Operating Funds

Day-to-Day Needs

Operating cash flow refers to the daily cash inflows and outflows generated from business revenues earned, excluding certain costs.

Learning Objectives

Define operating cash flow

Key Takeaways

Key Points

  • The International Financial Reporting Standards (IFRS) defines operating cash flow as cash generated from operations less taxation and interest paid, investment income received and less dividends paid.
  • “Cash and cash equivalents” on the balance sheet are the most liquid assets found on this statement. They are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper.
  • Cash flow forecasting or cash flow management is a key aspect of the financial management of a business, because planning for future cash requirements can help to avoid a liquidity crisis in the business.

Key Terms

  • International Financial Reporting Standards: International accounting standards that provide a common global language for business affairs, so that company accounts are understandable and comparable across international boundaries.
  • liquidity: An asset’s ability to become solvent without affecting its value; the degree to which it can be easily converted into cash.

Operating Cash Needs

Operating cash flow refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities. The International Financial Reporting Standards (IFRS) defines operating cash flow as cash generated from operations less taxation and interest paid, investment income received and less dividends paid. Business operations have daily cash inflows and outflows. Cash inflows come from cash sales of inventory, collection of credit sales, sales of other assets, and funds obtained through credit financing. Cash outflows occur due to cash payment of business expenses, purchase of assets, and payment on debt.

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Liquidity: Liquidity is essential for businesses, because it allows them to meet daily operating needs.

Cash and Cash Equivalents

“Cash and cash equivalents” on the balance sheet are the most liquid assets found on this statement. They are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are distinguished from other investments through their short-term existence; they mature within three months and have insignificant risk of change in value.

Cash and cash equivalents are also used in the contexts of payments and payment transactions and refer to currency, money orders, paper checks, and stored value products, such as gift certificates and gift cards.

Operating Cash Forecast

Cash flow forecasting or cash flow management is a key aspect of the financial management of a business, because planning for future cash requirements can help to avoid a liquidity crisis in the business. Cash flow is the life-blood of all businesses, particularly start-ups and small enterprises. As a result, it is essential that management forecast (predict) what is going to happen to cash flow to make sure the business has enough to survive.

Capital Expenditures

Capital costs are incurred for the purchase of land, buildings, construction of assets, and equipment, etc., used during business operations.

Learning Objectives

Explain how capital expenditures are accounted for

Key Takeaways

Key Points

  • Capital expenditures are needed to bring a project to a commercially operable status. Whether a particular cost is capital or not depends on many factors, such as accounting rules, tax laws, and materiality.
  • Capital costs include expenses for tangible goods, such as the purchase of plants and machinery, as well as expenses for intangibles assets, such as trademarks and software development.
  • A capital expenditure cannot be deducted in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized.

Key Terms

  • Trademark: A word, symbol, or phrase used to identify a particular company’s product and differentiate it from other companies’ products.
  • amortize: To reduce (a debt, liability, etc. ) gradually or in installments.
  • expenditure: Amount expended; expense; outlay.

Costs of Capital

Capital expenditures (“CAPEX”) are one-time expenses incurred for the purchase of land, buildings, construction of buildings and other assets, and equipment used in the production of goods or in the rendering of services. In short, capital expenditures are the total costs needed to bring a project to a commercially operable status.

Whether a particular cost is a CAPEX or not depends on many factors, such as accounting rules, tax laws, and materiality. CAPEX include expenses for tangible goods, such as the purchase of plants and machinery, as well as expenses for intangibles assets, such as trademarks and software development. CAPEX are not limited to the initial construction of a building or other asset and should include other expense items, such as interest incurred during the construction phase.

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The construction of a building requires the use of capital.: The funds used to construct and put a building into use are capital expenditures.

Accounting for Capital Expenditures

A CAPEX cannot be deducted as an expense in the year in which it is paid or incurred and must be capitalized. The general rule is that if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. The CAPEX costs are then amortized or depreciated over the life of the asset in question. The following capital expenditures are capitalized:

  1. Acquiring fixed and, in some cases, intangible assets
  2. Repairing an existing asset so as to improve its useful life
  3. Upgrading an existing asset, which increases its value (original cost)
  4. Preparing an asset to be used in business
  5. Restoring property or adapting it to a new or different use
  6. Starting or acquiring a new business

An ongoing question for the accounting of any company is whether certain expenses should be capitalized. Costs that are expensed in a particular month simply appear on the financial statement as a cost incurred that month. Costs that are capitalized, however, are amortized or depreciated over multiple years. Capitalized expenditures show up on the balance sheet. Most ordinary business expenses are clearly either expensable or capitalizable, but some expenses could be treated either way, according to the preference of the company. Capitalized interest, if applicable, is also spread out over the life of the asset.The counterpart of capital expenditure is operational expenditure (“OpEx”).

