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HI5020 Corporate Accounting Assignment - Issues in Cash Flow Statement, Holmes Institute, Australia

Purpose: This assignment aims at developing a clear understanding of students on cash flows statement and use of cash flow statement to comprehend different key business decisions taken by the management. They will have to consult relevant literature and demonstrate understanding of key concepts. As part of their assignment, they will also conduct a minor empirical analysis on cash flow statement.

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Part A - Do the relevant research to critically examine the relative information content of the income statement and statement of cash flows. Why do investors find both income statement and statement of cash flows useful?

Cash in key for successful and uninterrupted running of any business. Whether a firm needs to pay its suppliers or its employee just having profit is not enough. It needs to have cash in the bank for making these day to day payments in time. And the management of a firm needs to make sure that enough cash resources are maintained all the time for uninterrupted business operations.

The income statement is one of the three financial statements which is prepared and presented to the users of the financial statements including the shareholders for letting them know how the business is operating and whether it has made profits. Profits are often key for the shareholders as it lets them know if dividends would be paid and stock price movements are linked to good profitability. If a firm fails to generate profits adequately then stock price movement might be negative for a firm and that is more likely to erode the market value of the firm. Thus the income statement once prepared lets the users know the total revenue, costs of goods sold, gross profit margin and operating expenses and operating profits apart from listing the PBT and PAT. How much tax is needed to be paid is also listed. Thus the incomes statement shows how expenses and revenues are recognized and how much percentage of the net revenue generated is eventually retained by the concerned firm after accounting for all the necessary expenses (Horngren, et al., 2014).

However, in many cases, a firm which is generating good profit margins won't have a good liquid position and might not be able to maintain a better level of cash flow for making sure they pay the suppliers, lenders, and employees, etc. in the nick of the time. This is one of the well-known issues present in many cases and as a result of which it is required to read and see the cash flow for better understanding of the relative importance of profits and cash position in the same period for a firm as they differ often (David, et al., 2013).

A cash flow statement is prepared to let the users of the statements know how the business has received the cash resources in the given period and how the cash resources are used. The statement is prepared to show three different levels of activities like the financing, operating and investing activities. If we add the net cash flow position of the three activities then we get to know if the business has added cash to the opening balance or it has used cash from the previous period. However, the cash resources generated or used in the operating activity is one of the most important cash resources needed to be studied to know if the firm has generated positive cash flows from operations independent of the financing and investing activities. Taking a number of economic decision require the assurance that enough cash resources are generated by the business to meet the demand for payments in the coming periods. The same information can be provided on a reliable basis by the cash flow information and not by the income statement (Deegan, 2015).

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However, it must be remembered that the cash flow statement is not an original statement which is prepared by the business. The cash flow statement is prepared by taking information from the income statement and also form the balance sheet and then additional information's are adjusted to prepare the statement. For example, the starting point is the net profit generated in a year and the same is adjusted for non-cash expenses like depreciation and gains of disposal, etc and then adjusted for changes in working capital to find the operating cash flows. In most cases, the operating cash flow is either higher or lower than the net profit. This is exactly why the users of the financial statements require both the income and the cash flows prepared by the reporting firm to know the cash position in relation to the net profits of the business (Carl S Warren, 2011).

Because of these necessity to derive the cash flow statement from the balance sheet and the income statement , the users the financial statements would make sure they analyze the income statement along with the cash flow. This allows the users of the financial statements to know the flow of the cash resources in the given period and also make direct comparisons with the net profits for the same period.

Part B - 1. For each of the three years on the Statement of Cash Flows:

a) What are the major sources of cash for each firm? What are the major uses of cash for each firm?

Major sources of cash for each of the three listed firms are:

a) Payments received from clients and customers

b) Cash received from the issue of new stocks

c) Dividend received was also a major source of cash resources for one of the three firms.

