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Unit- 7: Financial Statement Analysis

Notes
Structure
7.1 Introduction
7.2 Tools And Techniques Of Financial Statement Analysis
7.2.1 Horizontal and Vertical Analysis
7.2.2 Ratio Analysis
7.3 What do we want ratio analysis to tell us?
7.4 The Ratios
7.5 Users of Accounting Information and What they should Know
7.6 Profitability Ratios
7.6.1 Gross Profit Margin
7.6.2 Net Profit Margin
7.6.3 Return on Equity Ratio
7.6.4 Return on Total Assets (Capital Employed) Ratio
7.7 Liquidity Ratios
7.7.1 Current Ratio
7.7.2 Acid Test Ratio
7.7.3 No such thing as an Ideal Ratio
7.8 Activity/ Assets Usage Ratios
7.8.1 Total Asset Turnover
7.8.2 Stock Turnover Ratio
7.8.3 Debtors' Turnover Ratio
7.8.4 Creditors' Turnover Ratio
7.8.5 Advanced Asset Usage Ratios
7.9 Solvency Ratios
7.9.1 Gearing Ratio I
7.9.2 Gearing Ratio II
7.9.3 Interest Coverage Ratio
7.10 Other Ratios
7.10.1 Earning Per Share(EPS)
7.10.2 Dividend Per Share(DPS)
7.10.3 Dividend Yield
7.10.4 Dividend Cover
7.10.5 P/E Ratio
7.11 Ratio Analysis and Bankruptcy Prediction
7.12 Limitations of Ratio Analysis
7.13 Advantages of Ratio Analysis
7.14 Summary

Objectives
Giving students brief idea about interpreting financial statements.
Compute and interpret financial ratios related to liquidity, profitability, activity
and solvency etc.

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7.1 Introduction
Notes Financial statement analysis is defined as the process of identifying financial
strengths and weaknesses of the firm by properly establishing relationship between the
items of the balance sheet and the profit and loss account. There are various methods
or techniques that are used in analyzing financial statements, such as comparative
statements, schedule of changes in working capital, common size percentages, funds
analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also
for decision making purposes. They play a dominant role in setting the framework of
managerial decisions. But the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these statements alone.
However, the information provided in the financial statements is of immense use in
making decisions through analysis and interpretation of financial statements.

7.2 Tools And Techniques Of Financial Statement Analysis:


Following are the most important tools and techniques of financial statement
analysis:

7.2.1. Horizontal and Vertical Analysis:


1. Horizontal Analysis or Trend Analysis:
Comparison of two or more year 's financial data is known as horizontal analysis, or
trend analysis. Horizontal analysis is facilitated by showing changes between years in
both dollar and percentage form.

Trend Percentage:

Horizontal analysis of financial statements can also be carried out by computing


trend percentages. Trend percentage states several years' financial data in terms of a
base year. The base year equals 100%, with all other years stated in some percentage
of this base.

2. Vertical Analysis:
Vertical analysis is the procedure of preparing and presenting common size
statements. Common size statement is one that shows the items appearing on it in
percentage form as well as in dollar form. Each item is stated as a percentage of some
total of which that item is a part. Key financial changes and trends can be highlighted by
the use of common size statements.

7.2.2 Ratio Analysis


Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios
will aid in understanding the company's strategy and in understanding its strengths and
weaknesses relative to other companies and over time. They can sometimes be useful
in identifying earnings management and in understanding the effect of accounting
choices on the firm's reported profitability and growth. Finally, the ratios help in
obtaining a better understanding of a firm's current profitability, growth, Liquidity and risk
which can improve forecasts of future profitability and growth and estimates of the cost
of capital. Ratio analysis can also help us to check whether a business is doing better
this year than it was last year; and it can tell us if our business is doing better or worse
than other businesses doing and selling the same things.

7.3 What Do We Want Ratio Analysis to Tell Us?


We can use ratio analysis to try to tell us whether the business
is profitable
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has enough money to pay its bills
could be paying its employees higher wages Notes
is paying its share of tax
is using its assets efficiently
has a gearing problem
is a candidate for being bought by another company or investor and more, once we
have decided what we want to know then we can decide which ratios we need to
use to answer the question or solve the problem facing us.

7.4 The Ratios


We can simply make a list of the ratios we can use here but it's much better to put
them into different categories. We can put our ratios into categories that are designed
exactly to help us to answer these questions.

Profitability: has the business made a good profit compared to its turnover or
compared to its assets and capital employed, has the business made a good
profit?

Liquidity: does the business have enough money to pay its bills?

Asset Usage or Activity: how has the business used its fixed and current
assets?

Solvency: does the company have a lot of debt or is it financed mainly by


shares?

others

7.5 Users of Accounting Information and What They Should Know


Now we know the kinds of questions we need to ask and we know the ratios
available to us, we need to know who might ask all of these questions! This is an
important issue because the person asking the question will normally need to know
something particular.

The users of accounts that we have listed will want to know the sorts of things we
can see in the table below: this is not necessarily everything they will ever need to
know, but it is a starting point for us to think about the different needs and questions of
different users.

Investors to help them determine whether they should buy shares in the
business, hold on to the shares they already own or sell the shares
they already own. They also want to assess the ability of the
business to pay dividends.
Lenders to determine whether their loans and interest will be paid when due
Managers might need segmental and total information to see how they fit into
the overall picture
Employees information about the stability and profitability of their employers
to assess the ability of the business to provide remuneration,
retirement benefits and employment opportunities
Suppliers and businesses supplying goods and materials to other businesses

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other trade will read their accounts to see that they don't have problems: after
Notes creditors all, any supplier wants to know if his customers are going to pay
their bills!
Customers the continuance of a business, especially when they have a long
term involvement with, or are dependent on, the business
Governments the allocation of resources and, therefore, the activities of
and their business. To regulate the activities of business, determine taxation
agencies policies and as the basis for national income and similar statistics
Local Financial statements may assist the public by providing information
community about the trends and recent developments in the prosperity of the
business and the range of its activities as they affect their area
Financial they need to know, for example, the accounting concepts
analysts emplayed for inventories, depreciation, bad debts and so on
Environmental many organisations now publish reports specifically aimed at
groups informing us about how they are working to keep their environment
clean.
Researchers researchers' demands cover a very wide range of lines of enquiry
ranging from detailed statistical analysis of the income statement
and balance sheet data extending over many years to the
qualitative analysis of the wording of the statements

7.6 Profitability Ratios


7.6.1 Gross Profit Margin
First some basic profitability equations:

Gross Profit
Gross Profit Margin = * 1oo
Turnover
Remember:
Turnover = Sales
Gross Profit= Net Sales -Cost of Sales
Cost of Sales= Opening Stock+ Net Purchases+ Other Direct Expenses- Closing
Stock

The gross profit margin ratio tells us the profit a business makes on its cost of sales,
or cost of goods sold. It is a very simple idea and it tells us how much gross profit pe
Rs1 of turnover our business is earning. Gross profit is the profit we earn before we
take off any administration costs, selling costs and so on. So we should have a much
higher gross profit margin than net profit margin.

7.6.2 Net Profit Margin


First some basic profitability equations:

Net Profit = Net = Profit before Interest and


Margin Profit x 100 Taxation x 100
Turnover Turnover

Net Profit= Gross Profit- (Direct Expenses & Losses) + Other Income
Why do we have two versions of this ratio - one for net profit and the other for
Earning before interest and taxation ( EBIT) ? Well, in some cases, you will find they
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use the term net profit and in other cases, especially published accounts, they use
profit or earning before interest and taxation. They both mean the same. The net profit
margin ratio tells us the amount of net profit per Rs1 of turnover a business has earned.
Notes
That is, after taking account of the cost of sales, the administration costs, the selling
and distributions costs and all other costs, the net profit is the profit that is left, out of
which they will pay interest, tax, dividends and so on.

7.6.3 Return on Equity Ratio


The Return on Equity ratio (ROE) tells us how much profit we earn from the
investments the shareholders have made in their company. Think of it this way: if we
had a savings account with a bank and we'd been paid, say, Rs25 interest at the end of
a year; and we had saved Rs500, we could work out the rate of interest we had earned:

Profit for the Year(EAIT) 25 1 100


ROCE=--------- * 100""- ... 100""- ... 100""-""5%
Equity Shareholders' Funds 500 20 20

Did you notice that we use the Equity Shareholders' Funds instead of Capital
Employed? In fact, they are different names for the same thingl We could call the ratio
the Return on Shareholders' Funds (ROSF) just as easily if we wanted; but generations
of accountants and students only know it as ROE.

In accounting, there can be different definitions of what certain terms mean. The use
of the term 'capital employed' can mean different things. It can, for example, include
bank loans and overdrafts since these are funds employed within the firm. Because
there are different interpretations of what ROE can mean, it is suggested that you use
a method which you feel comfortable with but be aware that others may interpret your
definition in a different way Below is a guide to some of the interpretations that can be
important on this issue

Definition of Capital Employed/ Equity/Shareholders' Fund


Capitalemployed = total assets
Capital employed = fixed assets + current assets - current liabilities
Shareholders' Fund = Equity share capital + reserves ..1. preference share capital minorit'y iniere& ..1.
provisions + totalborrowings intangible assets

TRADING capital employed = share capital + reserves + all borrowings inclup!ng lease obliga4ions,
overdraft, minority interest,provisions, associates and investments
OVERALL capital employed = share capi4al .1 reserves .1 all borrowings including lease obligaiions,
overdraft, minority interest,provisions
Capitalemployed= totalfixed assets+ current assets- (current liabilitieslong term liabilities+
provisions) Equti y= Equity Share Capital+ Reserves- External Liabilities ( short term+ Long term)

There does seem to be a relationship between the net profit margin and the ROE:
the higher the net profit margin, the higher the ROE.

7.6.4 Return on TotalAssets(Capital Employed) Ratio


The Return on Total Assets Ratio (ROTA) has a similar meaning to ROCE and the
method of calculating it is the same, too.