Alternate Sources of Funds

Funds typically originate from company sales and earning revenue; other cash sources include the sale of non-current assets and company stock.

Learning Objectives

Differentiate between operating, investing and financing cash flows

Key Takeaways

Key Points

  • Cash inflows and outflows can originate from three types of activities: operating, investing, and financing.
  • Operating activities that generate cash flows include receipts from the sale of goods or services; receipts from the sale of loans, debt, or equity instruments in a trading portfolio; and interest received on loans.
  • Cash inflows from investing activities involve non-current assets, such as sales of land, building, equipment, and marketable securities; loans from suppliers; and payments related to mergers and acquisitions.
  • Financing activities include the inflow of cash from investors, such as banks and shareholders, proceeds from issuing short-term or long-term debt; sale of repurchased company shares (treasury stock); for non-profit organizations, receipts of donor-restricted cash; and sale of the company’s stock.

Key Terms

  • non-current assets: assets and property not easily converted into cash; a fixed/non-current asset can also be defined as an asset not directly sold to a firm’s consumers/end-users

Sources of Funds

Funds for business operations typically originate from company sales and earning revenue. However, a business can also generate cash funds from other sources as well, such as the sale of non-current assets and through the sale of company stock. The cash flow statement, which shows cash inflows and outflows for a specific reporting period and distinguishes between three types of activities that generate or use cash: operating, investing, and financing.

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Cash Flow Statement: The cash flow statement shows cash inflows and outflows for a specific reporting period and distinguishes between three types of activities that generate or use cash: operating, investing, and financing.

Cash from Operating Activities

Operating activities include the production, sales, and delivery of the company’s product, as well as collecting payment from its customers. This could include purchasing raw materials, building inventory, advertising, and shipping the product. Operating activities that generate cash flows are:

  1. Receipts from the sale of goods or services
  2. Receipts for the sale of loans, debt, or equity instruments in a trading portfolio
  3. Interest received on loans
  4. Merchandise items which are added back to the net income figure
  5. Dividends received
  6. Revenue received from certain investing activities

Cash from Investing Activities

Cash inflows from investing activities involve cash flows associated with non-current assets:

  1. Sale of a non-current asset (assets, such as land, building, equipment, marketable securities, etc.)
  2. Loans from suppliers
  3. Payments related to mergers and acquisitions

Cash from Financing Activities

Financing activities include the inflow of cash from investors, such as banks and shareholders. Other activities which impact long-term liabilities and equity of the company are also listed under financing activities, such as:

  1. Proceeds from issuing short-term or long-term debt
  2. Sale of repurchased company shares (treasury stock)
  3. For non-profit organizations, receipts of donor-restricted cash
  4. Sale of the company’s stock

Credit Operations

Business operations can require the use of credit, or the transfer of money or property on promise of repayment, to meet operating needs.

Learning Objectives

Outline the types of credit used for financing business operations

Key Takeaways

Key Points

  • Credit is sometimes not granted to a person or business with financial instability or difficulty. Companies frequently offer credit to their customers as part of the terms of a purchase agreement.
  • A line of credit is any credit source extended to a business or individual by a bank or other financial institution and may take several forms.
  • A revolving credit line provides a borrower with a maximum aggregate amount of capital, available over a specified period of time; it allows the borrower to draw down, repay, and re-draw credit amounts advanced to her by the available capital during the term of the debt.
  • In a loan, the borrower initially receives or borrows an amount of money, called the “principal,”, from the lender and is obligated to pay back or repay an amount with interest to the lender at a later time.

Key Terms

  • creditor: A person to whom a debt is owed.
  • debtor: A person or firm that owes money; one in debt; one who owes a debt

Use of Credit and Financing for Operations

Business operations can require the use of credit and financing to meet operating needs. Credit, in commerce and finance, is a term used to denote transactions involving the transfer of money or other property on promise of repayment, usually at a fixed future date and at a specific interest rate. The transferor thereby becomes a creditor, and the transferee (the recipient of the funds or property) becomes a debtor. Credit is sometimes not granted to a person or business with financial instability or difficulty. Companies frequently offer credit to their customers as part of the terms of a purchase agreement. Organizations that offer credit to their customers frequently employ a credit manager.

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Loans can weigh a business down.: The use of credit is a necessity in business and should be managed wisely.

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Interest Rates: Long-term interest rate statistics for non-Euro countries plus Greece, Portugal, and Ireland.

Types of Credit

A line of credit is any credit source extended to a business or individual by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of commercial bills, traditional revolving credit card account, etc. It is effectively a source of funds that can readily be used at the borrower’s discretion. Interest is paid only on money actually withdrawn. Lines of credit can be secured by collateral or may be unsecured.

