Question

CLASSIFICATION OF CASH FLOWS The accountant for Delta Ltd prepared the following statement of cash flows.

DELTA LTD Statement of cash flows for the year ended 30 June 2019 $'000 Cash flows from operating activities Cash received from customers Cash paid to suppliers of goods and services Interest received Interest paid Income tax paid Net cash outflow from operating activities Cash flows from investing activities Cash received from sale of investments Cash paid for purchase of property, plant and equipment Net cash outflow from investing activities Cash flows from financing activities Proceeds from borrowings Dividends paid Net cash inflow from financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at the beginning of the year Cash and cash equivalents at the end of the year 870 (650 40) (200) (100) (40) 300 (400) (100) 160 (30) 130 (10) 15

The managers were worried that investors would be displeased by the negative operating cash flow and that the company’s share price might fall as a result. One manager suggested that the interest paid and interest received might be classified as financing cash flows and investing cash flows respectively, so that the company’s cash flow would look better.

Required 1. Calculate the net cash flows for each activity if Delta Ltd reclassified interest paid and interest received as suggested by the manager. 2. Drawing on your understanding of the efficient market hypothesis (see chapter 2), is the change in the classification of interest paid or received in the statement of cash flows likely to make a differ- ence to the share price? Give reasons for your answer.

Answer 1

Delta Ltd

Statement of Cash Flows

for the year ended 30 June 2019

Cash Flow From operating activities
Cash received from customers	870
Cash paid to suppliers of goods and services	-650
Income Tax Paid	-100
Net Cash outflow from operating activities	120
Cash Flow From Investing activities
Cash received from sale of investments'	300
Cash paid for Purchase of Property Plant and Equipment	-400
Interest Received	40
Net Cash Outflow from Investing activities	-60
Cash flow from Financing activities
Proceeds from Borrowing	160
Dividends Paid	-30
Interest Paid	-200
Net Cash Outflow From Financing activities	-70
Net decrease in cash and Cash Equivalents	-10
Cash and cash equivalents at the beginning of the year	15
Cash and Cash equivalents at the end of the year	5

  

2. Drawing on your understanding of the efficient market hypothesis (see chapter 2), is the change in the classification of interest paid or received in the statement of cash flows likely to make a differ- ence to the share price?

Answer: Yes,It will affect the market price .There are two methods currently used to find the market price. One is the use of EBITDA as a measurement and the other is earnings per share.Primarily with earnings per share because it is located on the income statement. Bankers however, lean on EBITDA.When Interest paid was part of operating activities,It reflects Net Cash Inflow From Financing activities while if we show it as part of investing activities it becomes Net Cash Outflow (negative balance) From Financing activities.It says that Delta Ltd have done lot of Financing transactions during year.Investors can think about financing Cash Inflow or Outflow as per Industry situation.

After re Classification, Net Cash Outflow from Investing activities is lower than before . It says that Company has sold Investment of $300, Interest earned $40 and Invested during year $ 400 means. There is a little difference between investment disposed off and investment made during year. It is a positive symbol for company.

Hence overall it will affect market price of Delta Ltd