cash from internally generated revenue, so they still have to raise external funds, but not as much as when you were a start up, as you are generating more money.

Question 35

Explain the cash flow cycle for Mature firm

Answer 35

Now this firm has a bigger market audience and making regular sales, so huge amount of operating cash flow They have captured many target audiences so they now do not have too much investment to do, hence their investment activites are lower. Now you don't need that much cash to invest, as you don't need as much non current asset. As you are making huge amounts of money, you repay loans and shareholders dividends etc.

Question 36

Explain the life cycle for a decline firm

Answer 36

Lets say now the firm has a lot more competitiors, the patent has run out, there are other companies producing the same pill, but for cheaper prices, hence people are not buying pill from this firm, so operating cash flow falls. They have run out of ideas to sell and they invest smaller than previous. It still making cash from operating expenses hence it can now pay loans etc.

Question 37

Firm ABC showed negative cash flow from operating activities. What could the reasons be? A. Business is unprofitable B. Business is expanding C. Both of the above D. Firm is not getting enough money from investors

Answer 37

C. Both of the above

Question 38

Classify into operating, investing and financing activities 1. ABC sold shares worth £100,000 2. ABC bought land and building worth £25,000 3. ABC sold products to customers worth 4. ABC’s CEO borrowed money from a bank to buy a new house 5. ABC collected cash from customers against trade receivables 6. ABC gave dividends of 40p per stock to their stock holders 7. ABC spend £4,000 on advertising

Answer 38

1) Financing 2) Investing 3) Operatings 4) None 5) Operatings 6) Financing but Any 7) Operating

Question 39

What are the 2 ways of calculating cash flow statement from operations?

Answer 39

Direct method Indirect method ( most commonly used)

Question 40

What is the formula for the direct method?

Answer 40

Cash flow from operations = Gross cash payment - Gross cash recepits.

Question 41

How do you use the indirect method?

Answer 41

To prepare the statement of cash flow using the indirect method, you will need: 1- The income statement ( you need to remove all the accurals parts and only keep cash parts) 2- A comparative balance sheet 3- Other additional information

Question 42

Give an example of why Net profit is different from net cash?

Answer 42

Depreication expense is a non cash expense that is deducted in the income statement, since its a non cash expense we need to add it back to profit if we want to calculate cash from operations.

Question 43

What is the long list of things to do when calculating cash flow from operations ( basically removing any non-cash transcations.

Answer 43

Question 44

Say there is a dry cleaners business that only deals with cash how would the direct and indirect method look like.

Answer 44

Question 45

How would the affect of depreciation affect the dry cleaners business using the direct and indirect method.

Answer 45

Question 46

Does depreciation increase your cash flow?

Answer 46

No as we have seen it is a non cash expense it should have no impact on cash flow statement, but it looks like it has an impact.

Question 47

How would the effect of accounts receivable look like using indirect and direct method?

Answer 47

As you haven't received cash yet, you decrease it for the indirect method.

Question 48

How would the effect of accounts payable be on the dry cleaner business using indirect and direct method?

Answer 48

You have the money to pay for suppliers but you haven't paid so you increase your cash.

Question 49

How do you calculate the interest that you actually paid in cash?

Answer 49

Interest expense was deducted from the income statement. Generally interest expenses can be cash or credits. Therefore we add interest expenses, then we deduct interest paid to ensure that only cash paid for interest is included. Interest paid = Interest payable + Interest expense for a current period - closing interest payable.

Question 50

How do we calculate Tax& dividend you actually paid?

Answer 50

Taxation paid is deducted because it was not dedcuted before in calculating 'profit before taxation ' and it is a cash flow Taxation paid = Taxable payable + Tax expense for current period - closing taxation payable. Dividend is deducted because it was not deducted from profit ( dividend is not an expense) but it is a cash outflow.

Question 51

What happens if the question states Dividend declared or Dividend is paid?

Answer 51

If Declared : Do not touch cash flows If paid: you can touch cash flows

Question 52

Complete cash flows from operating expenses ( look up the additional information and SOFP)

Answer 52

Profit before taxation look at on I/S - 400 Then make adjustments for Depreication ( in additional information it states depreciation of plant is (150,000 ) and for Motor vechiles it is 70000 so total = 220000. Previously you minused it from I/S so you Add. Interest expense from I/S is 50. You previously took away, so now you add. Loss on disposal you subtracted it so you now add it ( + 130) ( not a revenue gernerating activity. Increase in inventories ( you go on SOFP and there is an increase of 80, you reverse it becasue it is a cash outflow) Increase in trade receivables ( you go on SOFP and there is an increase of 120, you reverse it because you have not got cash yet) Increase in Trade payables ( you go on SOFP and there is an increase of 150, you have the money but haven't paid, so you add it) To find how mich interest actually paid = 0( interest payable beginning)+50( interest expense)- 0 (interest payable end) paid interest which is cash outflow so you put minus it) To find out how much taxation you actually paid = (tax payable you look at SOFP the beginning is 200) + 100 ( tax expense on SOFP) - closing tax payable - 100 = 200, as you have paid you minus. So net cash from operations = 500

Question 53

To calculate purchase of a New Non current asset what is the formula?