A revolving credit line provides a borrower with a maximum aggregate amount of capital, available over a specified period of time. However, unlike a term loan, revolving debt allows the borrower to draw down, repa,y and re-draw credit amounts advanced to her by the available capital during the term of the debt. Each credit line is borrowed for a set period of time, usually one, three, or six months, after which time it is technically repayable. Repayment of revolving credit is achieved either by scheduled payments on the total amount of the debt over time, or by all outstanding loans being repaid on the date of termination.

In a loan, the borrower initially receives or borrows an amount of money, called the “principal,” from the lender and is obligated to pay back or repay an equal amount of money to the lender at a later time. Typically, the money is paid back in regular installments, or partial repayments; in an annuity, each installment is the same amount. The loan is generally provided at a cost, referred to as interest on the debt, which provides an incentive for the lender to engage in the loan.

Purchasing Inventory

Inventory management is primarily about specifying the quantity and placement of stocked goods.

Learning Objectives

Explain how an organization makes purchasing decisions

Key Takeaways

Key Points

  • The scope of inventory management includes items such as: stock replenishment lead time, carrying costs of inventory, asset management, and inventory forecasting.
  • There are four basic reasons for keeping an inventory: time lags present in the supply chain, the maintenance of inventory for consumption during variations in lead time, inventories maintained to meet uncertainties in demand and supply, and economies of scale.
  • Purchasing refers to a business or organization acquiring goods or services to accomplish the goals of its enterprise. Companies generally use operating funds to finance their purchasing program.
  • One of the goals of purchasing inventory is to acquire goods at the most advantageous terms for the buying entity (the “Buyer”).

Key Terms

  • lead time: The amount of time between the initiation of some process and its completion, e.g. the time required to manufacture or procure a product; the time required before something can be provided or delivered.
  • economies of scale: The characteristics of a production process in which an increase in the scale of the firm causes a decrease in the long-run average cost of each unit.

Inventory Management

Inventory management is primarily about specifying the quantity and placement of stocked goods. Inventory management is required at different locations within a facility or within multiple locations of a supply network to maintain the regular and planned course of production and to manage the risk of running out of materials or goods for sale. The scope of inventory management also involves stock replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space for inventory, quality management, returns and defective goods, and demand forecasting.

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Clothing Retailers Should Have Sufficient Inventory On Hand: Inventory purchases should be carefully managed to prevent overstocking merchandise or having inventory shortages.

There are four basic reasons for keeping an inventory:

  1. Time: The time lags present in the supply chain, from supplier to user at every stage, require that businesses maintain certain amounts of inventory to use in this lead time.
  2. Consumption: Inventory is to be maintained for consumption during variations in lead time. Lead time itself can be addressed by ordering a specified number of days in advance.
  3. Uncertainty: Inventories are maintained as buffers to meet uncertainties in demand, supply, and movements of goods.
  4. Economies of scale: The idea of “one unit at a time, at a place where a user needs it, when they need it” tends to incur lots of costs in terms of logistics. So bulk buying, movement, and storing brings in economies of scale and creates inventory.

Purchasing

Purchasing refers to a business or organization acquiring goods or services to accomplish the goals of its enterprise. Companies generally use operating funds to finance their purchasing program. Most organizations use a three-way check as the foundation of their purchasing programs. This involves three departments in the organization completing separate parts of the acquisition process. These departments can be purchasing, receiving, and accounts payable; or engineering, purchasing, and accounts payable; or a plant manager, purchasing, and accounts payable. Combinations can vary significantly, but a purchasing department and accounts payable are usually two of the three departments involved.

Historically, the purchasing department issued purchase orders for supplies, services, equipment, and raw materials. Then, in an effort to decrease the administrative costs associated with the repetitive ordering of basic consumable items, “blanket” or “master” agreements were put into place. These types of agreements typically have a longer duration and increased scope to maximize the quantities of scale concept. When additional supplies were required, a simple release would be issued to the supplier to provide the goods or services.

From time to time, an organization will “shop” for suppliers through the process of bidding. When selecting bidders, an organization identifies potential suppliers for specified supplies, services, or equipment. These suppliers’ credentials and history are analyzed, together with the products or services they offer. The bidder selection process varies from organization to organization, but can include running credit reports, interviewing management, testing products, and touring facilities. Organizational goals will dictate the criteria for the selection process of bidders. It is also possible that the product or service being procured is so specialized that the number of bidders are limited and the criteria must be very wide to permit competition.

Negotiating is a key skill in purchasing. One of the goals of purchasing inventory is to acquire goods at the most advantageous terms for the buying entity (the “Buyer”). Purchasing agents typically attempt to decrease costs while meeting the Buyer’s other requirements, such as an on-time delivery and compliance to the commercial terms and conditions (including the warranty, the transfer of risk, assignment, auditing rights, confidentiality, remedies, etc.).