Statement of Cash Flows: Q7

Q7: Describe the direct method of presenting a firm’s cash flows from operating activities in a firm’s Statement of Cash Flows.

A:

The direct method of reporting cash flows from operating activities discloses ‘major classes of gross cash receipts and gross cash payments’ (AASB 107, para 18). For most firms, cash flows from operating activities relate to transactions that determine a firm’s profit or loss, such as cash receipts from customers (from the sale of goods or services), cash payments to suppliers (for good and services) and to employees; cash payments of income tax; as well as potentially a few other miscellaneous items such as various forms of other revenue:

“Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the entity. Therefore, they generally result from the transactions and other events that enter into the determination of profit or loss. Examples of cash flows from operating activities are:

(a)    cash receipts from the sale of goods and the rendering of services;

(b)    cash receipts from royalties, fees, commissions and other revenue;

(c)     cash payments to suppliers for goods and services;

(d)    cash payments to and on behalf of employees;

(e)    …

(f)     cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and

(g)    cash receipts and payments from contracts held for dealing or trading purposes.”

AASB 107 para 14

Cash receipts from customers

We can see in Ryman Healthcare’s Consolidated statement of cash flows that a key item in its Cash flows from operating activities is Receipts from residents ($760m) (see Figure 7.1 below). These are the cash receipts from its customers, which are primarily from payments for occupancy advances in retirement village units; but also include a range of other transactions where Ryman Healthcare receives cash from its residents/customers, such as care fees from those in its aged care facilities and also management fees for running the retirement villages). That is a lot of cash being received from its residents in a year, more than three-quarters of a billion dollars in cool, hard cash.

If all sales to customers are paid for in cash when the sale is made, calculating the cash receipts from customers in a period is very straightforward. However, it is common practice for sales to also be made on credit terms with customers: buy now and pay later. For example, customers of a business may be given one or two months to pay for the sales made to them. This means that some of the sales made on credit may be recorded as sales in a period (and thus contribute to the profit for the period) but not involve the customer actually paying cash for the sale until the next period. For this reason, we cannot simply use the sales figure for a period to present the cash receipts from customers.

To calculate the cash receipts from customers we can include the amount for cash sales; but for sales made on credit we need to adjust them for the change in the balance of Accounts receivable during the period.  To do this, we add to credit sales opening Accounts receivable (ie we can assume this item will become cash during the period) and deduct closing Accounts receivable (ie credit sales made during the period for which cash has not yet been received). In this way, cash receipts from customers equals cash sales for a period as well as credit sales (adjusted for the change in Accounts receivable) during the period. This can be shown as:

Cash receipts from customers:

  • Cash sales for a period

            +

  • Credit sales + (opening Accounts receivable – closing Accounts receivable)

Cash payments to suppliers

The other two key items in Ryman Healthcare’s Cash flows from operating activities are its Payments to suppliers and employees ($214m) and also Payments to residents ($213m) (see Figure 7.1 below). These in total make up Ryman Healthcare’s Cash payments to suppliers. The item called Payments to residents represents the amount of cash paid to residents when they left a Ryman Healthcare retirement village and sold their occupancy rights for their retirement village unit back to Ryman Healthcare. In this situation, the residents are suppliers to Ryman Healthcare of occupancy rights to retirement village units (which Ryman Healthcare is then able to sell to new residents/customers). In this way, Payments to residents can be seen as a form of ‘Payments to suppliers’, which Ryman Healthcare has chosen to disclose separately. So the combination of Payments to suppliers and employees ($214m) and Payments to residents ($213m) represents for Ryman Healthcare its Cash payments to suppliers (a total of $427m).

We saw that when we calculate cash receipts from customers, we start with sales (both cash and credit sales). In a similar way, when we calculate cash payments to suppliers, we can start with Cost of goods sold (COGS). Some (perhaps most) of the COGS will be paid for by our firm on credit. As we needed to adjust sales for changes in Accounts receivable when calculating a firm’s Cash receipts from customers, so we also need to adjust a firm’s COGS for changes in Accounts payable (opening Accounts payable – closing Accounts payable):

Cash payments to suppliers:

  • COGS

            +

  • (opening Accounts payable – closing Accounts payable)

In addition, the cash payments to suppliers in a period would also need to be adjusted for changes in Inventories (if a firm has Inventories; which everyone’s firm in our unit does, except for my firm Ryman Healthcare). The reason for this is that the Cost of goods sold will only include items from Inventories that we actually sold. If, for example, our firm increased its level of Inventories during the year, then its purchases from suppliers will be more than its Cost of goods sold for the year (and vice versa if its Inventories had decreased). For this reason, Cash payments to suppliers during a period equals Cost of goods sold (COGS) adjusted for changes in Inventories as well as for changes in Accounts payable. This can be shown as:

                Cash payments to suppliers:

  • COGS

           +

  • (opening Accounts payable – closing Accounts payable)

           +

  • (closing Inventories – opening Inventories)

  

Typically, there are also a wide range of other expenses and revenue that affect the operating cash flows of a business. These include various expenses such as salaries, insurance, electricity, rent and many other expenses that involve the payment of cash during a period. These items are included in the Income statement. To calculate the cash paid for these items of expenses and revenue, these items in the Income statement often need to be adjusted for accruals (where an expense is incurred but not yet paid to suppliers in a period; or, where revenue is earned but not yet received from customers in a period); and for prepayments (where an expense is paid to suppliers in a period, but not yet incurred; or where revenue is received from customers in a period, but not yet earned). For example, for an expense such as insurance (which is usually paid in advance before the expense is incurred) the cash payments for insurance would be the insurance expense (in the Income statement) plus closing Prepaid insurance (in the current year’s Balance sheet) less opening Prepaid insurance (in the previous year’s Balance sheet):

Cash payments to suppliers:

  • COGS

           +

  • (opening Accounts payable – closing Accounts payable)

           +

  • (closing Inventories – opening Inventories)

           +

  • Insurance expense + (closing Prepaid insurance – opening Prepaid insurance)

 

We can see how this works with Ryman Healthcare’s 2017 Consolidated statement of cash flows (in Figure 7.1 below). Ryman Healthcare has presented its Cash flows from operating activities using the direct method. It has presented these as Receipts from residents (being occupancy advance cash receipts from retirement village residents) ($759.8m); Interest received ($0.5m); Payments to suppliers and employees (negative $214.0m); Payments to residents (re-purchase of occupancy rights on retirement village units) (negative $212.5m); and Interest paid (negative $10.9m). This gives Net operating cash flows of $322.8m for Ryman Healthcare in 2017.

video

Also, see Martin’s videos, Direct Method of presenting Cash flows from operating activities.

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