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Topic 5 Recommended Tutorial/Homework Solutions

Comprehension Questions
7.2

What is the purpose of a statement of cash flows?

The purpose of the statement of cash flows is to provide users of financial statements
with information about the cash flows of the entity. It shows the cash receipts and
payments, and the net effect. The statement of cash flows can help a user evaluate the
entitys potential to generate cash flows, meet its financial commitments, fund its
activities and obtain finance.
7.3

Which of the following are not disclosed in a statement of cash flows?


a. Cash outflows from operating activities
b. The cash on hand at the beginning of the reporting period
c. The amount of depreciation for a reporting period
d. The payment of a long-term debt

The correct response is c. The amount of depreciation for a reporting period is not
disclosed in the statement of cash flows.
7.5

ABC Company had a positive net cash flow for the year, but its income
statement reported a loss for the period. Explain.

There are three sources of net cash flow: cash from operating activities, financing
activities and investing activities. The loss indicated in the income statement could be
related to the cash from operating activities. However, the entity could have
significant positive cash flows from the financing and investing activities. That is, the
entity could have borrowed money or could have sold a significant investment, such
as an asset.
The statement doesnt indicate whether the loss indicated in the financial performance
was from normal operations or was after an extraordinary event, such as a sale of a
major asset. There may have been a major loss on the sale of an asset which resulted
in a loss in the income statement but affected a significant cash inflow in the
statement of cash flows.
7.6

Outline some cash-flow warning signals.

Some cash flow warning signals are:


cash received less than cash paid
operating outflow
cash receipts from customers being less than cash payments to suppliers and
employees
cash from operating activities being lower then operating profit after tax
proceeds of share capital being used to finance operating activities
consistent inflows from investing activities
proceeds from borrowings continually much greater than the repayment of
borrowings.

Application and analysis exercises

7.21

Helen Hobbs has the following items in its accounts:


a.
b.
c.
d.
e.
f.
g.
h.
i.

Bank interest paid


Loan repaid
Cash purchase of fixed asset
Sale of goods on credit
Taxation payable
Receipts from share capital issue
Cash from load
Dividends payable
Purchase of goods for cash

State whether each of the above items would appear in the statement for cash
flows and if so, under which classification it would appear (investing, operating
or financing).
Solution
a.
b.
c.
d.
e.
f.
g.
h.
i.
7.25

Bank interest paid


Loan repaid
Cash purchase of fixed asset
Sale of goods on credit
Taxation payable
Receipts from share capital issue
Cash from loan
Dividends payable
Purchase of goods for cash

operating
financing
investing
non-cash item
non-cash item
financing
financing
financing
operating

The sole trader of the Murphy Ltd has approached you for a loan. You
note that the closing cash balances for the last two years were $12 000
and $15 000 respectively. Murphy Ltd also took out a loan of $25 000 for
the current year, and sold plant worth $60 000 over the past two years.
The cash from operating activities last year was negative $34 000, and in
the preceding year was $5000. Indicate whether you would advance the
loan. Give reasons.

The figures indicate that the Murphy Store is having a cash problem. Although the
ending cash balances are positive it seems that this may be due to the selling of plant
worth $60 000 and a new loan worth $25 000. Selling the plant means that the Murphy
Store is decreasing its capacity to earn money in the future. The cash from operations
has decreased from $5000 to ($34 000). This means that cash from operating activities
may not be able to be relied upon to repay the loan. So unless the Murphy Store owns
significant assets that could be sold if needed to repay the loan it would not be wise to
advance the loan to the Murphy Store.

7.27

Fit and Fantastic produces and sells a range of fitness equipment. Its
capital expenditure for the current year of new plant was $130 000, and
dividends paid were $20 000. Current liabilities and non-current
liabilities were $43 000 and $560 000 respectively. Sales for the current
year were $205 000, and cash flows from operations totalled $52 000.
Compute the cash adequacy ratio, cash flow ratio, debt coverage ratio
and cash flow to sales ratio.