PBITIEBIT
Return on Total Assets (ROTA) = ToialAsseis
"100

Notice that we use a different profit figure for this ratio- we use profit before interest
and tax this time. This is because we try to match the profit we use with the total assets
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that operating managers use. Accountants would say that interest payments and tax
Notes payments are separate from the ways in which the total assets are used. That is, if we
are trying to measure the efficiency of our total assets, then take the profit that they
have generated before interest and taxation. Interest and tax problems are the senior
managers' concern, since they decide how much to borrow and therefore how much
interest they ought to pay; senior managers decide on capital investment, too, and
they have a big say in how much tax they pay for a year. Therefore, since operating
managers can't control the amounts of interest and taxation paid, they should not be
assessed against it.

Difficulties with using either ROA and ROE as a performance measure can be seen
in merger transactions. Suppose we have an organization that has been earning a net
income of Rs500 on assets with a book value of Rs1000, for a hefty ROA of 50 percent.
That organization is now acquired by a second firm, which then moves the new assets
onto its books at the acquisition price, assuming the acquisition is treated using the
purchase method of accounting. Of course, the acquisition price will be considerably
above the Rs1,000 book value of assets, for the potential acquirer will have to pay
handsomely for the privilege of earning Rs500 on a regular basis. Suppose the acquirer
pays Rs2,000 for the assets. After the acquisition, it will appear that the returns of the
acquired firm have fallen. The firm continues to earn Rs500, but the asset base is now
Rs2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a
result of other factors, such as increased depreciation of the newly acquired assets.
Yet in fact nothing has happened to the earnings of the firm. All that has changed is its
accounting, not its performance.

Another fundamental problem with ROA and ROE measures comes from the
tendency of analysts to focus on performance in single years, years that may be
idiosyncratic. At a minimum, one should examine these ratios averaging over a number
of years to isolate idiosyncratic returns and try to find patterns in the data.

7.7 Liquidity Ratios


Working capital management is concerned with making sure we have exactly the
right amount of money and lines of credit available to the business at all times. In part
1 of our look at working capital management we will look at the liquidity ratios. Cash is
the life-blood of any business, no matter how large or small. If a business has no cash
and no way of getting any cash, it will have to close down. It's that simple! Following on
from this we can see that if a business has no idea of its liquidity and working capital
position, it could be in serious trouble

Current Assets: Current Liabilities

(Current Assets-Stocks): Current Liabilities

The two liquidity ratios, the current ratio and the acid test ratio, are the most
important ratios in almost the whole of ratio analysis are also the simplest to use and to
learn

7.7.1 The Current Ratio


The current ratio is also known as the working capital ratio and is normally
presented as a real ratio. In order to survive, firms must be able to meet their short-term
obligations-pay their creditors and repay their short-term debts. Thus, the liquidity of
the firm is one measure of a firm's financial health. The Current ratio looks like this:

Current Assets: Current Liabilities = x: y eg 1.42: 1

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current assets = 315,528 = .4
1 2
current liabilities 222,348 Notes
so we automatically know that our ratio is 1.42: 1
Current Assets includes Cash + Bank balances + Marketable Securities + Stock +
Accrued/Outstanding Incomes + Prepaid Expenses while Current Liabilities include
Creditors+ Short term debt + outstanding expenses and unearned income etc

7.7.2 The Acid Test Ratio


The acid test ratio is also known as the liquid or the quick ratio. The idea behind
this ratio is that stocks are sometimes a problem because they can be difficult to sell
or use. That is, even though a supermarket has thousands of people walking through
its doors every day, there are still items on its shelves that don't sell as quickly as the
supermarket would like. Similarly, there are some items that will sell very well.

Nevertheless, there are some businesses whose stocks will sell or be used
slowly and if those businesses needed to sell some of their stocks to try to cover an
emergency, they would be disappointed. Engineering companies can have their
materials in stock for as much as 9 months to a year; a greengrocer should have his
stocks for no longer than 4 or 5 days - a good greengrocer anyway.

Acid Test Ratio = (Current Assets- Stocks- Prepaid Expenses) : Current Liabilities

7.7.3 No such thing as an Ideal Ratio


It's time to say that whatever you've read about the ideal current ratio being 2:1
and the ideal acid test ratio being 1: 1 forget it! This is a golden rule ...there's no such
thing as an ideal current ratio or acid test ratio ... or an ideal any other ratio for that
matter.

Which ratio is a better measure of a firm's short-term position? In some ways, the
quick ratio is a more conservative standard. If the quick ratio is greater than one,
there would seem to be no danger that the firm would not be able to meet its current
obligations. If the quick ratio is less than one, but the current ratio is considerably above
one, the status of the firm is more complex. In this case, the valuation of inventories
and the inventory turnover are obviously critical. A number of problems with inventory
valuation can contaminate the current ratio. An obvious accounting problem occurs
because organizations value inventories using either of two methods, last in, first out
(LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their
old costs. If the organization has a substantial quantity of inventory, some of it may be
carried at relatively low cost, assuming some inflation in overall prices. On the other
hand, if there has been technical progress in a market and prices have been falling, the
LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory
valuation, inventories are valued at close to their current replacement cost. Clearly, if
we have firms that differ in their accounting methods, and hold substantial inventories,
comparisons of current ratios will not be very helpful in measuring their relative
strength, unless accounting differences are adjusted for in the computations.

A second problem with including inventories in the current ratio derives from the
difference between the inventory's accounting value, however calculated, and its
economic value. A simple example is a firm subject to business-cycle fluctuations.
For a firm of this sort, inventories will typically build during a downturn. The posted
market price for the inventoried product will often not fall very much during this period;
nevertheless, the firm finds it cannot sell very much of its inventoried product at the
so-called market price. The growing inventory is carried at the posted price, but there
really is no way that the firm could liquidate that inventory in order to meet current
obligations. Thus, including inventories in current assets will tend to understate the

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precarious financial position of firms suffering inventory buildup during downturns.


Notes Might we then conclude that the quick ratio is always to be preferred? Probably not. If
we ignore inventories, firms with readily marketable inventories, appropriately valued,
will be undeservedly penalized. Clearly, some judicious further investigation of the
marketability of the inventories would be helpful.

Low values for the current or quick ratios suggest that a firm may have difficulty
meeting current obligations. Low values, however, are not always fatal If an
organization has good long-term prospects, it may be able to enter the capital market
and borrow against those prospects to meet current obligations. The nature of the
business itself might also allow it to operate with a current ratio less than one. For
example, in an operation like McDonald's, inventory turns over much more rapidly
than the accounts payable become due. This timing difference can also allow a firm to
operate with a low current ratio. Finally, to the extent that the current and quick ratios
are helpful indexes of a firm's financial health, they act strictly as signals of trouble
at extreme rates. Some liquidity is useful for an organization, but a very high current
ratio might suggest that the firm is sitting around with a lot of cash because it lacks
the managerial acumen to put those resources to work. Very low liquidity, on the other
hand, is also problematic.

7.8 Activity/ Assets Usage Ratios


The assessment of asset usage is important as it helps us to understand the overall
level of efficiency at which a business is performing.

7.8.1 Total Asset Turnover


The asset turnover ratio simply compares the turnover with the assets that the
business has used to generate that turnover. In its simplest terms, we are just saying
that for every Rs1 of assets, the turnover is Rs x. The formula for total asset turnover is:

Total Asset Turnover = Turnover


To al Asseis

As usual, we'll take a look at the X Ltd's total asset turnover ratios first, for practice,
and then we'll try to work out what we've found. Here are the figures we need:

X Ltd 31 March 2001 25 March 2000


Consolidated Profit and Loss Account
Rs'OOO Rs'OOO
Turnover 1'110,678 697,720
Toial Fixed Asseis 396,175 100,279
Total Current Assets 315,528 171,160

Total Asset Turnover Ratio for the X Ltd


31 March 2001 1,110,678 = 1.56 times
396,175 + 315,528
25 March 2000 =2.57 iimes

697,720
100,279 +
171,160

We see the result of 1.56 times for 2001 ... this means that turnover is 1.56 times
bigger than total assets. Another way of saying that is that the X Ltd was able to
generate sales of Rs1.56 for every Rs1 of assets it owned and used for the year ended
31 March 2001. For the year ended 25 March 2000, it was even higher at 2.57 times.
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The Total Asset turnover ratio has worsened a lot over the two years. If 2.57 times
was good, then 1.56 times is definitely worse. Can we see why this ratio fell so sharply?

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Actually, it's not as bad as it seems. Turnover increased by 59% but fixed assets
increased by 295% and current assets by 84%. Here we have one of those cases Notes
where a ratio is falling in value but the underlying changes might not be so bad. That
is, the X Ltd has made major investments in its assets that have yet to generate their
previous level of sales: 1.56 times versus 2.57 times. However, we should say that we
expect that next year this ratio should improve again.

7.8.2 Stock Turnover Ratio


In principle, the lower the investment in stocks the better. Apart from buffer stocks
that businesses sometimes need in case of shortages of supply and strategic stocks in
case of war, sudden changes in demand and so on, modern stock control theory tells us
to minimize our investment in stocks.

Let's see how the X Ltd behaves in this respect.

The formula for this ratio is:

Stock Turnover = Average Stocks


Cost of Sales/365

X Ltd 31 March 2001 25 March 2000


Consolidated Profit and Loss Account
Rs'OOO Rs'OOO
Cosi o sales 830,126 505,738
Siock 52,437 51,842

Stock Turnover Ratio for the X Ltd


31 March 2001 52,437 23.06 days
830,126 I 365
25 March 2000 51,842 37.42 days
505,738/365

Cost of Sales
Alternate Formula=-----
Average Stock

If you use alternative formulae and are happy with them, that's fine. If you
think you need help because of that, see your teacher/lecturer for guidance.

Firstly, the result of this calculation is that the answer is instantly in terms of the
number of days, on average, that the stocks are held in the business.

Secondly, we use the cost of sales figure because stocks are bought and shown in
the profit and loss account and the balance sheet at cost; so we need to compare
like with like.

Thirdly, we only have two years' worth of stock information, so we can't use the
average stock for both years as we should do according to the formula. Never mind,
even though the answer won't be 100% spot on, it will give us a very good estimate
of how stock control is going.

How can we interpret this ratio? With a result of 23.06 days, we can imagine that
we bought our Rs52,437,000 worth stocks of raw materials or whatever they were on
1st January 2002. We then know that we ran out of those raw materials on 1 + 23.06
days =just into 25th January. Similarly with the result of 37.42 days, if we bought our
Rs51,738,000 worth of raw materials on 1st January, we would run out and have to buy
some more on 7th February.