Answer 53

Closing Net book value + Depreication charge + NBV disposed - Opening NBV

Question 54

Complete the cash flow for investing activities?

Answer 54

Purchase of New vechile Closing NBV ( 400) SOFP + 70 Depreciation charge( Additional information)+NBV disposed (0) the additional information said there was written down value of plant sold not vechile so its 0. then you minus 320 which is on SOFP of which is the opening NBV. = 150 you paid this so this is cash outflow. Purcahse of new plant Closing NBV (1000) from SOFP + 150 ( from additional information)+ 200 NBV disposed from Additional information - 800 from from beginning on SOFP = 550. purcahsed this for 550 so you minus it is a cash outflow. As you have sold the plant you find Proceeds of it so you do NBV of disposed asset ( 200) - loss/gain on disposal on NCA ( 130) = 70 is the actual cash you got so its cash inflow of 70. Net cash used in investing activites (630)

Question 55

Complete cash flow for fianancing activites

Answer 55

On balance sheet share capital is has increased from 400 to 500+100 you have to include share premiumum, because when you got the share you got the entire 600. meaning cash increased by 200. Proceeds from long term borrowing on SOFP shows borrowing has gone up by 100 from 400 to 500. As you get cash, it is a inflow. It says on income statement dividends paid (250) as you paid this it is a cash outflow. Net cash from financing activites 500

Question 56

So what is Growling PLC final cash flow statement for year ended 31 dec 2010?

Answer 56

Question 57

Accounts receivable increased by 250 and inventory decreased by 125. What is the impact on Statement of cash flows? A) Cash inflow of 250 cash outflow of 125 b) Cash outflow of 250 cash inflow of 125 c) Cash outflow of 250, cash outflow of 125 4) Cash inflow of 250, cash inflow 125

Answer 57

b) Cash outflow of 250, cash inflow of 125

Question 58

NBV of buildings at the beginning of the yeat was £150. The closing NBV was £250. There was a disposal of equipment whose NBV was £40. This was sold for a gain of £10 and depreciation expense for the year was £13. What is cash flow from investing activites. A) Cash outflow 153 b) Cash inflow 153 c) Cash outflow 103 d) Cash inflow 103 E) Cash outflow 143

Answer 58

c) Cash outflow 103 because Purchase of buildings = Clo. NBV + Disposal NBV + dep expense – Op. NBV 250 + 40 + 13 - 150 = (153) as you purchase it is cash outflow. The proceeds from disopal = 40 + 10 ( gain) = 50 Net cash from investing = (153) + 50 = (103)

Question 59

Company ABC calculated its cash flow from operating activities to be £100,000. The depreciation for the year was £1,000. The company's accountants later discover that the depreciation expense was actually £1,500. What will be the new cash flow from operating activities be? Select one: a. £105,000 b. £100,000 c. £95,000 d. £115,000

Answer 59

b Changing depreciation expense has no impact on the cash flows. This is because depreciation is a non-cash expense (i.e. there is no exchange of cash).

Question 60

Answer 60

Question 61

If there is a sale of equipment in cash from investing activites how do you work out proceeds from sale of equipment?

Answer 61

NBV of equipment sold + profits

Question 62

TRICKY CLASS QUESTION NOW Calculate cash flow from operating activities get the rest of info from moodle

Answer 62

1) profit on dispoable ( because it is a profit you do the reverse) with trade and other payables look at the additional information 31 december accured interest was 7500, so you take that away from value in 2018, then you take away 5000 from value in 2019, then find a net decrease in TP interest and tax paid using formula

Question 63

Calculate cash flow from investing and financing? Get additional information and I/S from moodle

Answer 63

Proceeds from sale = NBV disposed + profit on dispoal 375 + 100 Purchase of new equipment using formula obviously land has gone up but not told why so leave it. Remember repayment of long term borrowings key!

Question 64

How does STONE PLC CASH FLOW LOOK LIKE ALTOGETHER?

Answer 64