Larger and major uses of the cash for the three firms are:

a) Buying of Property plant equipment

b) Payment made to the employees and suppliers

c) Investing in new assets such as oil and gas

d) Cash resources are also used for making repayment of the earlier year borrowings

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b) What was the trend in cash flow from (continuing) operations for each firm?

Funtastic Limited's operations have seen the cash flows generated from operations to be negative in all the 3years and increasing.

For BHP the cash flows from the operations have been positive and increasing in the same period. this shows the company is able to increase cash resources from the operations.

For Santos Limited, the cash flows from the operations have been positive and increasing in the same period. this shows the company is able to increase cash resources from the operations.

So while both BHP limited and Santos Limited has been growing their cash flows from operating activity on a consistent basis the same for Funstastic is on the decline and the same is a cause of concern for the management.

c) Was cash flow from operations greater than or less than net income? Explain in detail the major reasons for the difference between these two figures.

The cash flow from operations for the BHP limited is assessed to be higher. While the net income for the firm was 1,791, 11,137, and 14,751 million the cash flows were 10,625 million, 16,804 million and 18,641 million for the same periods. The difference can be explained as caused by the followings:

a) Depreciation and amortization expenses being non-cash were added back and were higher than $6000 million in all the 3 years.

a) The impairment expenses in relation to PPE, other assets and net finance costs were also added back which increased the cash flows.

b) The difference is also caused by changes in the working capital such as changes in the inventory, A/R, A/P and accounts payables, etc.

c) Further adjustments such as receipt of dividends and interests increased the cash flows whereas the payment of the interests reduced the cashflows.

d) Taxes paid related to operations and on royalty were deducted from the operating cash flows and that reduced the operating cash flows:

e) The operating cash flows increased also as a result of added cash flows from discontinued operations and all the above adjustments made sure cash flows are much higher than the net profits generated by BHP Limited.

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d) Was the firm able to generate enough cash from operations to pay for all of its capital expenditures?

The operating cash flows which were generated by the BHP limited in the three years were $10,625 million for 2016, $6,04 million for 2017 and $18,461 for the year 2018. As compared to the same the capital expenditures made by the company (net ) is much smaller at $7,245 million in 2016, $4161 million for 2017 and $5921 million for 2018. This shows that BHP limited was clearly in an advantageous position as operating cash flows were quite sufficient for meeting the investing requirements of the last three years. So the cash flows from operating is enough to meet the capital expenditure requirement in these years.

e) Did the cash flow from operations cover both the capital expenditures and the dividend payments made by the firm (if any)?

BHP limited paid dividends of $4130 million in 2016, $2921 in 2017 and $5220 million in 2018. As compared the capital expenditures made by the company (net ) is much smaller at $7,245 million in 2016, $4161 million for 2017 and $5921 million for 2018. Total cash expenses made during the three-year term ( Capex and dividends ) amounted to $11,375 million for 2016, $ 7082 million for 2017 and $ 11,141 million for 2018. This shows that the operating cash flows of the company for the three years were sufficient to meet the capex and dividends payments in 2017 and 2018butthe same were not sufficient to meet these expenses in2016 as expenses exceeded the OCF (Belverd E. Needles, 2012).

f) If the firm has generated excess cash from operations, how did the firm invest the excess cash? If not, what were the sources of cash the firm used to pay for the capital expenditures and/or dividends?

The excess cash generated from operations were used for paying the investing expenses and capex. It has also bene used by company like BHP limited to pay off the existing long term loans and debts. Apart from financing the capex partly form the operating cash form operations, partly these firms have financed the capex through new issue of equity and partly from new debt issues (ANTHONY A ATKINSON, 2012).

g) Did the firm use the working capital (current asset and current liability) accounts other than cash and cash equivalents as sources of cash, or uses of cash?