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This ratio has fallen from 37 days to 23 days over the tvvo years and that is probably
Notes a good thing. If there's less stock to worry about, lower investment in stocks meaning
that the money they used to have tied up in the stock room is now free to spend
somewhere else.In fact, stocks have remained at around Rs52 Lakh as we mentioned
before, but the cost of sales has increased by 64% over the tvvo years. Put these tvvo
facts together and that explains the improvement in this ratio.Well done the X Ltd !

7.8.3 Debtors' Turnover Ratio


In the same way that stock control is a vital aspect of working capital management,
so too is debtors' control. Many businesses need to sell their goods on credit, otherwise
they might find it difficult to survive if their competitors provide such credit facilities; this
could mean losing customers to the opposition.

Nevertheless, since we do provide credit, we must do so as optimally as possible.


We've used the word 'optimal' before and let me confirm that it doesn't necessarily
mean the best possible, but the best possible under the circumstances.

Why is credit control so important? For the X Ltd , the total amount owing by debtors
was Rs1490 Lakh at the end of 31 March 2001, which as a percentage of total assets,
is 14.09%. That's a lot of money in absolute terms and relatively, and it's 80% more
than it was the year before. So, they've given an additional Rs690 Lakh worth of credit
to their customers over the year. What we need to know, though, is whether they are
controlling these debtors. We can do that by looking at their debtors' turnover ratios for
the tvvo years, firstly.
X ltd. 31 Mar 2001 25 Mar 2000
Rs 000 Rs 000
Turnover 1 110 678 697 720
Debtors due within one year 149 200 82 826

The formula for debtors' turnover is:

Average Debtors
Debtors' Turnover Ratio= Net Credit Sales/365

We have to assume, by the way, that all sales are credit sales unless we know which
sales are for cash.

The calculations:
Debtors Turno ver Ratio for the X Ltd
31 March 2002 149,200 49.03 ays
1 110 678 365
25 March 2001 82,826 43.33 ays
697,720 + 365

Well, what do you think of that?


Firstly, the ratio seems to have worsened by going from 43 to 49 days over the
tvvo years; and it means that, on average, the X Ltd's debtors are taking one and a
half months to pay their accounts. Does this sound as if it's a good policy? How do we
know? Certainly we require additional details.

7.8.4 Creditors' Turnover Ratio


Creditors are the businesses or people who provide goods and services in credit
terms. That is, they allow us time to pay rather than paying in cash. There are good

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reasons why we allow people to pay on credit even though literally it doesn't make
sense! If we allow people time to pay their bills, they are more likely to buy from your Notes
business than from another business that doesn't give credit. The length of credit period
allowed is also a factor that can help a potential customer decide whether to buy from
your business or not: the longer the better, of course.

In spite of what we have just said, creditors will need to optimise their credit control
policies in exactly the same way that we did when we were assessing our debtors'
turnover ratio -after all, if you are my debtor I am your creditor!

We give credit but we need to control how much we give, how often and for how
long. Let's do some calculations for the X Ltd.

The formula for this ratio is:

Creditors' T rnover = Average Creditors


(Net Credit Purchases /365)

X ltd 31 March 2001 25 March 2000


Rs'OOO Rs'OOO
Net Credit Purchases 830 126 505 738
Creditors: Amounts fa ing due within one year 222,348 173,820

Creditors Turnover Ratio for the X Ltd


31 March 2001 222,348 97.76 days
830,126 7 365
25 March 2000 173,820 125.45 days
505 738 7 365

We interpret this ratio in exactly the same way as the debtors' turnover ratio. That is,
in 2001 if we had bought some supplies for Rs222,348 on 1st January, we would have
paid for them 97.76 days later on 6th April. You can work out the payment date for 2000
if we imagine buying some supplies for Rs173,820 on 1st January of that year.

7.8.5 Advanced Asset Usage Ratios


The advanced equations for other ratios are:

Turnover
Fixed Asset Turnover =
Fixed AsselS

Turnover
Current Asset Turnover =
Current Assets

Capital Employed Turnover = Turnover


Equity Shareholders' Funds

Sales
Working CapitalTurnover =
Working Capital

7.9 Solvency Ratios


7.9.1 Gearing Ratio
Gearing = Long
::
Term Liabilities _
Equity Shareholders' Funds
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Gearing is concerned with the relationship between the long terms liabilities that a
Notes business has and its capital employed. The idea is that this relationship ought to be
in balance, with the shareholders' funds being significantly larger than the long term
liabilities.

Shareholders ought to have the upper hand because if they don't that could cause
them problems as follows:

Shares earn dividends but in poor years dividends may be zero: that is, businesses
don't always need to pay any!

Long term liabilities are usually in the form of loans and they have to be paid
interest; even in bad years the interest has to be paid

Equity shareholders have the voting rights at general meetings and can made
significant decisions

Long term liability holders don't have any voting rights at general meetings but
they have the power to override the wishes of the shareholders if there are severe
problems over their interest or capital repayments

So, shareholders like to see the gearing ratio, the relationship between long term
liabilities and capital employed, being in their favour! Let's look at the X Ltd's gearing
ratio.

XLtd 31 March 25 March


2001 2000
Rs'OOO Rs'OOO

Amo1mts f,qllino riu,qftr morlh-'ln


14,107 21,033
one year
Equity shareholders' funds 436,758 44,190

Gearing Ratio for the X Ltd


31 March 2001 14,107: 436,758 0_032: 1
25 March 2000 21,033: 44,190 0_476: 1

A shareholder of the X Ltd will be happy with these results. Even in 2000 when the
ratio was relatively high at 0.476 or 47.6% they probably were not too worried because
their other ratios were fine too.

In 2001 the gearing ratio fell to almost zero indicating that the business much prefers
equity funding to debt funding. This minimises the interest payment problems and the
control problems of having a dangerously high level of long-term debt on the balance
sheet.

7.9.2 Gearing Ratio II


There is an alternative gearing ratio, we can call it the Gearing Ratio II.

The formula for this ratio is:

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Accounting for Managers 93
Long Term Liabilities
Gearing 2 = ---------
Long Term Liabilities+ Equity Shareholders' Funds Notes
The calcl!laiions:

Gearina II Ratio for the X Ltd


31 Marh 2001, 14,107:436,758...114,1071 0.031:1
25 March 2000 21,033:44,190 ..121,033 0.322:1

We should expect, smaller than Gearing 1 and they are still, therefore, insignificant
by the end of the two years.

7.9.3 Interest Coverage Ratio.


This ratio indicates the appropriateness of the profit to meet the fixed interest and
other liabilities. Certainly higher the better.
Formula:
. EBIT
Interest Coverage Rat1o = ----
Interest

The interest cover ratio tells us the safety margin that the business has in terms of
being able to meet its interest obligations. That is, a high interest cover ratio means that
the business is easily able to meet its interest obligations from profits. Similarly, a low
value for the interest cover ratio means that the business is potentially in danger of not
being able to meet its interest obligations.
X Ltd 31March 2001 25 March2000
Consolidated Profit and Loss Account

Rs'OOO Rs'OOO
6,012 25,300
Profit before interest and taxation
NAt iniArAc:l rAI"'Aiv::.hiA ln::.v::.hiA\
2,385 -196
.. J ,

Here's a reminder of the formula:

Interest Cover = Net profit before interest(EBIT)


Interest
Here's the first interest cover value calculated for you, now you work out the value
for the missing one.

l a1March 2001l 2s March 2000

Prnfit hPfmP intPrPt :: nrl t:: Y::tinn 1


45 012 18.87 1

Net interest receivable (payable) 1


2,385 1

In 2001, the X Ltd had no problem with its interest obligations since it was a net
receiver of interest: the interest it earned was greater than the interest it might have had
to pay. For the previous year, though, its interest obligations were negative, meaning
that it needed to pay more interest than it had earned. However, at 129.08, its interest
cover ratio is more than satisfactory as it means that the necessary profit is 129.08
times larger than the interest payments that the business had incurred

7.10 Other Ratios


In other ratios, we can include investors' ratios. Most of the investor ratios that we
might need to use are relatively simple both to use and to understand. We can contrast

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94 Accounting for Managers

these ratios with others, such as stock and debtors' turnover; and the relationships
Notes between the ROE and the profit margin and assets turnover ratios, at the top of the
pyramid of ratios.

7.10.1 Earnings per share: EPS


This is, perhaps, the fundamental investor ratio: in this case, we work out the
average amount of profits earned per ordinary share issued. The formula is:
Earnings per share = Profit available to equity shareholders
Average number of issued equity shares

Here are the extracts from the accounts that we need and they are followed by the
results for one of the two years, you should calculate the EPS for the other year.

The X Ltd 1 31 March 2001 1 25 March 2000


Consolidated Profit and Loss Account

Profit for the financial period (Rs) 38,159,000 16,327,000


Weiahted averaae number of issued shares 833,000,000 600,000,000

31 March 2001 25 March 2000


EPS 38,159,000 I Rs0.04648 16,327,000
- 1 = 0.02
833,000,000 6,00,000,000

The good news for investors here is that the average earnings per issued ordinary
share has almost doubled over the two years. Notice that the number of shares issued
has increased from 6000 Lakh to 8330 Lakh, so this really is a good result as profits
available for shareholders must have increased significantly too from Rs16,327,000 to
Rs38,159,000.

7.10.2 Dividends per Share: DPS


The DPS ratio is very similar to the EPS: EPS shows what shareholders earned
by way of profit for a period whereas DPS shows how much the shareholders were
actually paid by way of dividends. The DPS formula is:
Dividends paid to equity shareholders
Dividends per share =
Average number of issued equity shares

7.10.3 Dividend Yield


The dividend yield ratio allows investors to compare the latest dividend they received
with the current market value of the share as an indictor of the return they are earning
on their shares. Note, though, that the current market share price may bear little
resemblance to the price that an investor paid for their shares. Take a look at the history
of a business's share price over the last year or two and you will see that today's share
price might be a lot higher or a lot lower than it was a year ago, two years ago and so on.

We clearly need the latest share price for this ratio and we can get that from
newspapers such as the Financial Times, The Times, The Guardian and the Daily
Telegraph. We can also find the share prices on the Internet.

