Module 7: Case study – the Cash Flow Statement

Among the primary financial statements, the Cash Flow Statement always comes after the
Income Statement and the Balance Sheet and these ancillary statements that have been
developed to fill gaps between the two, the Statement of Comprehensive Income and the
Statement of Changes in Equity.

It is important not to ignore cash flow and believe that it can take care of itself – we know this
from personal financial experience and it applies equally to organisations.

For small start-up companies, cash flow is the life blood and failure to manage it properly can
undo a perfectly valid commercial proposition.

As companies grow, management preoccupation shifts from the short-term imperative of

ensuring that there is enough money to pay bills, towards ensuring continuity of financing for
the medium term and how to use that finance most effectively to minimise costs. Because
money costs and compounding cost is a slippery slope downwards whereas the road to wealth
is partly about compounded income.
The Cash Flow Statement sets out some clear categories of cash flow starting with:

 Cash generated from operations

The figure of £236.3 million, roughly 10% of turnover, does not appear on the face of the
Income Statement. It comes from Note 30 to the Financial Statements which starts with Profit
before taxation and then strips out anything to do with the financing of the business – interest
income and costs – and any non-cash items that are purely accounting adjustments. Having
taken these items out, profit before taxation becomes a positive cash flow of £231.3 million.
 Changes in working capital

Another activity which impacts operating cash flow is working capital management.

This aims to:

- Minimise the level of inventories through effective logistics and supply chain
management
- Encourage debtors to pay you quicker or even just to agreed terms
- Negotiate additional credit from suppliers

The difference between working capital levels at the beginning and end of each trading period
has a direct impact on the cash generated. In this instance, it has helped generate another £5.0
million which in interest terms, at say 4%, is worth £200,000 a year. This serves as a reminder
that attention to detail and the accumulated impact of small differences can make a big one.
Net cash flow from operating activities reflects adjustments for net Finance costs of £19.3
million and tax. The tax line shows a receipt of £1.0 million. Usually, organisations pay tax to the
government, not the other way round. The answer is in the taxation note to the Financial
Statements. Lease incentives received from landlords are capitalised as liabilities and then
released to income time. The tax treatment of lease incentives mirrors the accounting
treatment.

However, a change in reporting framework by one of the group’s principal subsidiaries from UK
Generally Accepted Accounting Practice or GAAP to International Financial Reporting Standards
(known by the acronym IFRS) has extended the life over which lease incentives are amortised,
giving rise to an accounting adjustment.

The tax consequence of this is a prior year tax credit that has resulted in a repayment. By way of
comparison, tax paid in the previous year 2013/14 was £20.9 million.

 Cash flows from investing activities

This section of the cash flow statement considers the money spent on the fixed capital element
of the business. This is referred to as investment as it is intended to protect and increase future
profits. In any event, it is an application of funds which will feed back into operating cash flows
over time as extra profit.

- Purchase of tangible assets – property, plant and equipment cost £79.6 million during the
year compared with £102.3 million during the previous year. Depreciation of tangible assets
was £87.7 million during the year.
-
- The level of expenditure suggests that investment is doing little more than maintaining the
status quo, even though new replacement assets will more than likely cost more than those
being depreciated. There are no hard and fast rules about what constitutes the right level of
investment but the level of investment in new fixed assets can be a measure of corporate
health.

- By contrast, the investment in intangibles of £54.0 million is greater than in the previous
year and exceeds the amortisation of intangibles of £16.5 million. It is clear that there is a
strategy of upgrading and improving systems. The analysis suggests a commitment to the
development of bespoke software in-house which is likely to be more expensive than simply
adopting tried and tested industry standard software .

 Cash flow from financing activities

- A vital component required to understand the finance of a business is insight into how it
adds to the store of money that is available to it. This section of the Cash flow statement
 shows that Debenhams has taken the opportunity of strong operating cash flow to repay
some of its debt, in the form of its senior notes and its revolving credit facility. This will give
rise to a significant reduction in interest costs and a resulting increase in profits.

- This section also includes the dividends paid to shareholders of £41.7 million. Why are
dividends shown here in financing activities and not in Net cash generated from activities
which is where interest costs are shown?
-
The important difference about dividends is that they are discretionary. Unlike interest
which is payable contractually and is a clear example of a business cost, dividends represent
an appropriation of profit and such distributions need ratification by shareholders.

The effect of all these inflows and outflows is the impact on the Net cash and cash equivalents
and the figure at the foot of the Statement ties in with the figure that appears in the
Consolidated Balance Sheet.

The Consolidated Cash Flow Statement does not include a reconciliation of the group’s net
debt because the expression “net debt” is not one that appears in Primary Statements because
it offsets assets (cash) and liabilities (borrowings). However, it is used by management within its
preferred KPIs and by investors/analysts and commentators. It is included in the Report and
Accounts at Note 31 Analysis of changes in net debt, which cross-refers to the Consolidated
Balance Sheet.

