Casper Van Leeuwen - Why cash flow should be a focal point
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This document discusses why cash flow should be the focal point of financial consolidation and reporting. It argues that traditional financial statements do not provide easy insights into value creation. The balance sheet mixes operating and non-operating items, and the income statement combines profits and non-profits. To analyze economic performance, the statements need to be reorganized. The document demonstrates reorganizing the balance sheet to the "capital employed" format, which separates operating, investing, and financing activities and clearly defines working capital and net debt. This integrated view of the financial statements through the lens of cash flow and capital employed better reveals how value is being created.
![Trade working capital (excl. inventories)
WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING
Stakeholders Prepaid amounts Invoiced amounts Accrued amounts
Customers Prepaid income Trade receivables Accrued income
Suppliers Prepaid expenses Trade payables Accrued expenses
Employees Employee advances Employee accruals
Tax authorities[1],[2] Prepaid taxes Tax liabilities
Others Guarantees & deposits
[1]Includes VAT, local taxes and social security
[2]Excludes income taxes as this is not a working capital measure
Assets, where an increase has a dampening effect
on operating cash flow
Liabilities, where an increase has a boosting effect
on operating cash flow
Accrued income, including underbilled
work in progress in project- or
construction work, is an infamous trade
working capital account. It is often the
account where fraud is detected by the
recording of non-existing revenue. It
should be closely monitored.
Legend
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Casper Van Leeuwen - Why cash flow should be a focal point
- 1. Why cash flow should be the focal point in your financial consolidation and reporting Contact Casper van Leeuwen +31 6 13 08 49 72 casper.van.leeuwen@satriun.com WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 1
- 2. WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 2 If it ain’t broke, don’t fix it. But what if it is broke?
- 3. The importance of cash flow to a business (1) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING “Most companies have historically viewed profit as king as cash as ‘free’. Only companies that make the culture change to see cash as a measure of world-class performance and run a tight ship make progress” Cash is king – again: supply chain management in Aerospace and Defense, September 2017 “Working capital can amount to as much as several months’ worth of revenues. Cash improvements can often be reinvested in ways that more directly affect value creation, such as growth initiatives” Uncovering cash and insights from working capital, July 2014 “Value may be a function of cash generation, yet managers often focus so intently on profitability that they give scant consideration to the cash conversion cycle” Transforming the culture of managing working capital, January 2018 “Capital productivity is an important and often underused value lever in capital- intense industries. The CFO who takes this to heart and knows where to plug in and how to push can make a big difference in boosting both return on invested capital and free cash flow” Why capital expenditures need more CFO attention, May 2015 3
- 4. The importance of cash flow to a business (2) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING “Creating shareholder value is not the same as maximizing short-term profits.” “For value-minded executives, creating shareholder value is about maximizing a company’s collective value to current and future shareholders, not just today’s.” “The amount of value they create is the difference between cash inflows and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows.” 4
- 5. Why cash flow is important in determining value creation WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Value Free Cash Flow Capital Employed Operating Profit Revenue Operating expenses Income taxes Working capital PP&E and Fixed Assets Discount Rate Cost of Capital PP&E and Fixed Assets IncomeStatementBalanceSheet Cash Flow Statement The value of a company is based on its future cash flows. The Discounted Cash Flow method (DCF method) is regarded as the most justifiable method to appraise economic value. This method considers future cash flows adjusted for the time value of money. Interested? Read “Valuation”! (Tim Koller, Marc Goedhart, David Wessels) 5
- 6. WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 6 Okay, so what now?