Yes. All the firms under analysis have used items such as accounts receivables , accounts payable and inventory for calculating changes in working capital and the same is adjusted in the operating activity for calculating cash from operations. For BHP limited the following items other than the cash and cash equivalents in the calculation of cash from operations.

a) Trade receivables - increase in the receivables would decrease cash flows and decline would increase cash flows under operating activity.

b) Trade payables - increase in the payables increase cash flow and vice versa.

c) Inventory - increase in the value of the inventory would decrease cash flows and decline would increase cash flows under operating activity.

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h) What other major items affected cash flows?

Major items which affected the cash flows other those mentioned above are categorized as follows:

a) Net interest costs paid by BHP limited was a major item in the operating segment.

b) Profits and gains or losses made by BHP from equity accounting investments were major items for operating segments.

c) Exploration expenditures made by BHP limited was a major cash use in all the years.

d) Purchase of shares by ESOP trusts was a major cash use item in all the three years.

e) Debts issued and repaid were major causes of cash resources and use in all the three years for BHP.

For Fantastic limited the following items are other major cash sources and use:

a) Share issues were major sources in both 2016 and 2018

b) Purchases made and payments for acquisition of intangible assets were significant cash use for the company in all the three fiscal periods.

For Santos limited the following items are other major cash sources and use:

  • Exploration activities, restoration costs, and seismic studies were a major use of cases resources for Santos in all years.
  • Net interest costs paid by Santos Limited was a major item in the operating segment.
  • Royalty expenses paid are major expenditures under operating activity.

i) What was the trend in capital expenditures for each firm?

The capital expenditures made by the company BHP Limited (net ) is much smaller at $7,245 million in 2016, $4161 million for 2017 and $5921 million for 2018. This shows that the capex was highest in 2016 and declined since to lowest in 2017 and then a slight increase in 2018. This shows that BHP invests heavily in long term assets.

For the Funstastic company, the capital expenditures incurred by the company in the last three years as reported has been on the rise in the first two years but the same has declined in the most recent FY. While the investments in long term assets were 558 million in 2016, the same has increased to $ 989 million in 2017 and $ 298 million in 2018. The lower Capex in 2018 was however caused by a one time sale of an existing subsidiary.

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For Santos Limited the capital expenditures incurred by the company in the last three years as reported has been on the rise. While the investments in long term assets were 2015 million for 2016, the same has increased to $ 534 million in 2017 and $ 2,373 million in2018. The general trend is thus increasing investment in long term assets for increasing revenue generating capacity. This has been apparently done in order to increase future revenue and profit generating ability.

j) What was the trend in dividends (if any) for each firm?

Dividends paid by all the three firms are shown as in the table below:


2016

2017

2018

BHP Limited

4130

2921

5220

Funtastic Limited

0

0

0

Santos limited

43

0

73

BHP Limited has paid a dividend in each of the last three years. However, as compared to 2016, there was a dip in the amount of dividend paid in 2017. In comparisons, Santos limited has paid a dividend in 2016 and 2018 but no dividend was paid in 2017. Funtastic is the only firm among the three which has not paid any dividend in any of the three years. Hence it can be said that three is no trend but BHP is more likely to follow an increasing ( growing dividend) in the coming years as profits recover from metal prices decline in the coming years (Beams, 2012).

k) What was the trend in net borrowing (proceeds from borrowing fewer payments of short- and long-term debt) for each firm?

The borrowings made and repaid by different firms are shown as follows:


2016

2017

2018

BHP Limited

7239

1,577

528


(2,781)

(7,114)

(4,188)


4,458

(5537)

(3,660)

Funtastic Limited

8457

3,647

2,630

Santos limited

0

783

1,193

Fantastic limited has net cash in the form of borrowings in the all the years as shown above and there is a decreasing trend in borrowed amounts. However Santos limited has shown that it has not borrowed anything in 2016 but the overall debts borrowed in 2017 and 2018 has gone up significantly. BHP Limited case is entirely different as it has both borrowed new debts and paid older debts. While the net borrowing after repayment of $2,781 million in 2016 was 4,458 million the same in 2017 was (5537) million in 2017 and (3660) million in 2018. This shows that as compared to 2016 in which the overall cash position of BHP was unfavorable, the management of the company has been trying to reduce the interest-bearing liabilities in both 2017 and 2018 (Banerjee, 2006).