The formula for the dividend yield is:


Latest annual dividends
Dividend yield =
Current market share price

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Accounting for Managers 95
It is common for newspapers and others to calculate the dividend yield automatically
as part of their offerings. Take a look at the extract from The Times and you'll find the Notes
dividend yield figure in the second right hand column, before the P/E ratio.

7.10.4 Dividend Cover


The dividend cover ratio tells us how easily a business can pay its dividend
from profits. A high dividend cover means that the company can easily afford to pay
the dividend and a low value means that the business might have difficulty paying a
dividend. Here's the formula followed by an example.
Net profit available to equity shareholders
Dividend cover
Dividends paid to equity shareholders

7.10.5 Price Earnings Ratio: P/E ratio


The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the
confidence that investors have in the future prosperity of the business. A P/E ratio of
1 shows very little confidence in that business whereas a P/E ratio of 20 expresses a
great deal of optimism about the future of a business.

Here's the formula, then we'll work through an example


Current market share price
Price/earnings or p/e ratio=
Earnings per share

Here are the P/E ratios of five businesses in the Telecommunications sector:

Telecommunication Companies PIE ratio

l=lh!>r!>ti Tolor'nmmn I trl


48.4
Idea lid 12.0
19.7
TtTPIP<:::Prvi rP<::: I trl

Coli.,n,-o rnmmn I trl


78.4
Vodalone 17.9
Average 35.28

Source: Imaginary Figures

See how big some of these P/E

X ltd PIE ratio

Current market share price 76.0


16.52
EPS 4.6

Note:

Figures are imiginary.


we have worked in pence here; but we could just as easily have worked in
Pounds and the answer would have been the same, at a P/E ratio of 16.5
The X Ltd
l a1 arch 2001
EPSI 38,159,000 R
s0.046
833,000,000

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96 Accounting for Managers

What does a PIE ratio of 16.52 mean? In raw terms it means that investors are
Notes currently paying the equivalent of 16.52 years' worth of earnings to own a share in the
earphone Warehouse. That is, they hare currently paying 76 pence per share and since
the EPS is 4.6 pence per share, this means that they will recover their investment in a
share after 16.52 years - equivalent to the break even and payback period if you like.

16.52 is a high value for a PIE ratio; but not the highest and essentially the higher
the ratio the better. However, we would say that PIE ratios of 78.4 and 48.4 are
excessive and might reflect an unreal situation. It's possible in extreme circumstances
that the share price is, in fact, independent of the current market share price so that a
high PIE ratio is actually based on more up to date news than last years EPS value.
BT has a PIE ratio of 48.4 yet it is not too long ago that it was heading for potential
liquidation as its victory in securing its third generation licences had led to its taking on
a massive debt burden that it could not, in reality, sustain. However, it seems now that
investors like the current performance of BT and are voting for it by buying its shares at
highly inflated values relative to its EPS.

7.11 Ratio Analysis and Bankruptcy Prediction: Z Score Ratio


Although an individual ratio may indicate a particular strength or weakness in a
company, no individual ratio can adequately evaluate the overall strength or weakness
in a company. Developed by Edward I. Altman in 1968, the Altman Z-Score has
become one of the most accepted and tested predictors of bankruptcy potential for a
firm. Although it was originally developed from a sample of manufacturing firms, it is
also applied to nonmanufacturing firms. Essentially, it considers strength or weakness
in five key ratios as an indication of a firm's bankruptcy potential. The five ratios are:
X1 = (Current Assets- Current Liabilities) I Total Assets;
X2 = Retained Earnings I Total Assets;
X3 = (EBT + Interest) I Total Assets;
X4 = Equity Market Value I Total Liability;
X5 = Net Sales I Total Assets.

If a company's equity is not publicly traded, a firm's book value of equity may be
substituted for equity market value in variable X4. However, with this substitution
in variable X4, the Altman Z-Score has proven to be a less reliable predictor of
bankruptcy.Aitman identified these variables and combined them to provide an
indication of the firm's bankruptcy potential. The Z-Score is calculated as:

Z = 1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

Z-Scores above 3 are generally considered safe in terms of bankruptcy while scores
below 1.8 are considered to have a high probability of potential bankruptcy. Scores
between 1.8 and 3 are considered to fall in the grey area which should cause both
management and potential lenders to be highly concerned and take corrective actions.
One might consider use of the Altman Z-Score in determining the credit worthiness of
the firm.

7.12 Limitations of Financial Statement Analysis:


Although financial statement analysis is highly useful tool, it has two limitations.
These two limitations involve the comparability of financial data between companies
and the need to look beyond ratios.

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Accounting for Managers 97
7.13Advantages Of Financial Statement Analysis:
There are various advantages of financial statements analysis. The major benefit is Notes
that the investors get enough idea to decide about the investments of their funds in
the specific company. Secondly, regulatory authorities like International Accounting
Standards Board can ensure whether the company is following accounting standards or
not. Thirdly, financial statements analysis can help the government agencies to analyze
the taxation due to the company. Moreover, company can analyze its own performance
over the period of time through financial statements analysis.

7.14Summary
It is difficult to infer organizational performance from one or two simple numbers.
Nevertheless, in practice a number of different ratios are often calculated in strategic
planning endeavors and, taken as a whole and with some caution, these ratios
do provide some information about the relative performance of an organization. In
particular, a careful analysis of a combination of these ratios may help you to distinguish
between firms that will eventually fail and those that will continue to survive. Evidence
suggests that, as early as five years before a firm fails, one may be able to detect
trouble from the value of these financial ratios. In this note, the basic financial ratios
are reviewed, and some of the caveats associated with using them are highlighted. The
ratios tend to be most meaningful when they are used to compare organizations within
the same broad industry, or when they are used to make inferences about changes in
a particular organization's structure over time. In this note, we have briefly reviewed
a variety of ratios commonly used in strategic planning. All of these ratios are subject
to manipulation through opportunistic accounting practices. Nevertheless, taken as a
group and used judiciously, they may help to identify firms or business units in particular
trouble. Finding profitable new ventures requires rather more work.

Questions
1. The condensed financial statements of Westward Corporation for 2006 are
presented below.

Check Your Progress


1) Calculating the change (amount and percentage) from one year to the next is
referred to as analysis.

2) size financial statements result from vertical analysis.

3) A higher debt to ratio indicates more risk than a lower ratio.

4) Another term for carrying value is value.

5) The denominator of the accounts receivable turnover ratio is the _


accounts receivable.

6) One way to determine the number of days' sales in the average inventory is to
divide 360 by the inventory ratio.

7) Horizontal analysis is also referred to as analysis.

8) Working capital, the current ratio, and the quick ratio are indicators of a company's

9) For this liquidity ratio, Inventory is excluded from the current assets
Westward Corporation Westward Corporation
Balance Sheet Income Statement

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98 Accounting for Managers

December 31, 2006 For the Year Ended December 31, 2006
Notes
Assets Revenues Rs 2,000,000
Current assets Expenses
Cash and temporary Cost of goods sold 1,080,000
investments Rs 30,000 Selling and administrative
Accounts receivable 70,000 expenses 495,000
Inventories 120,000 Interest expense 30 000
Total current assets 220,000 Total expenses 1,605,000
Property, plant, and Income before income taxes 395,000
equipment (net) 780,000 Income tax expense 140 000
Total assets Rs 1,000,000 Net income Rs 255,000

Liabilities and Stockholders' Equity


Current liabilities Rs 80,000
Long-term liabilities 300,000
Common stockholders' equity 620,000
Total liabilities and
stockholders' equity Rs1,000,000

Additional data as of December 31, 2006: Inventory = $100,000; Total assets =


$900,000; Common stockholders' equity =Rs 540,000.

Instructions
Compute the following listed ratios for 2006 showing supporting calculations.

(a) Current ratio=------------------------

(b) Debt to total assets = --------------------

(c) Inventory turnover= ---------------------

(d) Profit margin ratio=----------------------

(e) Return on common stockholders' equity=--------------

(f) Return on assets= ---------------------

Further Readings
1. Accounting Principles . Robert N Anthony.
2. Accounting For Managers. Maheshwari and Maheshwari.
3. Introduction to Accountancy.T S Grewal. S Chand & CO.
4. Advanced Accounting, Sehgal Ashok, Sehgal Deepak .Taxman Allied Services (P)
Ltd., New Delhi
5. Advanced Accountancy, Jain S.P., Narang K. L..Kalyani Publishers, Ludhiana.
6. Advanced Accounts, Shukla M.C., Grewal T.S.: S. Chand & Company Ltd., New
Delhi.
7. Advanced Accountancy, Gupta R.L., M. Radhaswamy: Sultan Chand & Sons, New
Delhi.
8. Financial Accounting, Tulsian. Tata McGraw-Hill, New Delhi

Amity Directorate of Distance and Online Education


Unit-8: Cash Flow Statement
Notes
Structure
8.1 Introduction
8.2 Purpose of Cash Flow Statement
8.3 Cash Flow Activities
8.3.1 Operating Activities
8.3.2 Investing Activities
8.3.3 Financing Activities
8.4 Difference between Cash Flow Statement and Profit and Loss Account
8.5 Types of Cash Flow Statement
8.6 Components of Cash Flow Statement
8.7 Methods of Preparing Cash Flow Statement
8.7.1 Direct Method
8.7.2 Indirect Method
8.8 Analyzing Cash Flow Statement
8.9 Summary

Objective
Objective of this unit is to make student aware of importance of cash flo\11
and liquidity and also give preliminary knowledge of preparing the cash flo\11
statement.

8.11ntroduction
It is often said that in business "Cash is King", this is said because cash is all
important to businesses. Without cash employees cannot be paid, suppliers cannot
be paid, and therefore the business will grind to a halt. Cash is the oil in the machine
of business, and a Cash Flow Statement tells us the cash inflows and outflows in a
business over a period of time. A Cash Flow Forecast is an estimate, made by the
business, of the cash it expects to receive over a period (the inflow) and what it expects
to spend over that same period (the cash outflow). A Cash Flow Statement tells us how
much cash is available in a business to keep the business running - the actual cash
flow. A Cash Flow Forecast gives an estimate of how much cash will be available in
a business. It is used to plan ahead and to help monitor business progress over the
period.