Ratio
Cash Adequacy Ratio
(Cash adequacy)
Cash Flow Ratio
(Liquidity)

Calculation

Fit and Fantastic Ltd

Cash from operating activities

$52 000
$130 000 $20000
0.35 times or 35%

Capital Expenditure Drawings

Cash from operating activities

Current liabilities

$52 000
$43 000
1.21 times or 121%

Debt Coverage Ratio


(Solvency)

Non - current liabilities


Cash from operating activities

$560 000
$52 000
10.77 times or 10.8%

Cash Flow to Sales Ratio


(Profitability)

Cash from operating activities

Net Sales

$52 000
$205 000
0.25 times or 25%

Analysis of business cases


7.51
Required
a.
Hypothesise why cash and future cash flow is so important for an
individual, business or country and why it is important to report such
information.
Cash in king. Whether for an individual, business or country, cash is needed to sustain
the family, support operations and provide good social infrastructure for a country.
Given its importance it is necessary to report its flow as it means for individuals,
business and government there is some conscious thinking about what cash resources
are available, what are the future cash needs and the inflows expected and to predict
whether the existing cash generation would be sufficient to make interest and debt
payments. Living on debt for an individual, business or country is not sustainable.
b.

Many critical commentators throughout the press have called for an end
to an attitude of the debt-is-money style of thinking. Differentiate
between solvency and liquidity and their relationship to debt.

Liquidity relates to the short term while solvency relates to the long term. Debt could
be used to help in a short term liquidity crisis as long as predicted medium to long
term cash flow is positive. In the long term debt is a useful method to fund long term
investments that would increase cash flow over and above interest payments.
However, if debt is being used to fund a long term solvency issue then the debt-ismoney style of thinking would led to a business demise.

In relation to the countries in economic trouble it could be argued that some have a
solvency problem not a liquidity problem. For example, Greece may be seen to be
insolvent and therefore the European Union and other more affluent European
countries (eg. Germany) lending them money may help with their liquidity in the
short term but at the end of the day Greece needs to start earning more money (being
productive) than it spends if it is to remain solvent. The US federal reserve hoped that
by using debt to stimulate the economy the short term liquidity problem would be
addressed and the stimulus would then spur on the economy so that production would
be increased in the future thus allowing greater taxes to be collected (to help pay
down the debt) and social welfare would cost less (as more people would be
employed).
c.

Make a judgement about the governments economic stimulus efforts.


Should the governments have bailed out the banks? In answering this
question assess a governments duty to provide an economic framework
that encourages investment, employment, opportunities and social
infrastructure with its desire to keep a banking system intact and credit
forthcoming.

This question is entirely personal and will probably be affected by your political and
social philosophy. If you were an economic purist you would probably feel that the
bail outs should not have happened and that there should have been no government
interference. Let the free market and competition sort the weakest from the strongest
and the lessons learnt (by the bankers and their associates) would have led to a
stronger more robust economy in the future. In other words you cant first of all give
the bankers a free economy to make deals with as they wish and then bail them out
when it didnt go their way. This probably would have led to a more severe economic
outcome for the weakest economies at the time but with a faster and more steady regrowth. However, by doing this the whole economy suffers (everyone not just the
bankers). So if you are a believer in government regulation and intervention you
would probably argue that the government should have stepped in. Stimulating the
economy to maintain jobs and production would help future re-growth.
It probably wasnt the economic stimulus (of 2007) that has led to this minor popular
uprising but rather that a few years later (2011) the economy is still not picking up.
Many blame the government for not putting tighter controls over the bail-out money
and that the bankers took the money and used it to spur on more derivative style
products and trading. That is, rather than the banks using the money to fund small
business entrepreneurial growth and housing, the banks used the money (spurred on
by bank bonus-driven performance incentives) to start a new style of investment
driven sub-prime gambling in exchange traded funds and derivatives. So given that
the economy hasnt been stimulated to the desired degree, and the governments have
no more money (or no more access to debt) they have now started cutting their
spending on physical and social infrastructure.
Again the importance of cash and on reporting what cash is coming in and what cash
is being spent and on assessing the ability to pay debt in the long term is just as
important for a country as it for a business.
d.