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l) What was the trend in working capital accounts? (Answer this question using only Appendix B: Cash flow statement for BHP Limited).

The working capital accounts of the BHP limited shows the following trends as Shown in the following table:

Changes in Working Capital

 

2018

2017

2016

Trade receivables

(662)

267

1,387

Inventory

(182)

(687)

521

Trade payables etc

719

512

(1,272)

Provisions and other assets and liabilities

7

(333)

(316)

Changes in Working Capital , Net

-118

-241

320

Overall the firm was seen making an investment of cash in working capital in both 2016 and 2017 but the same trend reversed in 2018 as the form recovered cash from working capital. In 2018 the BHP limited continued to invest in trade receivables and inventory while cash was used as a resource in increases in trade payables and other labilities. So it can be said that apart form 2016when the cash was realized on a net basis, both 2017 and 2018 saw the from investing more and more cash in the working capital (BAKER & CORTRELL, 2011).

2. Critically evaluate the financial strength of each of the three companies based on the evidence presented in the Statement of Cash Flows.

Funtastic limited is able to increase its revenue but not generating enough cash to pay for its operating expenses. As a result of increasing cash payment to run operations, the operating cash flow has been increasingly negative. It has to thus rely on cash generated from new debts and other sources for keeping its business going.

On the other hand the BHP limited is a company which has been able to generate positive operating cash. Its cash flows from the continued operations is sufficient to cover both its cash used n investing and financing activities. As a result of which the BHP limited is able to generate a net increase in cash balances ( all their activities summed together) to the tune of $4138 million in 2016, $3047 million in2017 and $1650 million in2018. The situation allowed the BHP limited management to repay a major chunk of the long term debts and reduced financial risks.

As far as Santos limited is concerned it has been good cash from operations and covering for increased investing in long term assets. To meet its growing needs the management of the Santos firm has decided to use new issue of shares and net issue bonds etc. as the size of the form is very small as compared to BHP and Fantastic , the management is relying on external funding for meeting growing investing needs and to maintain better working capital (Atrill, 2013).

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3. If you are asked to evaluate these three companies for lending purposes, which of the three companies you will select for lending? Explain Why.

For Santos Limited, the cash flows from the operations have been positive and increasing in the same period. this shows the company is able to increase cash resources from the operations. The overall cash balance has increased in 2016, declined in 2017 and increased in 2018. Overall the cash balance is healthy and covers for its operating expenses.

For BHP the cash flows from the operations have been positive and increasing in the same period. this shows the company is able to increase cash resources from the operations. Overall it can be noted that despite the Firm deciding to pay off a major chink of the long term interest bearing debts in 2017 and 2018 and not issue too many new debts, the closing cash balances of the firm has increased from $10,276 million in 2016 to $ 14,108 million in 2017 and $ 15,813 million in 2018. It has also significantly reduced its debts and interest paying liability as a result.

So while both BHP limited and Santos Limited has been growing their cash flows from operating activity on a consistent basis the same for Funtastic is on the decline and the same is a cause of concern for the management. Even if the closing cash balances for the form remained more or less similar the negative operating cash flow is a major concern as the firm did not manage to reduce and keep the operating expenses under control

Hence keeping in mind the cash position and the ability to generate cash from operations, I would like to make a decision to lend to BHP limited rather than lending to other two firms as its cash generating capacity has been immense apart from increasing cash from operations (ANTHONY A ATKINSON, 2012). Also BHP limited has been able to maintain a very good interest coverage ratio in all the three years for which the analysis was undertaken and as a supplier of funds, it would be quite necessary to make sure the ability of the borrowing firm is assessed in relation to its interest paying capacity.

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