8.2 Purpose Of Cash Flow


The cash flow statement reflects a firm's liquidity or solvency. The balance sheet is
a snapshot of a firm's financial resources and obligations at a single point in time, and
the income statement (Trading & Profit and Loss Account) summarizes a firm's financial
transactions over an interval of time. These two financial statements reflect the accrual
basis accounting used by firms to match revenues with the expenses associated with
generating those revenues. The cash flow statement includes only inflows and outflows
of cash and cash equivalents; it excludes transactions that do not directly affect cash
receipts and payments. These non-cash transactions include depreciation or write-
offs on bad debts to name a few. The cash flow statement is a cash basis report on
three types of financial activities: operating activities, investing activities, and financing

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100 Accounting for Managers

activities. Non-cash activities are usually reported in footnotes. The cash flow statement
Notes is intended to

1. provide information on a firm's liquidity and solvency and its ability to change cash
flows in future circumstances

2. provide additional information for evaluating changes in assets, liabilities and equity

3. improve the comparability of different firms' operating performance by eliminating


the effects of different accounting methods

4. indicate the amount, timing and probability of future cash flows.

8.2.1 Interested People


People and groups interested in cash flow statements include:

1. Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses

2. Potential lenders or creditors, who want a clear picture of a company's ability to


repay

3. Potential investors, who need to judge whether the company is financially sound

4. Potential employees or contractors, who need to know whether the company will be
able to afford compensation

The cash flow statement has been adopted as a standard financial statement
because it eliminates subjectivity , which might be derived from different accounting
methods, such as various timeframes for depreciating fixed assets.

A cash flow statement is concerned only with cash and cash equivalents. This
includes cash on hand, cash in the bank, and any cash invested in what is defined
as short-term, highly liquid financial instruments. Generally, only instruments with
original maturities of three months or less qualify as cash equivalents. Accepted cash
equivalents include treasury bills, commercial paper, and money market funds.

8.3 Cash Flow Activities


The cash flow statement is partitioned into three segments, namely: cash flow
resulting from operating activities, cash flow resulting from investing activities, and cash
flow resulting from financing activities.The money coming into the business is called
cash inflow, and money going out from the business is called cash outflow.

8.3.1 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 cash
flows include:

Receipts from the sale of goods or services

Receipts for the sale of loans, debt or equity instruments in a trading portfolio

Interest received on loans

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Accounting for Managers 101
Dividends received on equity securities
Notes
Payments to suppliers for goods and services

Payments to employees or on behalf of employees

Interest payments

Items which are added back to [or subtracted from, as appropriate] the net income
figure (which is found on the Income Statement) to arrive at cash flows from operations
generally include:

Depreciation (loss of tangible asset value over time)

Deferred tax

Amortization (loss of intangible asset value over time)

Any gains or losses associated with the sale of a non-current asset, because
associated cash flows do not belong in the operating section.(unrealized gains/
losses are also added back from the income statement)

8.3.2 Investing Activities.


Examples of Investing activities are

Purchase of an asset (assets can be land, building, equipment, marketable


securities, etc.)

Loans made to suppliers or customers

8.3.3 Financing Activities.


Financing activities include the inflow of cash from investors such as banks and
shareholders, as well as the outflow of cash to shareholders as dividends as the
company generates income. Other activities which impact the long-term liabilities and
equity of the company are also listed in the financing activities section of the cash flow
statement. Examples of these cash flow are

Proceeds from issuing short-term or long-term debt

Payments of dividends

Payments for repurchase of company shares

Repayment of debt principal, including capital leases

For non-profit organizations, receipts of donor-restricted cash that is limited to


long-term purposes

8.4 Difference Between Cash Flow and Profit& Loss Account


As we stated earlier, Cash Flow Statements do not show the profitability of a
business, they show either an historic view, or a prediction of the flows of cash into and
out of the business. It is only a Profit and Loss Account that tells us about profitability
of a business. Cash flow is not the same as net income. Cash flow will not match the
amount of net income shown on your profit and loss (P & L) statement..

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102 Accounting for Managers

But why is this? After all, many if not most of the features are the same. They both
Notes show income, they both show expenses. So why is not the bottom line on the Profit
and Loss Account the same thing as the Net Cash Flow? The answer is quite simple,
the figures included in each are to seen from two different angles i.e. profitability and
liquidity therefore, they are not identical. To put it more simply, net income includes
non-cash items, such as depreciation. And also because net sales are Sales not cash
payments . The table below gives details of the main differences between the two,
showing how the main differences arise, and why profit and loss accounts and cash
flows are in fact quite different financial animals.

Difference Between Cash Flow and Profit & Loss Account


Cash Flow n.
Sales Income from sales is entered as Sales are applied to the accounting period in
it is received, not before. If a which the sale occurs. So a good sold in one
credit sale is made, the income period on credit, is entered as a sale for that
is only entered when the actual period, even though the payment may not be
bill is paid. due untilthe next accounting period.
Expenses Enlered.as paid: Provision is made in accounts for expenses
incurred but not yet paid, these are known as
accru ls.
Depraciaiion As depreciation is a paper Depreciation is shown as a business expense.
accounting transaction, not
involving actual expenditure, this
is not shown.
Capiial If a business receives a further This account will only show an inflow of capital
ln+lows injection of capital that has not that has arisen as a result of trading activity.
arisen from its trading activities
then this is shown as a type of
income.

8.5 Types of Cash Flow Statement


There are two types of Cash Flow Statement which you will come across, these are:

1. Actyal Cash Flow 5tatements, these show an historic view, showing the
actual flows of cash into and out of a business that have occurred over a
previous trading period, e.g. 6 months, or 1 year.
2. Or a Forecast Cash Flow Statement showing the expected flows of cash into
and out of a business over a trading period in the immediate future, e.g next 6
months or year.

Forecast and actual cash flow -why do they differ?


Before we examine methods of funding Cash Flow shortages or deficits it is
worth examining why Forecast and Actual (Historic) Cash Flows can differ Cash
Flow Forecasts are a prediction of the likely flows of cash into and out of a business.
They will be based on: Past experience, (when the business has a previous trading
history), Current and likely future economic and financial trends, The knowledge and
understanding of the managers/owners And, the future plans of the business etc.
As with all forecasts, the further we look into the future, the less certainty we have.
Because of this, and because businesses operate in a world with changing fashions,
changing economic climate, and changing competition, a businesses' Actual Cash Flow
statement can in some cases be very different from its Cash Flow Forecast.

All businesses should monitor cash flow and examine any differences between
actual and forecast figures. This will allow action to be taken before a real business
crisis arises. As experience is gained of managing and monitoring cash flow business
owners and managers will be able to improve the accuracy of their forecasts. But what

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Accounting for Managers 103
happens when a business needs cash, or liquidity? Up to now we have just referred to
cash, but the fact is we are talking about the liquidity of business. Liquidity is a measure Notes
of the availability of Working Capital. If managers of a business say they have a liquidity
or working capital problem, this means that they will have a problem meeting all their
immediate expenditure demands. i.e. they do not have enough cash in hand, do not
expect enough cash to be flowing into the business and cannot convert enough assets
into cash in the short term to be able to pay all their bills, wages, debts etc. That ' and' is
important, firms do not always (in fact rarely) need to keep enough immediate cash on
hand to meet likely future expenditure, what they must do though is keep enough 'liquid
assets' available, so that cash flow can be effectively managed.

8.6 Components of Cash Flow Statement


Cash Flow Statement are made up of three parts, these are:

1. Revenue.
Jan Feb War

Revenu

Cash Sales 600 1200 1750

0 600 850
ueow'::' aymems
-tolal Ravsnu.s 600 1800 2600

Revenue is the income received by a business for goods sold or services provided.
It is the cash flowing into a business. For Bipasha & Co we see that it is sub divided into
Cash Sales, and Debtors Payments.

Cash sales occur when sales are made and payment is immediate. This payment
can be by cash, cheque, or credit card. In all of these cases the money is immediately
available for use by the business.

Debtors Payments. Many businesses sell goods on credit; payment for the goods
may not be due for 30 days or more. When goods are sold on credit a Debtor is
created. We only enter the revenue from these sales. when payment is made.

Total. This is the total revenue; all the payments received by a business within the
time period, in this case January. This is the total of money flowing into the business. All
of this is available for use by the business

2.Expenses
Jan Feb War

Revenu

Cash Sales 600 1200 1750


0 600 850

'2ill r elftlla.w"' 5
BOO 1800 2800

Expenses

AaWIV'III,.aQfiBIB 970 1200 1350


Wages BOO BOO BOO

220 220 220


Ra11ea .<0 .<0 .<0

EI&OinCitY eo 60 BO
-traveng. eo eo 150

Su!ld.r-es 130 eo eo
160 160 260
7111on Charg es 2630 2950
2"'60

1\..61 C&ah Flow 18!50 -830 150

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104 Accounting for Managers

Expenses. Under expenses or expenditure you will find all of the money spent by a
Notes business within a time period. This is the money flowing out of the business. There are
many different types of expenditure; some of the more common are shown in the cash
flow statement. The expenses for Bipasha & Co are broken down into its parts. We can
see exactly where the money is going. In January Bipasha & Co will spend Rs 40 on
rates, Rs 60 on electricity and so on. All of these are examples of money flowing out of
a business.

3 Net Cash Flow


Follow the links for explanations of the terms used in the cash flow forecast.

Jan Feb War

Revenu

Cash Sales 600 1200 1750

Debtors Pavments
0 600 850

+oial Revenu 600 1800 2600

Expenses

Raw Waierials 970 1200 1350

Wages 800 800 800

220 220 220

Rates lO lO lO

Eleciricit'y 60 60 60

+ravelling 80 80 150

Supd ies 130 80 80

Exhib ion Charges 150 150 250

+oial 2"60 2630 2950

1\I:M Cash Flow -1850 -830 -350

Total Revenue. Remember this is the total of cash flowing into the business.

Total Expenses. Remember this is the total spending by the company, i.e. the total
flow of cash out of the Bipasha Trading. Note. If goods are bought on credit, then they
only appear on the cash flow statement when the payment is made.

Net Cash Flow. This calculated by taking total expenses away from total revenue. If
revenue is greater than expenses then this figure is positive (+), if expenses are greater
than revenue, then the Net Cash Flow is a negative(-).