In Europe, the European banks have been forgiven for not valuing some
of their asset holdings (creditors that owe them money) in Greek,
Portuguese, Irish and Spanish securities in line with the required
marked to market accounting rules. This means that they have not
revalued downward these assets to what they are really worth. (One
could argue that they are worthless.) If they did their equity would be

wiped out. Assess this situation by commenting on the transparency of


this approach, on whether this is sound accounting practice and the
effect of this position in the long term.
Accounting rules and regulations are used to encourage consistency, objectivity and
transparency. If the assets are not re-valued to their true market worth then potential
investors in these economies may be taking on more risk than they would have
otherwise have wanted to. Further, the ownership of the crisis needs to be
acknowledged and by hoping that the debt is worth more than it is may lengthen the
time for recovery. It may result in a worse situation down the track. Transparency is
one of the issues of importance to the nudists in the first article. If it were a business
then not revaluing the assets could be seen as deceptive and unethical behaviour.
On the other hand some would say that the true value of these instruments are widely
known in the market and adjusting the financial statements would not have any
practical effect.
e.

Appraise the reactions of both the nudists and the looters to their
governments response to the changing global economy.

Again your appraisal would be aligned to your political and social standing and your
ethical philosophy. Would you strip off in a public place for your convictions? Would
you feel the right to take what isnt yours because everyone else is?

Comprehension Questions
13.5

(a)
(b)
(c)
(d)
13.6

(a)
(b)
(c)

As production manager for a scarf manufacturing company, how would


you react regarding your inventory levels in the following circumstances?
a. continual breakdowns in the machine used to weave the fabric for the
scarves
b. unreliable out-sourced final colouring of the scarves
c. reduction in interest rates
d. unreliable supplier of wool for the scarves
increase stock of mid-stage completed goods (to avoid hold-ups in the finishing
stage)
increase stocks of finished goods (to avoid being unable to supply to customers);
may increase stock if this had the potential to increase profits
increase raw material stocks (to avoid production hold-ups).
As stock manager in a retail-chain warehouse, how would you react
regarding your inventory levels in the following circumstances?
a. sudden volatility in sales
b. continual short deliveries by suppliers
c. managerial suggestions to reduce the number of product lines
d. an increase in interest rates
increase stock levels to cover sudden increases in sales to ensure always having
stock on hand
increase orders and stocks to cover anticipated shortages
analyse the profitability of holding and selling some lines and reduce stocks if
required

(d)
13.7

analyse stock-holding costs and adjust stocks as appears necessary.


If you had just started a business and were in the early development
phase, which forms of short-term credit would you try to maximise?
Why?

The form of short-term credit that would be maximised would be trade credit and
accruals. These are sources of free finance, which are vitally important to early-stage
firms which are normally short of funds.

Application and analysis exercises


13.18 Entities must juggle the costs of holding cash with the costs of not having
enough. Explain the issues involved.
The cost of holding cash is the opportunity cost of not investing in the short-term
market. The cost of not having enough cash could be late payment of bills, loss of
reputation, trade credit withheld, and increased cost of loans through increase in risk
margin in interest rates.

Synthesis and analysis problems


13.29 Managing trade creditors
Brunswick Ltd has been growing relatively slowly in a mature industry.
Here are its trade creditor and credit purchases data for the last five years
(in $ million):

Required
a.
Compute the creditors turnover (days) for its trade creditors for the
last four years.
Creditors turnover=

Average creditors x 365


Credit purchases

Creditors turnover1 = [(380 +410)/2] 365/4580 = 31.5 days


Creditors turnover1 2 = [(410 +502)/2] 365/4826 = 34.5 days
Creditors turnover1 3 = [(502 +594)/2] 365/5010 = 39.9 days
Creditors turnover1 4 = [(594 +690)/2] 365/5340 = 43.9 days
b.

What do this ratio tell you about the company?

The company is falling behind in paying its creditors. This suggests cash flow
problems or sloppy office processes.

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