- 7. Reorganizing the Financial Statements WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING “Traditional financial statements –the income statement, balance sheet, and statement of cash flows– do not promote easy insights into operating performance and value.” “The balance sheet mixes together operating assets, nonoperating assets, and sources of financing. The income statement similarly combines operating profits, interest expense, the amortization of acquired intangible assets, and other nonoperating items.” “To prepare the financial statements for analyzing economic performance, you need to reorganize the items on the balance sheet, income statement, and statement of cash flows.” 7
- 8. Disconnected view on financial statements WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Income Statement Sales Cost of goods sold Gross margin Operating expenses Operating profit Other income & expenses EBITDA Depreciation Amortization EBIT Interest income Interest expenses Other finance expenses Profit before tax Income taxes NET PROFIT Balance Sheet (GAAP) Goodwill & intangible assets Property, plant & equipment Financial assets Non-current assets Inventories Other current assets Current assets Assets Equity Non-current loans & borrowings Non-current provisions Deferred tax liabilities Non-current liabilities Trade & other current liabilities Equity & liabilities Cash Flow Statement Operating profit Change in working capital Payments from provisions Income taxes paid Cash from operating activities Investments in intangible assets Investments in PP&E Investments in financial assets Cash from investing activities Equity cash flows Debt cash flows Cash from financing activities Currency effect on cash CHANGE IN CASH OperatingInvestingFinancing OperatingInvestingFinancing Mixofoperating,investingandfinancingactivities 8
- 9. Balance sheet: from GAAP to Capital Employed (1) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Goodwill & intangible assets 550 Share capital 150 Property, plant & equipment 1,410 Retained earnings 1,800 Loans receivable, non-current portion 340 EQUITY 1,950 Deposits, non-current portion 410 NON-CURRENT ASSETS 2,710 Loans & borrowings, non-current portion 800 Provisions, non-current portion 280 Inventories 1,290 Deferred tax liabilities 190 Trade receivables 1,530 NON-CURRENT LIABILITIES 1,270 Loans receivable, current portion 160 Deposits, current portion 210 Trade payables 2,070 Interest receivable 40 Loans & borrowings, current portion 300 Cash & cash equivalents 860 Provisions, current portion 60 CURRENT ASSETS 4,090 Income tax liabilities 420 Accrued expenses 730 CURRENT LIABILITIES 3,580 ASSETS 6,800 EQUITY & LIABILITIES 6,800 Operating Investing Financing Legend ① Group assets and liabilities by nature instead of by maturity 9
- 10. Balance sheet: from GAAP to Capital Employed (2) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Goodwill & intangible assets 550 Share capital 150 Property, plant & equipment 1,410 Retained earnings 1,800 Loans receivable 500 Deposits 620 Loans & borrowings 1,100 Provisions 340 Inventories 1,290 Deferred tax liabilities 190 Trade receivables 1,530 Trade payables 2,070 Interest receivable 40 Cash & cash equivalents 860 Income tax liabilities 420 Accrued expenses 730 Operating Investing Financing Legend ② Present operating and investing separate from financing activities 10
- 11. Balance sheet: from GAAP to Capital Employed (3) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Goodwill & intangible assets 550 Share capital 150 Property, plant & equipment 1,410 Retained earnings 1,800 Loans receivable 500 Deposits 620 Provisions -340 Loans & borrowings 1,100 Deferred tax liabilities -190 Inventories 1,290 Trade receivables 1,530 Trade payables -2,070 Interest receivable 40 Cash & cash equivalents -860 Income tax liabilities -420 Accrued expenses -730 Operating Investing Financing Legend ③ Group operating, investing and financing activities in a logical order 11
- 12. Balance sheet: from GAAP to Capital Employed (4) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Inventories 1,290 Share capital 150 Trade receivables 1,530 Retained earnings 1,800 Deposits 620 EQUITY 1,950 Trade payables -2,070 Accrued expenses -730 Loans & borrowings 1,100 WORKING CAPITAL 640 Cash & cash equivalents -860 NET DEBT 240 Provisions -340 Income tax liabilities -420 Deferred tax liabilities -190 Goodwill & intangible assets 550 Property, plant & equipment 1,410 Loans receivable 500 Interest receivable 40 CAPITAL EMPLOYED 2,190 FUNDS PROVIDED 2,190 Operating Investing Financing Legend 12
- 13. Benefits of the Capital Employed presentation WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Benefits of presenting the balance sheet according a Capital Employed lay out include: • Promotes easy insights into operating performance and value • Provides a logical view on each of operating, investing and financing activities • Features a clear definition and presentation of working capital • Presents net debt on the face of the balance sheet • Provides a transparent link to a RoCE performance indicator • Enables consistent analysis of operating performance across income statement, balance sheet and statement of cash flows Working capital Equity Provisions Taxes Loans & borrowings Operating activities …………… Cash & cash equivalents Investing activities Net Debt …………… CAPITAL EMPLOYED …………… FUNDS PROVIDED …………… 13
- 14. Integrated view on financial statements WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Income Statement Sales Cost of goods sold Gross margin Operating expenses Operating profit Other income & expenses EBITDA Depreciation Amortization EBIT Interest income Interest expenses Other finance expenses Profit before tax Income taxes NET PROFIT Balance Sheet (capital employed) Working capital assets Working capital liabilities Working capital Provisions Income tax liabilities Goodwill Intangible assets Property, plant & equipment Financial assets CAPITAL EMPLOYED Equity Loans & borrowings Cash & cash equivalents Net debt FUNDS PROVIDED Cash Flow Statement Operating profit Change in working capital Payments from provisions Income taxes paid Cash from operating activities Investments in intangible assets Investments in PP&E Investments in financial assets Cash from investing activities Equity cash flows Debt cash flows Cash from financing activities Currency effect on cash CHANGE IN CASH OperatingInvestingFinancing OperatingInvestingFinancing OperatingInvestingFinancing 14
- 15. WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 15 What does that mean to how we organize financial information?