4. Balances
Follow the links for explanations of the terms used in the cash flow forecast.

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Accounting for Managers 105
Jan Feb W.llr

Revenu
Notes
Cash Sales 600 1200 1750

Debtors Payments 0 600 850

+oial Revenu 600 1800 2600

Expenses

Raw W.llierials 970 1200 1350

Wages eoo eoo eoo


220 220 220

Raies q:) q:) q:)

Electricity 60 60 60

+ravelling eo eo 150

Su.nd ies 130 80 80

Exhibiiion Charges 150 150 250

+oial 2450 2630 2950

t\Cash Flow -1850 -830 -350

Opening Balance 750 -1100 -1930

.l/- t\Cash Flow -1850 -830 -350

Closing Balance -1100 -1930 -2280

Net Cash Flow. Once calculated this can then be used to obtain the Closing
Balance for the period. To do this we deduct the Net Cash Flow from the opening
balance if it is a negative figure, or we add it if it is a positive figure.

Closing Balance. Here we see that we have a closing balance of -Rs1100, i.e.
a predicted cash shortage of Rs1100. This was found by taking the Net cash Flow
-Rs1850 from the Opening Balance Rs750. The Closing Balance for one month or
period, becomes the Opening Balance for the next month or period. In this case we
see that the Closing Balance for January, -Rs1100, becomes the Opening Balance for
February, -Rs1100

8.7 Methods of Preparing Cash Flow Statement


The direct method of preparing a cash flow statement results in a more easily
understood report. The indirect method is almost universally used, because most of the
accounting standards requires a supplementary report similar to the indirect method if a
company chooses to use the direct method.

8.7.1 Direct method


The direct method for creating a cash flow statement reports major classes of gross
cash receipts and payments. If taxes paid are directly linked to operating activities,

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106 Accounting for Managers

they are reported under operating activities; if the taxes are directly linked to investing
Notes activities or financing activities, they are reported under investing or financing activities.
Under the direct method, you are basically analyzing your cash and bank accounts to
identify cash flows during the period. You could use a detailed general ledger report
showing all the entries to the cash and bank accounts, or you could use the cash
receipts and disbursements journals. You would then determine the offsetting entry for
each cash entry in order to determine where each cash movement should be reported
on the cash flow statement.

Another way to determine cash flows under the direct method is to prepare
a worksheet for each major line item, and eliminate the effects of accrual basis
accounting in order to arrive at the net cash effect for that particular line item for the
period. Some examples for the operating activities section include:

Cash receipts from customers:


Net sales per the income statement.
Plus beginning balance in accounts receivable .
Minus ending balance in accounts receivable.
Equals cash receipts from customers.

Cash payments for inventory:


Ending inventory
Minus beginning inventory
Plus beginning balance in accounts payable to vendors
Minus ending balance in accounts payable to vendors
Equals cash payments for inventory

Cash paid to employees:


Salaries and wages per the income statement
Plus beginning balance in salaries and wages payable
Minus ending balance in salaries and wages payable

Equals cash paid to employees

Cash paid for operating expenses:


Operating expenses per the income statement
Minus depreciation expenses
Plus increase or minus decrease in prepaid expenses
Plus decrease or minus increase in accrued expenses

Equals cash paid for operating expenses

Taxes paid:
Tax expense per the income statement
Plus beginning balance in taxes payable
Minus ending balance in taxes payable

Equals taxes paid

Interest paid:
Amity Directorate of Distance and Online Education
Accounting for Managers 107
Interest expense per the income statement
Plus beginning balance in interest payable Notes
Minus ending balance in interest payable

Equals interest paid

Under the direct method, for this example, you would then report the following in the
cash flows from operating activities section of the cash flow statement:

Cash receipts from customers


Cash payments for inventory
Cash paid to employees
Cash paid for operating expenses
Taxes paid
Interest paid

Equals net cash provided by (used in) operating activities

Similar types of calculations can be made of the balance sheet accounts to eliminate
the effects of accrual accounting and determine the cash flows to be reported in the
investing activities and financing activities sections of the cash flow statement.

Sample cash flow statement using the direct method

Cash flows from (used in) operatinQ activities


Cash receipts from customers 27,500

Cash paid to suppliers and employees (20,000)

Cash generated from operations (sum) 7,500

lnieresipai (2,000)

Income taxes paid (4,000)

Net cash flows from operatinQ activities 1,500

Cash flows from (used in) investing activities

Proceeds from the sale of equipment 7,500

Proceeds from sale of investment 3,000

Net cash flows from investinQ activities 10,500

Cash flows from (used in) financing activities


Divi ens pai (2,500)

Net cash flows used in financing activities (2,500)

Net increase in cash and cash equivalents 9,500

Cash and cash equivalents, beginning of year 1,000

Cash and cash equivalents, end of year Rs10,500

8.7.2 Indirect method


The indirect method uses net-income as a starting point, makes adjustments for

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108 Accounting for Managers

all transactions for non-cash items, then adjusts for all cash-based transactions.
Notes An increase in an asset account is subtracted from net income, and an increase in a
liability account is added back to net income. This method converts accrual-basis net
income (or loss) into cash flow by using a series of additions and deductions.

1 Rules of Converting Profit to Cash flow under Indirect Method

The following rules are used to make adjustments for changes in current assets and
liabilities, operating items not providing or using cash and non-operating items. The
following is an example of how the indirect method would be presented on the cash flow
statement:

Net income per the income statement

Minus entries to income accounts that do not represent cash flows

Plus entries to expense accounts that do not represent cash flows

Equals cash flows before movements in working capital

Plus or minus the change in working capital, as follows:

An increase in current assets (excluding cash and cash equivalents) would be


shown as a negative figure because cash was spent or converted into other
current assets, thereby reducing the cash balance.

A decrease in current assets would be shown as a positive figure, because


other current assets were converted into cash.

An increase in current liabilities (excluding short-term debt which would be


reported in the financing activities section) would be shown as a positive figure
since more liabilities mean that less cash was spent.

A decrease in current liabilities would be shown as a negative figure, because


cash was spent in order to reduce liabilities.

The net effect of the above would then be reported as cash provided by (used in)
operating activities.The cash flows from investing activities and financing activities
would be presented the same way as under the direct method.

2 Cash flow example using Indirect Method :

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Accounting for Managers 109
Cash Flow Statement :Example
(al numbers in thousands)
Notes
Period ending 12/31/2007 12/31/2006 12/31/2005

Nai. income 21,538,000 24,589,000 17,046,000

Operating activities, cash flows provided by or used in:

Depreciation and amortization 2,790,000 2,592,000 2,747,000

Adjustments to net income 4,617,000 621,000 2,910,000

Decrease (increase) in accounts receivable


12,503,000 17,236,000 -
Increase (d crease) in liabililies (AlP, iaxes 131,622,000 19,822,000 37,856,000
payable)

Decrease !increase\ in inventories - - -


in othP.r .::trtivitiP.
(173,057,000) (33,061,000)
l& & .aem
13,000 31,799,000 (2,404,000)
1\1 fl. f"' 'n -.+I nn.-+;.,;,;

.. .
., "
(4,035,000) (3,724,000) (3,011,000)
r-
Vt>tJOO<." <:>AtJ<:>OOUOOU O <;>->

lnvesimeniS (201,777,000) (71,710,000) {75,649,000)

1,606,000 17,009,000 (571,000)


Vlllt::H Cd::ill IIUW::i IIUIII IIIVtl::iliiiY avUVILit:i;:>
(204,206,000) (58,425,000) (79,231,000)
1\let CdSII IIOWS IIUIIIIIIVeSLIIIY dCLIVILie::;

o'r<JI lCa
I 11t1eS,cash IIOWS prOVIded by or USed
lVI n pa. 1 . '1 .826,000) (9,188,000) (8,375,000)

(5,327,000) (12,090,000) 133,000


Sale (repurchase) of stock
101'122,000 26,651,000 21,204,000
Increase (decrease) in debt

Other cash flows from financing activities 120,461,000 27,910,000 70,349,000

Net cash flows from financing activities 206,430,000 33,283,000 83,311,000

Effect of exchange rate changes 645,000 (1,840,000) 731,000

"'"'' ;,.. '""''"' ..... """''"' a,.aonnn a..A .::117 nnn a.. Al\7 nnn
equivalents

8.8 Analysing Cash Flow


Analyzing cash flows is an important part of financial statement analysis. Here are
some important things to look for:

1. There should be a net Increase in Cash from Operating Activities. If operations


don't produce positive cash flows, the business will soon be in trouble. Without
adequate operating cash flows, the company may have to dip into cash reserves or
sell investments to meet regular payment of expenses.

2. If a company shows net Increase in Investing Cash Flows, it means they are selling
off assets. That is generally not a good sign. I would also look to see if teh company
was posting losses and had negative cash flows from Operating activities. This
might indicate that Management is selling off assets to pay bills. More analysis is
needed in this case.
Amity Directorate of Distance and Online Education
110 Accounting for Managers

8.9 Summary
Notes A Cash Flow Statement reports the amount cash coming in (cash receipts) and the
amount of cash going out (cash payments, disbursements) during a period of time.
The statement of cash flows shows the net increase or net decrease in cash over a
period of time and the cash balance at the end of the period. Cash for purposes of the
cash flow statement normally includes cash and cash equivalents. Cash equivalents
are short-term, temporary investments that can be readily converted into cash, such as
marketable securities, short-term certificates of deposit, treasury bills, and commercial
paper. The cash flow statement shows the opening balance in cash and cash
equivalents for the reporting period, the net cash provided by or used in each one of the
categories (operating, investing, and financing activities), the net increase or decrease
in cash and cash equivalents for the period, and the ending balance.

There are two methods for preparing the cash flow statement - the direct method
and the indirect method. Both methods yield the same result, but different procedures
are used to arrive at the cash flows.

Check Your Progress


1. Cash Flow Forecast is made up of three parts, these are:

a)

b)

c)

Answer the Questions


2. All questions refer to the Cash Flow Forecast of Bipasha & Co. given in the chapter
(a) In which month are Debtor Payments the highest?
(b) In which month is Total Expenditure the lowest?
(c) In which month is the difference between Revenue and Expenditure the
largest?
(d) In which months is Revenue greater than Expenses?
(e) How much is the difference between Total Revenue and Total Expenditure over
the period January to June inclusive?
(f) What is the Total Expenditure for the period January to June inclusive?
(g) What is the Opening Balance for March?
(h) What will be the Opening Balance for July?
(i) What is the Total Revenue for the period January to June inclusive?
(i) In which month are Cash Sales the highest?
(k) What is the Closing Balance for the month of April?
(I) Which is the largest item of Expenditure in May?
(m) If Bipasha & Co received a biII for Rs1500 on the 1st of July, would the
business have enough in the Bank to pay it?

