Business Activities

To understand the information in an annual report, it is useful to think

about the fundamental types of activities that a firm might engage in
and report on. These activities are divided into three categories as;
financing, investing and operating.
1. Financing Activities:
Financing refers to activities of obtaining funds (cash) with which the
firm can operate. This activity is necessary, of course, to start the firm,
but it is also a continuing activity as the firm grows and expands its
operations.
Sources of Funds:
Creditors: creditors expect to be repaid on a timely basis and very
often charge the firm for the use of their money, goods or services in
the form of interest. The amount to be repaid is generally a fixed
amount.
Owners: owners, on the other hand, invest their funds in the firm in
the hope that their investment will generate a profit. They realize their
return from their investment either in the form of dividends
(withdrawal of funds from the firm) or by selling their ownership
interest to another investor. Owner may experience a gain or loss
(sometimes referred to as capital gain or loss) on the sale of their
ownership interest.
The primary source of new funds to the firm is the profit generated by
the business that are not paid out to owners in the form of dividend;
called retained earnings. If the firm is unprofitable, or if all profits are
distributed to owners in the form of dividends, the only way the firm
can expand is to get more funds from owners (existing owners or new
owners) or to borrow from creditors
How much to borrow from creditors and how much to obtain from
owners are important decisions that management of the firm must
make.
Typical financing activities:
Borrowing money
Repaying loans
Issuing stock
Repurchasing of stock
Paying dividend on stock
Cash receipts Cash payments
Proceeds from both short term Payment of amount
and long term borrowings. borrowed(excluding interest
payments)
Cash received from owners (e.g. Payments to owners such as cash
issuing stock) dividends

2. Investing Activities:
Once the firm obtains funds, it must invest those funds to accomplish
its purposes. Most firms make both short term and long term
investments. Most short term investments are considered operating
activities, such as the purchase of raw materials and inventories.
Some short term investments, such as investment in stock of other
companies (called marketable securities) and most long term
investments are considered investment activities.
Long term investment in property, plant and equipment is one such
investing activity.
Long term investment in stock of other companies would also be
considered an investing activity.

Typical investing activities:

Purchase of PP&E
Sale of PP&E
Investment in stock of other companies
Sale of investment in stock of other companies
Cash receipts Cash payments
Cash proceeds from selling Payments to acquire investments
investments and plant assets and plant assets
Cash proceeds from collecting Amounts advanced to borrowers.
principal amounts on
loans(excluding Interest receipt)

3. Operating Activities:
Operating activities are those associated with developing, producing,
marketing, and selling the products and/or services of the firm.
The operating activities section shows the cash effects of revenue and
expense transactions. Stated another way, the operating activities
section of the statement of cash flows includes the cash effects of
those transactions reported in the Income Statement.
Typical operating activities:
Sales to customers
Collections on A/R
Purchase of inventory
Payment on A/P
Payment of operating expense
Payment of tax expense

Cash receipts Cash payments

-Collection from customers for
sale of goods and services
-Interest and dividend received
-Other receipts from operations:
-Payment to suppliers of
merchandise and services,
including payments to employees.
-Payment of interest
-Payment of income taxes
e.g. proceeds from settlement of -Other expenditures relating to
litigation. operations: e.g. payment in
settlement of litigation.

Where from and where to:

Cash comes from Cash Funds Cash goes to

(Sources) In Out (Applications)
1. Profits → → 1. Losses
2. Sales of Fixed → → 2. Purchase fix assets
assets
3. Decrease in Stock → → 3. Increase in stock
4. Decrease in → → 4. Increase in Debtors
debtors
5. Capital introduced → → 5. Drawings /
dividends
6. Loans received → → 6. Loans repaid
7. Increase in → → 7. Decrease in
creditors creditors

Classifying Sources and Uses of Cash

The Sources and Uses of Cash

Sources Uses
• Decrease in any asset • Increase in any asset
• Increase in any liability • Decrease in any liability
• Net Profit after taxes • Net Losses
• Depreciation and other noncash charges • Dividend paid
• Sale of Stock • Repurchase or retirement of stock

1. A decrease in asset such as the firm’s cash balance is source of cash flow because
cash that has been tied up in the asset is released and can be used for some other
purposes, such as repaying a loan. On the other hand, an increase in the firm’s
cash balance is a use of cash flow, because additional cash is being tied up in the
firm’s cash balance.
2. The financial manager is concerned with cash flows rather than net profits as
reported on income statement. To adjust the income statement to show cash flow
from operations, all noncash charges must be added back to the firm’s net profit
after taxes.
Noncash charges are expenses that are deducted on income statement but don’t
 involve an actual outlay of cash during the period. Depreciation, depletion and
amortization allowances are the examples.
Because depreciation charges are the most common noncash charges, we shall
focus on their treatment; amortization and depletion charges are treated in a
similar fashion.
The general rule for adjusting net profit after taxes by adding back all noncash
charges is expressed as follows;

Cash flow from operations = Net profit after taxes + Noncash charges

(This value is only approximate, because not all sales are made for cash and not
all expenses are paid when they are incurred.)