- 16. The Satriun approach to designing a CPM data model (1 of 2) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 16 Balance sheet (start of period) Balance sheet (end of period) Income statement Cash flow statement Balance sheet flows Our approach to designing a financial data model is built around three key concepts: • Connectivity between balance sheet, income statement and cash flow statement, represented by movement schedules that clearly identify the logical relationship between non-cash movements to income statement or other comprehensive income, and cash movements to cash flow statement. • Completeness of the potential transactions that can be posted to assets, equity and liabilities, and making sure the data model is able to digest those potential transactions both for a single company as for the consolidated financial statements. • Control over the quality of the data reported by introducing easily over 100 data quality controls that not only enforce connectivity and completeness, but also logical signage such as capital expenditure having to be an increase of property, plant & equipment.
- 17. The Satriun approach to designing a CPM data model (2 of 2) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Identify balance sheet accounts “by nature” Classify as operating, investing or financing Identify recognition in comprehensive income Identify / create corresponding P&L and equity accounts Identify recognition in cash flow Create corresponding cash flow accounts Identify other transaction types (non-cash) Identify / create corresponding balance sheet flows 17 Identify / create data quality controls
- 18. Balance sheet flows – example WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING ① ② ③ ④ ⑤ ⑥ ① Cash relevant flow, feeds into the indirect cash flow statement ② Non-cash flow, represents a reclassification between accounts ③ Non-cash flow, arising from the financial consolidation process ④ Non-cash flow, represents amounts posted in income statement ⑤ Non-cash flow, represents amounts posted in income statement ⑥ Non-cash flow, arising from the financial consolidation process 18
- 19. Opening balance Capital expenditure Assets avail. for use Depreciation Impairments Translation differences Closing balance Balance sheet flows – connectivity WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 584 20 68 -56 -5 11 621Land and buildings Cash Flow Statement Income Statement Depreciation Impairments -56 -5 Capital expenditure -20 -68 11 Construction in progress Currency translation reserve Balance Sheet 19
- 20. Balance sheet flows and relation to non-current / current portions WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING To satisfy the information needs both for the purpose of financial statement disclosures and cash flow reporting, balance sheet flows do not have to be detailed by each of the long-term (non-current) and short-term (current) portions. For various reasons it is more practical to detail balance sheet flows only by the nature of the asset or liability rather than by the maturity of the asset or liability. 20
- 21. Opening balance Additions Utilizations Releases Change in discount rate Balance sheet flows – connectivity and maturity WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 160 23 -15 -4 -28Environmental provisions Cash Flow Statement Income Statement Releases of provisions Change in discount rate 4 28 Payments of provisions -15 140…of which long-term Currency translation reserve Balance Sheet Unwind of discount 5 Translation differences Closing balance 4 144 -4 20 124 20…of which short-term Additions to provisions -23 Unwind of discount -5 21
- 22. WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 22 …but what about working capital? You know, indirect method and such.