Questions and Exercises


1. Give two examples of cash inflow from operating activity.
2. Give two example of cash outflow due to financing activity.
3. Increase in stock will reduce the cash inflow? State.
4. Indirect and Direct method are applicable for calculating which type of activity.
Explain.

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Accounting for Managers 111
5. Cash Flow is not subjective. Explain it
4. Define the following terms: Notes
(a) Revenue
(b) Cash Sales
(c) Debtors Payments
(d) Total Revenue
(e) Expenditure
(f) Total Expenditure
(g) Net Cash Flow
(h) Opening Balance
(i) + I - Net Cash Flow
(j) Closing Balance
Further Readings
1. Accounting Principles. Robert N Anthony.
2. Accounting For Managers. Maheshwari and Maheshwari.
3. Introduction to Accountancy.T S Grewal. S Chand & CO.
4 Cost Accounting. Jain S.P and Narang, K.L. Kalyani Publishers.
5. Introduction to Management Accounting, Homgren, C.T., Gary L. Sundem and
Walliam 0. stratton : Prentice Hall of India, Delhi.
6. Cost Accounting : lall, B. M. and I.C. Jain : Principles and Practice, Prentice Hall of
India, Delhi.
7. Management Accounting, Sharma R.K. and Gupta S.K.; Kalyani Publishers,
Ludhiyana.
8. Managerial Accounting, Lal Jawahar ; Himalya Publishing House, New Delhi.

Amity Directorate of Distance and Online Education


Unit-9 Fund Flow Statement
Notes
Structure
9.1 Introduction
9.2 Difference between Income Statement and Fund Flow Statement(FFS)
9.3 Utility of Fund Flow Statement
9.4 Distinction between FFS and Cash Flow Statement
9.5 Format of Fund Flow Statement
9.6 Sources of Funds
9.7 Application of Funds
9.8 Preparing Schedule of Changes in Working Capital
9.9 Summary

Objectives
Objective of this unit is to make the student aware about the fund flo\/\
statement, its utility and the method to prepare. Though in last few years thE
Cash Flow Statement is gaining more importance but understanding of FFS i
also very important.

9.11ntroduction
The term 'funds, has now been adopted as to include assets or financial resourceful
which do not flow through the working capital accounts. It seems to be the most suitable
meaning fort the term 'funds' but the most commonly used interpretation of the term
'funds' is 'working capital'. The funds-flow-statement is a report on financial operations
changes, flow or movements during the period. It is a statement which shows the
sources an application of funds or it shows how the activities of a business is financed
in a particulate period. In other words, such a statement shows how the financial
resources have been used during a particular period of time. It is, thus, a historical
statement showing sources and application of funds between the two dates designed
especially to analyze the changes in the financial conditions of an enterprise. In the
simpler words, it is-

"A statement of Sources and Application of Funds is a technical device designed to


analyze the changes in the financial condition of a business enterprises between two
dates."

9.2 Difference Between Income Statement and Fund Flow


Statatement
Funds Flow Statement is not an income statement . Income statement shows the
items of income and expenditure of a particular period, but the Funds flow statement
is an operating statement as it summaries the financial activities for a period of time. It
covers all movements that involve an actual exchange of assets. Various titles are used
for this statement such as 'Statement of sources and Application of Funds', 'Summary
of Financial operations,' 'Changes in Financial Position', 'Fund received and Disbursed',
'Funds Generated and Expended', Changes in Working Capital", "Statement of Fund'
etc. Title of Funds Flow Statement has been modified from time to time. Really it is
very difficult to find a short time for such statement which carries much to the readers
regarding its contents an functions.

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Accounting for Managers 113
9.3 Utility Of Fund Flow Statement
Objectives (or Importance) of Funds Flow Statement Funds Flow Statement is an an Notes
analytical tool in the hands of financial manager. The basic purpose of this statement is
to indicate on historical basis the changes in the working capital i.e., where funds came
from and were there are used during a given period. The utility of this statement can
be measured on the basis of its contributions to the financial management. It generally
serves the following purposes:

1. Analysis of Financial Position. The basic purpose of preparing the statement is to


have a rich into the financial operations of the concern. It analyses how the funds
were obtained and used in the past. In this sens, it is a valuable tool for the finance
manager for analyzing the past and future plans of the firm and their impact on the
liquidity. He can deduce the reasons for the imbalances in uses of funds in the past
an take necessary corrective actions. In analyzing the financial position of the firm,
the Funds Flow Statement answers to such questions as-

(a) Why were the net current assets of the firm down, though the net income was
up or vice versa?

(b) How was it possible to distribute dividends in absence of or in excess of current


income for the period ?

(c) How was the sale proceeds of plant and machinery used?

(d) How was the sale proceeds of plant and machinery used?

(e) How were the debts retired?

(f) What became to the proceeds of share issue or debenture issue ?

(g) How was the increase in working capital financed ?

(h) Where did the profits go?

Though it is not an easy job to find the definite answerers to such questions because
funds derived from a particular source re rarely used for a particular purpose. However,
certain useful assumptions can often be made and reasonable conclusions are usually
not difficult to arrive at.

2. Evaluation of the Firm's Financing. One important use of the statement is that it
evaluates the firm' financing capacity. The analysis of sources of funds reveals how
the firm's financed its development projects in the past i.e., from internal sources or
from external sources. It also reveals the rate of growth of the firm.

3. An Instrument for Allocation of Resources. In modern large scale business,


available funds are always short for expansion programmes and there is always
a problem of allocation of resources. It is, therefore, a need of evolving an order
of priorities for putting through their expansion programmes which are phased
accordingly, and funds have to be arranged as different phases of programmes
get into their stride. The amount of funds to be available for these projects shall be
estimated by the finance with the help of Funds Flow Statement. This prevents the
business from becoming a helpless victim of unplanned action.

4. A Tool of Communication to Outside World. Funds Flow Statement helps in


gathering the financial states of Business. It gives an insight into the evolution of
the present financial position and gives answer to the problem 'where have our

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114 Accounting for Managers

resources been moving'? In the present world of credit financing, it provides a


Notes useful information to bankers, creditors, financial, it provides a useful informations
and government etc. regarding amount of loan required, its proposes, the terms
of repayment an sources for repayment of loan etc. the financial manager gains
a confidence born out of a study of Funds Flow Statement. In fact, it carries
information regarding firm's financial policies to the outside world.

5. Future Guide. An analysis of Funds Flow Statements of several years reveals


certain valuable information for the financial manager for planning the future
financial requirements of the firm and their nature too i.e. Short term, long-term or
mid term. The management can formulate its financial policies based on information
gathered from the analysis of such statements. Financial manager can rearrange
the firm's financing more effectively on the basis of such information along with
the expected changes in trade p payables and the various accruals. In this way, it
guides the management in arranging its financing more effectively.

9.4 Distinction Between Funds Flow Statement and Balance Sheet


A summary of main points of differences between these two is give below:

1. Balance sheet is a statement showing the financial position of the concern on a


particular date. The asset side portrays the development of resources in various
type of properties an liabilities side indicates the manner in which these resources
are obtained. It shows all assets and liabilities whether current or fixed, tangible or
intangible etc., while Funds Flow Statement shows the changes in current assets
an current liabilities during a particular period of time.

2. Balance Sheet shows the total financial position on a particular date and in this way, it
is of a historical nature an therefor, its utility is very limited for the management.
On the other hand, Funds Flow Statement is a comparative statement of assets
and liabilities and depicts the changes in working capital during the period of two
Balance sheets.

3. Funds Flow Statement is an analysis and control device for the management.
Management can ensure the long term an the short term solvency of the firm by
studying the internal funds flow cycles. It is a modern technique of knowing the
inflows and outflows of funds during a particular period. Balance Sheet represents
the balance of various assets an liabilities and does not present analysis of any
kind.

4. There are two views of h financial position of the firm-long term an short-term. Short-
term financial position means the technical solvency of the firm in the near future
while on the other hand, long-term financial position means future financial structure
of the firm. Both are inter-relate but there is a differences in their analysis. The
short-term view of the financial position of the firm can not be had from the Balance
Sheet.

9.5 Distinction Between Funds Flow Statement and Cash Flow


Statement
distinction between these two statements may be briefed as under:

1. Funds Flow Statement is concerned with all items constituting funds (Working
Capital)for the business while Cash Flow Statement deals only with cash

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Accounting for Managers 115
transactions. In other words, a transaction affecting working capital other than cash
will affect Funds statement, and not the Cash Flow statement. Notes
2. In Funds Flow Statement, net increase or decrease in working capital is recorded
while in Cash Flow Statement, individual item involving cash is taken into account.

3. Cash Flow Statement is started with the opening cash balance and closed with ht
closing cash balance while there a no opening or closing balances in Funds Flow
statement.

9.6 Format Of Funds Flow Statement


Generally, Funds Flow statement can be prepared in two formats-in report from or in
an account form as shown below

1. Report Form
Funds Flow Statement
For the year ending 31st march, 2008

Sol.!rces of FL!n s: Amo nt (Rs)


1. Operating profit
2. Issue of Share capital
3. Issue of Debentures
4. Long-lerm loans
5. Sale of Non-Current assts
6. Non-trading Receipt (e.g. dividend received)

Total

Application of fl.!n s:

1' Operating Loss


2. Redemption of Preference Share Capital
3. Redemption of Debentures
4. Repayment of Long-term Loans
5. Purchase of Non-current Assets
6. Non-trading Payment (e.g. dividend paid)

Total

Increase/Decrease in Working Capital


(as per schedule of changes in Working capital)

2. Account Form

This account is of 'T shape'. On the left side different sources of funds are shown
while on the right side different application of funds are shown. The following is an
example of account form:
Funds Flow Statement
For the year ending 31st march, 2008

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116 Accounting for Managers

So rces of F nds Application of fl!nds Amol!nl


Notes "'t'"''""'1:11 t''....... -
Issue of Share capital Redemption of Preference Share
-ption
Capital
Issue of Debentures
Redemption of Debentures
Long-.Lerm loans
Repayment of Long-term Loans
Sale of Non-Current assts
Purchase of Non-current Assets
Non-trading Receipt
Non-trading Payment
Decrease in working
capital (if any) Increase in working capiial (li
any)

9.7 Sources Of Funds


Transactions that increase working capital are sources of funds.
Some of them are:
1. Funds from Operations.
To calculate the fund from operations , certain additions/deduction from the net profit
is required or one can calculate afresh. Items to be Deducted from Net Profits In order
to find out funds from operations, items of in come (i) which do not affect the current
assets or current liabilities, and (ii) which are not business income, are to be deducted
from net profit.