Note that a firm can have a net loss (negative net profits after taxes) and still have
positive cash flow from operations when noncash charges (typically depreciation)
during the period are greater than the net losses. In the statement of cash flows,
net profit / losses after taxes and noncash charges are therefore treated as separate
entries.
Depreciation and other noncash charges shield the firm from taxes by lowering
taxable income.
Some people don’t define depreciation as a source of funds; however, it is a
source of funds in the sense that it represents a “nonuse” of funds.
3. Because depreciation is treated as a separate source of cash, only gross rather than
net changes in fixed asset appear on the statement of cash flows. This treatment
avoids the potential double counting of depreciation.
4. Direct entries of changes in Retained earnings are not included on the statement
of cash flows. Instead, entries for items that affect retained earnings appear as net
profit or loss after taxes and dividend paid.

Benefits of Cash flow Statement:

1. CFS provides a tool to evaluate liquidity, solvency, and financial stability of an
entity.
2. CFS presents a detailed summary of cash inflows and cash outflows, the data
that is not directly provided by Balance sheet and Income statement.
3. CFS serves as an indicator of amount, timing and extent of future cash flows.
4. CFS facilitates comparability as the reporting is standardized. Emphasizes the
qualitative aspect of the profit i.e. what portion of profit represents cash inflows.
 Developing the Statement of Cash flows

Statement of cash flow can be developed in five steps:

Step 1:
Calculate the balance sheet changes in assets, liabilities, and stockholders’ equity
over the period of concern.(note: Calculate the gross fixed assets changes for the
fixed asset account along with any changes in accumulated depreciation.)
Step 2
Classify each change calculated in Step 1 as either a source (S) or a use (U).

• (Note: An increase in accumulated depreciation would be classified as a source,

whereas a decrease in accumulated depreciation would be a use. Changes in
stockholders’ equity accounts are classified in the same way as changes in
liabilities—increases are sources, and decreases are uses.)

Step 3
Separately sum all sources and all uses found in steps 1 and 2. If this statement is
prepared correctly, total sources should equal total uses.

Step 4
• Net profits after taxes; typically can be taken directly from the income statement.
• Depreciation can also be taken directly from the income statement.
• Dividends may have to be calculated by using the following equation:
 Dividends = net profits after taxes – change in retained earnings

The change in retained earnings can be found in the statement of sources and uses of
cash or can be calculated by using the beginning- and end –of- period balance
sheets.
The dividend value could be obtained directly from the statement of retained
earnings, if available.
Step 5
Classify relevant data into one of three categories:
1. Cash flow from operating activities.
2. Cash flow from investment activities
3. Cash flow from financing activities

Categories and Sources of data included in the Statement of cash Flows

Cash flow from Operating Activities:

Net Profit/Loss after taxes I/S
Depreciation and other noncash charges I/S
Change in all Current Assets other than cash and marketable Securities U/S
Change in all current Liabilities other than Noted Payable U/S
Cash flow from Investing Activities:
Change in Gross Fixed Assets U/S
Change in Business Interests U/S
Cash flow from financing Activities:
Change in Note Payable U/S
Change in long term debt U/S
Change in stockholders’ equity other than retained earnings U/S
Dividend Paid I/S

-----------------------------------------------------------------------------------------------------------
-
Cash flow from operating activities
Operating Profit XXXX
Add: noncash items
Depreciation XXX
Depletion XXX
Amortization XXX
Add:
Loss on sale of Fixed Assets XXX
Loss on sale of stock / debenture XXX XXXX
Less:
Gain on sale of Fixed assets (XX
X)
Gain on sale of investment (XX XXXX
X)
Add/ Less:
Change in all current Assets other than cash and XXX
Marketable Securities
Change in all current liabilities other than note XXX XXXX
payable
Return on investment and servicing of finance
Dividend Received XXX
 Interest received XXX
Interest paid XXX
Net cash inflows from return on investment and XXXX
servicing of finance
Net cash inflow from operating activities $XXXX
Taxation:
Corporate tax paid (Including advance corporation XXX XXXX
tax)
Net cash flow from operations:

Investing Activities:
Payment to acquire intangible fix assets XXX
Payment to acquire tangible fix assets XXX
Receipts from sale of tangible fix assts XXX
Fire Insurance claims XXX
Net cash flow from investing activities: XXXX

Financing Activities:
Issue of ordinary share capital XXX
Repurchase of debentures loan (XXX)
Expenses paid in connection with share issues (XXX)
Dividend Paid (XXX)
Borrow of Loan from Public XXX
Net cash inflow / (outflow) from financing XXXX
Increase in cash and cash equivalents XXXX

XYZ
Income Statement
For the year ended, 2004

Sales revenue 000 000

Less: cost of goods sold $1700
Gross profits 1000
Less: Operating expenses $700
Selling expense $80
General and administrative expense 150
Depreciation expense 100
Total operating expense 330
Operating profits $370
Less: Interest expense 70
Net profits before taxes $300
Less: Taxes (rate = 40 %) 120
Net profits after taxes $180
Less: Preferred stock dividends 10
Earnings available for common stockholders $170
Earnings per share (EPS) $1.70

XYZ
Balance Sheet
For the year ended, 2004

December 31
Assets 2003 2004
Current Assets: 000 000
Cash $300 $300
Marketable securities $200 600
Accounts receivable $500 400
Inventories $900 600
Total current assets $1900 $2,000
Gross fixed assets (at cost)
Land and buildings $1050 $1,200
Machinery and equipment 800 850
Furniture and fixture 220 300
Vehicles 80 100
Other (includes certain leases) 50 50
Total gross fixed assets (at cost) $2200 $2,500
Less: Accumulated depreciation 1200 1300
Net fixed assets $1000 $1,200
Total assets $2900 $3,200
Liabilities and stockholders’ equity
Current liabilities
Accounts payable $500 $700
Notes payable 700 600
Accruals 200 100
Total current liabilities $1,400 $1,400
Long-term debt $400 $600
Total liabilities $1,800 $2,000
Stockholders’ equity
Preferred stock $100 $100
Common stock-- $ 1.20 per, 100,000 shares outstanding in
2003 and 2004. 120 120
Paid-in capital n excess of par on common stock 380 380
Retained earnings 500 600
Total stockholders’ equity $1,100 $1,200
Total liabilities and stockholders’ equity $2,900 $3,200

Solution:
XYZ Corporation Statement of Sources and Uses of Cash ($000) for the year ended
December 31, 2004.

(Step 1, 2 & 3)
Account Balance
Account December, 31 Change Classification
2004 2003 2004 -2003 Source Use
Assets
Cash 400 300 +100 100
Marketable Securities 600 200 +400 400
Account Receivable 400 500 -100 100
 Inventories 600 900 -300 300
Gross fixed assets 2500 2200 +300 300
Accumulated Depreciation 1300 1200 +100 100
Liabilities
Account Payable 700 500 +200 200
Notes Payable 600 700 -100 100
Accruals 100 200 -100 100
Long term debt 600 400 +200 200
Stockholder’s Equity
Preferred Stock 100 100 0
Common Stock 120 120 0
Paid-in-capital in excess of par 380 380 0
Retained earnings 600 500 +100 100
Total 1000 1000

Step 4:
Net profit after taxes and Depreciation, and dividend can be found in its financial
statements.
Net profit taxes $180,000
Depreciation 100,000

Dividend Paid = (Net profit after Taxes - ∆ in retained Earnings)

= (180,000 – 100,000) = 80,000

Step 5:
XYZ Corporation Statement of Cash flows ($000) for the year ended December 31,
2004
Cash flow from operating activities $000 &000
Net profit after taxes 180
Depreciation 100
Decrease in A/R 100
Decrease in inventory 300
Increase in Accounts Payable 200
Decrease in Accruals (100)
Cash provided by operating Activities &780
Cash flow from investment activities
Increase in Gross fixed Assets (300)
Change in Business Interests 0
Cash provided by Investment Activities (300)
Cash flow from Financing activities
Decrease in Notes Payable (100)
Increase in long term debt 200
Change in Stockholders’ Equity 0
Dividend Paid (80)
Cash flow from Financing activities 20
Net Increase in Cash and Marketable Securities $500

Retained earnings are excluded here, because their change is actually reflected in the
combination of “Net profit after taxes” and dividend entries.