Solution 16.2

Net debt and net funds

Net debt is defined as “the borrowings of the entity less cash and liquid resources”. If cash and liquid resources exceed debt then the term used becomes Net Funds.

Operating profit and cash generated from operations

Cash flows from operating activities are the cash effects of transactions relating to the operating or trading activities of the business(the normal trading activities of the business, not capital activities). Operating cash flows will be concerned with:

• cash collected from customers

• cash paid to trade creditors for purchases

• cash paid to staff /PAYE/PRSI

• cash paid for services (overheads)

Operating profit is the profit before interest and tax achieved by a business from its main trading activities. It is the sales of a business less all the operating expenses including cost of sales, administration, selling, distribution and depreciation expenses. The main reasons for differences between cash flow from operations and operating profit are:

1. Operating profit is the difference between revenues earned and expenses charged whereas cash flow from operations is the difference between revenues received and expenses paid.

2. Operating profit includes non cash items such as depreciation in its calculation.

The direct and indirect method of calculating net cash generated from operating activities

1. The Direct Method.

Under this method we gather the information from a detailed cashbook, collections from customers, and cash paid to suppliers, staff, and overheads.

Calculation of operating cash flow - The Direct method

	€	€
Cash collected from customers Less payments to suppliers payments to staff /paye/prsi payments of other operating expenses Net cash generated from operations Less payments for loan interest Corporation tax Net cash generated from operating activities	88,790 26,150 15,100 7,000 8,000	162,100 130,040 32,060 15,000 17,060

2. The Indirect Method

In this format we are adjusting the operating profit figure (net profit before interest and tax) back to an operating cash figure. This is calculated as follows.

1. Adjusting operating profit for items in the profit and loss account that do not appear in the cash book. These items would include the following:

• Depreciation

• Provision for bad debts

• Profits or losses on the sale of fixed asset

These items are all categorised as ‘non-cash’. In other words they do not give rise to a cash transaction/movement and would not appear in the cash/bank account. If these items have reduced the operating profit (if they were expenses) then to adjust for them we need to add them back to operating profit. If they had the effect of increasing profit then we deduct them from operating profit.

2. Adjust the operating profit for changes in stocks, debtors, prepayments, accruals and creditors. Changes in the above working capital items causes differences between figures in the profit and loss account and figures in the cash/bank account. For example a business generated sales of €10,000 during the year. If debtors at the

Calculation of Operating cash flow - Indirect method

	€	€
Net operating profit (before interest and tax) Adjust for non cash items in profit and loss +Depreciation +Increase in provision for bad debts +Loss on sale of fixed assets Adjust for movements in working capital Increase in stocks Increase in prepayments Decrease in trade debtors Increase in trade creditors Increase in accruals Cash generated from operations Less payments made for Loan Interest Corporation tax Net cash generated from operating activities	10,000 3,000 2,200 (2,000) (500) 12,100 1,210 250 7,000 8,000	5,800 15,200 21,000 11,060 32,060 (15,000) 17,060

The cash flow from operations is €17,060 whether we use the direct or indirect method. Ultimately the indirect method outlines for us some of the main reasons for differences between the profit figure and the net cash generated from operating activities.

Cash flow from investing activities and cash flow from financing

The cash flow from investing activities includes the following cash receipts and payments that arise from the following:

• Sale of tangible, intangible and financial long-term assets.

• Purchases of tangible intangible and financial long-term assets.

• Acquisitions or disposals of subsidiaries associated or joint venture companies.

• Loan interest received and dividends received from investments.

The cash flow from financing includes the cash receipts and payments, which arise from the following;

1. Issue of shares, debentures/bonds or just simply getting a bank loan.

2. Repayments of the capital elements of loans/ debentures.

3. Any related expenses (stamp duty or broker fees on the issue of shares/debentures bonds) or commissions regarding the above.

4. Dividend payments made during the year to shareholders