 Management of net debt

To reiterate, the management of cash flow is an important financial management activity which
sits beside the management of net debt. The exploitation of a business’ net assets is the
preoccupation of the executive management team in their pursuit of profit or value. They rely
on Finance and in particular the Treasury function to manage cash flow and the financial
liabilities within the Balance Sheet.
The componentss of net debt are:
- Cash (in the bank) and cash equivalents (such as bank or money market deposits)
- Bank overdrafts
- Borrowings split between Senior Notes and the Revolving Credit Facility
- Finance lease obligations

Senior notes are IOU’s issued to lenders for a fixed period of time at a fixed rate of interest.
Notes to the value of £225 million were issued in July 2014 repayable in 2021. The group bought
back £25 million of these notes during the year. The revolving credit facility of £425 million was
also arranged at the same time although £75 million was cancelled during the year, reducing the
facility to £350 million. This credit facility gives the company flexibility to draw as and when it
requires funds for varying short term periods. It is therefore effectively variable rate financing. It
does not have to be fully drawn and it is available to suit the borrower. For this discretionary
right to draw down, Debenhams will pay a commitment fee for the undrawn element. This is
because the funding bank will have to reserve part of its capital to cover its commitment to
Debenhams and this has a cost. The facility expires in October 2018, although there is an option
to extend the borrowing to 2019.

There appears to have been a concerted effort to reduce the reliance on traditional bank
funding and diversify the sources of financing available to Debenhams. But within a relatively
short period of time, the scale of financial flexibility has been reduced by £100 million
suggesting a change in the group’s investment ambitions. It suggests a lack of clarity in the
corporate strategy or a deferral of expansion plans in the face of continuing difficulties with the
UK economic environment. It also reflects the recent arrival of a new finance director, Matt
Smith, who is more focussed on improvements in profitability and stronger operational cash
flow.

 Financial risk management

So how does a Treasurer determine what mix of these different components is optimal. Why
not simply borrow money from a bank and just deposit any surplus money until it is needed?

The Treasurer is first and foremost a risk manager. In the majority of cases, corporate treasuries
are not profit centres, that is to say, they do not operate like a bank. The business and its needs
come first and the Treasurer’s role is to address the following:

The need for cash to pay bills as they fall due and collect revenue from
Liquidity customers efficiently is a clear priority, so day-to-day cash management
comes first. In addition is the need to ensure that when debts fall due to be
 repaid there are funds available. The Treasurer needs to be conscious of
the debt repayment profile and ensure that he is prepared. A spread of
maturities avoids the possibility that at precisely the moment when he
needs to borrow, the market doesn’t turn round and say ‘I’m sorry, not
now’.

Applies particularly to investments. Historically Treasurers relied upon their

Security relationship banks to be deposit takers if they had surplus funds. But banks’
creditworthiness has changed since 2008 and the UK government’s deposit
protection scheme only covers about £85,000 these days. So the
creditworthiness of counter-parties requires regular review to ensure
safety. Equally no Treasurer wants to arrange a credit facility with a
counter-party is unable to renew when repayment comes around;

How does an organisation ensure that people with money will be happy to
Credit lend to it? Through prudent financial management, a decent credit rating
for any public debt, and transparency over its performance and its financial
structures;

The Treasurer needs to balance the need to be cost effective when

borrowing and try and obtain competitive rates when borrowing. In a
classic market, short-term rates are lower than long term rates as the
longer you want to borrow, the more the market will factor in the risk of
non-repayment and charge a higher rate. If you borrow too short term
there is a risk of being caught out by sudden increases in interest rates. So a
balance is needed between debt that is variable in its cost and that which
Cost has a fixed cost depending on:

- your view on the future course of interest rates

- your pain threshold if rates do suddenly increase unexpectedly

Typically the higher the debt the more the Treasurer will want the peace of
mind of knowing what the cost of funds is. But fixing the cost ten years ago
might have proved a costly mistake as interest rates plummeted after 2008
with a consequence of comparatively high cost of funds in a slowing or
static operating environment. And this would have constrained profit
margins and profit growth.
  Summary

The effective control of an organisation’s cash flow is a critical challenge for management in
terms of its ability to carry on its business and invest for the future at a reasonable cost. Cash
flows can be distinguished between:

- Operating cash flows;

- Investing activities; and
- Financing activities

The Treasurer has to be clear where an organisation’s pain threshold is and make decisions
about:

 the optimal level of indebtedness for the organisation i.e. what is a safe level of debt;
 an acceptable level of cost for the required financial security;
 the repayment profile that suits its projected cash flows; and
 gives it a degree of flexibility against the unexpected.

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