- 23. Working capital definitions WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Trade working capital • Trade working capital is the difference between current assets and current liabilities directly associated with everyday business operations. This definition we would like to use within the application! Working capital • Working capital is the difference between current assets and current liabilities. Examples of current assets and current liabilities not relevant to trade working capital Current portion of financial assets, since this is related to investing activities Short term loan liabilities, since this is related to financing activities Income tax liabilities, since this is not related to everyday business operations Accrued interest, since this is related to financing activities ① ② ③ ④ 23
- 24. Two ways of looking at trade working capital WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Trade working capital by business stakeholder Customers Suppliers Employees Tax authorities Trade working capital by timing of cash Accrued amounts Invoiced amounts Prepaid amounts Cash almost due Cash not due Cash transferred 24
- 25. Trade working capital (excl. inventories) WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Stakeholders Prepaid amounts Invoiced amounts Accrued amounts Customers Prepaid income Trade receivables Accrued income Suppliers Prepaid expenses Trade payables Accrued expenses Employees Employee advances Employee accruals Tax authorities[1],[2] Prepaid taxes Tax liabilities Others Guarantees & deposits [1]Includes VAT, local taxes and social security [2]Excludes income taxes as this is not a working capital measure Assets, where an increase has a dampening effect on operating cash flow Liabilities, where an increase has a boosting effect on operating cash flow Accrued income, including underbilled work in progress in project- or construction work, is an infamous trade working capital account. It is often the account where fraud is detected by the recording of non-existing revenue. It should be closely monitored. Legend 25
- 26. Trade working capital types of presentation WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING Presentation by asset/liability Inventories Trade receivables Accrued income Prepaid expenses Employee advances Prepaid taxes Guarantees & deposits Trade working capital assets Trade payables Prepaid income Accrued expenses Employee accruals Tax liabilities Trade working capital liabilities Trade working capital Presentation by stakeholder Inventories Trade receivables Accrued income Prepaid income Customer capital Trade payables Accrued expenses Prepaid expenses Supplier capital Employee accruals Employee advances Employee capital Tax liabilities Prepaid taxes Tax authority capital Guarantees & deposits Trade working capital DSO ingredients DPO ingredients 26
- 27. Monitoring cash conversion for operating activities WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 27 Ahold Delhaize 2015 2016 2017 2018 Net sales 38,203 49,695 62,890 62,791 Operating income 1,318 1,584 2,225 2,395 Depreciation & amortization 1,035 1,456 1,859 1,816 Gain/loss on sale of non-current assets -18 -22 -47 -7 Share-based payments expenses 47 61 79 60 Adjusted operating income 2,382 3,079 4,116 4,264 Operating cash flow (excl. income taxes) 2,366 3,172 4,180 4,608 Operating Cash Conversion Ratio 99% 103% 102% 108% Excess Cash Margin 0.0% 0.2% 0.1% 0.5% (4,608 / 4,264) x 100% = 108% ((4,608 – 4,264) / 62,791) x 100% = 0.5% Monitoring operating cash flow and working capital development can be achieved by introducing one or both of indicators: • Operating Cash Conversion Ratio indicates the degree at which operating profits are converted into operating cash flows. This ratio should be around 100%. A ratio over 100% indicates a relatively declining working capital; a ratio below 100% indicates a relatively increasing working capital. Both situations are not sustainable in the long term. • Excess Cash Margin indicates the degree at which operating profits and operating cash flow develop in relation to revenue. This ratio should be around 0%. A ratio over 0% indicates a relatively declining working capital; a ratio below 0% indicates a relatively increasing working capital. Both situations are not sustainable in the long term.
- 28. WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 28 That’s all great, now give us your conclusions!
- 29. Conclusions WHY CASH FLOW SHOULD BE THE FOCAL POINT IN YOUR FINANCIAL CONSOLIDATION AND REPORTING 29 Why existing financial reporting is mostly broken… • Too much focus on the income statement; a one-dimensional view on financial performance. • A financial accounting-view of balance sheet features a lack of insight into value dynamics. • Cash flow mostly exists in the obscurity of financial reporting and is not a true performance measure. How do you recognize this in your own organization? • Segmental balance sheets, perhaps with the exception of working capital, are not consistently analyzed within the monthly management reviews. • Cash flow statements are (mostly) prepared in Excel, and only reported for the consolidated group. How to fix it? • Create awareness that management accounting & reporting concepts do not apply to income statement alone! • Define a performance management model that provides a true value-oriented view on your financial statements. • Implement the right technology to enable both financial accounting / consolidation and management accounting / consolidation & analysis from a single source of truth. • Educate your colleagues to increase the understanding of balance sheet and cash flow dynamics.
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