Such items are:

(a) Dividend Received or Receivable. Although it increases current assets


(cash or bank or debtors) but it is not a business income. Hence, it should
be deducted from the net profit in order to calculate funds from operations
and should be shown in the Funds Flow Statement as a separate item under
sources of funds.

(b) Retransfer of Excess Provisions. It simply involves a book-keeping entry i.e.,


a transfer of excess provision to profit and loss account and does not bring any
change in current assets or current liabilities. Also it does not constitute trading
income or profit. Hence it will be deducted from net profit.

(c) Profits on Sale of Non-Current Assets. Any profits arising out of sale of fixed
assets which have already been credited to profit and loss account should b
deducted from the net profit because, it is not a business profit.

(d) Appreciation of Fixed Assets on Revaluation. If any fixed asset has been
appreciated as a result of revaluation process, the amount should be deducted
from profits, if it has already been credited to profit and loss account.

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Accounting for Managers 117
Calculating Funds From Operations. Funds from operations can be calculated
by making necessary adjustments in the profits shown by profit and loss account as Notes
discussed above, in either of the two forms:-

a. Statement Form. It can be prepared as under:

Net Profit for the current year

Add- Non-Fund Items and Non-trading Charges

i. Depreciation an Depletion

ii. Amortization of Fictitious and intangible assets ..........................


like writing off preliminary expenses, discount on
issue of shares or debentures, Premium on
redemption of debentures or preference shares,
Goodwill, Patents etc.
..........................
iii. Provision for taxation
..........................
iv. Appropriation of Retained Earnings such as
Transfer to GeneralReserve, Sinking Fund etc. ..........................
v. Proposed Dividend
..........................
vi. Loss on sale of fixed assets (if debited to P&L
account)
..........................

Less-Non -Fund Items and Non-trading Incomes .......................... ..............................


(i) Dividend received and receivable ..........................
(ii) Excess provision written back ..........................
(iii) Profit on sale of fixed assets (if already
credited to P & L account)
..........................
(iv) Profit on revaluation of fixed assets (if already
credited to profit & Loss account)

Trading Profit or Funds from Operations.

b. Account Form. Alternatively, an adjusted profit and loss account may be


written up as follows and the balancing figure thus represents Trading Profit or
Funds from Operation:

Adjusted Profit and Loss Account (Proforma)

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118 Accounting for Managers

To Depreciai.ion By PIL
Notes appropriation
To Preliminary account (opening
Expenses balance)

By Dividends
already credited to
P/L
To discount on issue
of debentures or
shares written off.

By excess
provision wriuen
back
To Transfer to
General Reserve or
Sinking fund or
contingency Reserve
or any other reserves
etc.
By Trading Pro ii.s
or Funds form
operations
To Loss on sale of (Balancing figure)
machinery written off

To closing Balance
c P/L appropriation t--------i
acco ni.

It will be noted from the above proforma that:

(a) All items to be added back to net profit are shown on the debit side and all items
to be deducted on credit side.

(b) Net profit does not appear on either side. Instead, opening balance of
P/L appropriation is shown on the credit side an closing balance of P/L
appropriation on the debit side. The balancing figure represents "trading Profit
or Funds from Operations'.

2. Funds from issue of Share Capital.


Proceeds of fresh issue of share capital (including share premium or excluding any
discount on issue of shares) increase the current asset (cash or bank) without any
corresponding increase in current liabilities hence is a source of funds.But, if shares are
issued against the purchase of any fixed asset, it shall not be a source of funds.

3. Funds from Issue of Debentures, Acceptance of Public Deposits and other


Long-termLoans.
Funds from Issue of Debentures, Acceptance of Public Deposits and other Long-
term Loans These all sources contribute to funds. But if debentures like shares, are
issued for consideration other than cash, they do not generate funds.

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Accounting for Managers 119
4. Sale of Fixed Assets.
Sale of Fixed Assets Set proceeds of any fixed assets such as building, machinery, Notes
furniture or long-term investments shall generate funds because cash or debtors
increase without any corresponding increase in current liabilities.

9.8 Application Of Funds


The following are application of funds
1. Loss from operations. Loss from operations either decreases the current assets or
increases the current liabilities or in other words reduces the funds. It may either be
shown as application of funds in the Funds Statement or as a reduction in sources
of funds.
2. Purchase of Fixed Assets. If any fixed asset like building, machinery, furniture
or investments is purchased, it will reduce the current asset (cash) without any
corresponding decrease in current liability. It is, thus, an application of funds.
Purchase of asset against issue of share capital is not application of funds.
3. Repayment of loans, Redemption of Debentures or preference share capital.
Any such repayment including the payment of premium on redemption of
debentures or preference shares is an application of funds because it reduces the
current assets.
4. Payment of Dividend. Payment of dividend (and not proposed dividend) is an
application of fund if paid in cash. If bonus shares are issued, it shall not be treated
application of funds.
5. Other Applications. Any loss such as embezzlement, compensation, donations
etc. involving cash, is an application of fund.
6. Increase in Working Capital. Increase in working capital (as per schedule of
changes in working capital) represents investment in current assets hence it is
an application of funds. In other words, the excess of sources over application of
funds is increase in working capital. The difference of these two parts, is change
in working capital. When sources of funds exceed the application of funds, it is
increase in working capital and when application of funds exceeds the sources, it is
decrease in working capital.

9.9 Preparing Schedule of Changes in Working Capital


For preparing the Fund Flow statement we should know the components of working
capital. Preparing fund flow statement states the flow of funds for various reasons
and schedule of change in working capital tells the composition of working capital and
the change in the components. There are two components of working capital, current
assets and current liabilities. Schedule of changes in net working capital is a statement
prepared to ascertain the net change (increase or decrease) in working capital over
period of time. An increase in working capital is shown as a use of funds, while a
decrease is shown as a source of fund in the fund flow statement.

1. Current Assets
Current assts are those assets which are converted into cash within one year. For
example cash, bank balances, debtors, stock, bills receivables, prepaid expenses, short
-term investment etc.

2. Current liabilities
Current liabilities mean liabilities including loan, deposits, and overdrafts etc. which
fall due for payment in a relatively short period normally not more then one year. For
example creditors, bills payable, outstanding expenses, income tax payable, declared
dividend etc.

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120 Accounting for Managers

Schedule of changes in Working Capital


Notes
Previol!s CL!rrent Effect of Working Capital
Increase Decrease
Items Year Year
(As) (As)
(As.) (As.)
(A)CURRENT
ASSETS:
- -
Cash in hand
- -
Cash aibank
Debiors
- -
Siocks - -
Bills Receivable - -
Advances - -
Prepaid Expenses - -
Accrl!ed.lncome - -
Sheri
lnvesimeni
- ierm - -
Total(A)
(B) CURRENT
LIABILITIES
& PROVISION :
Bills Payable
- -
Creditors - -
Bank OverdraU
- -
Outstanding Liabilities
Sheri-ierm Loans - -
Total(B) - -
- -
Net working Capital
(A- B) - -

Increase/Decrease in - -
Working Capital
- -
Total - -

9.10Summary
A fund flow statement is a summary of a firm's inflow and outflow of funds. It tells us
from where funds have come and where funds have gone. Fund flows statement can
indicate whether sourcing of funds and their use match in ALM sense and also reveal
the prudence or otherwise of a firm's financing and investment decisions. Funds Flow
statement presents those items only which affect the working capital. If any transaction
does not affect the working capital at all i.e, if it results in increase or decrease in
both current assets and current liabilities (such as payment to creditors) or it affects
only fixed assets and fixed liabilities (such as conversion of debentures into shares, or
shares into stocks or vice versa, issue of bonus shares, purchase of fixed assets like

Amity Directorate of Distance and Online Education


Accounting for Managers 121
building or machinery by issue of shares or debentures etc.), it is not to be shown in
funds Flow Statement. Notes
Check Your Progress
1 ........................ is the most commonly used term for the Fund.

2. The Fund Flow Statement is prepared just to judge the .... of the business.

3. Funds Flow Statement is a comparative statement of assets and liabilities and


depicts the changes in ...................during the period of two Balance sheets.

4. . .................... transactions are not shown in funds Flow Statement.

5. If shares are issued against the purchase of any fixed asset, it .... be a source
of fund.

6. Item wise change in the components in the current assets and current liabilities are
shown in the .

7. Sale of non-current assets is ............ ....... source of funds.

8. Paying debtors by bills receivable is ............ ................source of fund.

Questions and Exercises


1. What is Fund Flow Statement? How it is different from Cash Flow Statement and
Balance Sheet?

2. Prepare a imaginary Fund Flow Statement in Statement Form.

3. How Funds from Operation is calculated?

4. What is Schedule of change in working capital ? how it is important ?

Further Readings
1. Accounting Principles . Robert N Anthony.

2. Accounting For Managers. Maheshwari and Maheshwari.

3. Introduction to Accountancy.T S Grewal. S Chand & CO.

4 Cost Accounting. Jain S.P. and Narang, K. L. KAlyani Publishers.

5. Introduction to Management Accounting, Homgren, C.T., Gary L. Sundem and


Walliam 0. stratton : Prentice Hall of India, Delhi.

6. Cost Accounting : lall, B. M. and I.C. Jain : Principles and Practice, Prentice Hall of
India, Delhi.

7. Management Accounting, Sharma R.K. and Gupta S.K.; Kalyani Publishers,


Ludhiyana.

8. Managerial Accounting, Lal Jawahar ; Himalya Publishing House, New Delhi.

Amity Directorate of Distance and Online Education