Chapter 3

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW

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OUTLINE Balance Sheet

Profit and Loss Account

Finance Topics Statement of Cash Flows Manipulation of Bottom Line Taxes

Free Cash Flow

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IMPORTANT QUESTIONS
Managers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm:
What is the financial position of the firm at a given point of time?
How has the firm performed financially over a given period of time? What have been the sources and uses of cash over a period of time?

The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions
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BALANCE SHEET

Horizontal Form
Liabilities + Equity Assets
Fixed assets
Investments Current assets, loans and advances Current assets

Share capital
Reserves and surplus Secured loans Unsecured loans Current liabilities and provisions

Current liabilities
Provisions

Loans and advances

Miscellaneous expenditures and losses

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BALANCE SHEET

Vertical (or Report) Form

I. Sources of Funds (1) Shareholders funds: (a) Capital (b) Reserves and Surplus (2) Loan funds: (a) Secured loans (b) Unsecured loans

II. Application of funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses
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BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

A. Account Form Liabilities Share capital Equity 20 x 1 15.00 15.00 20 x 0 15.00 15.00 Assets Fixed assets Investments Rs.in crore 20 x 1 33.00 1.00 20 x 0 32.20 1.00

Preference Reserve & surplus Secured loans Unsecured loans Current liabilities and provisions

11.20 14.30 6.90

10.50 57.90

10.60 13.10 2.50

8.10 49.30

Current assets, loans and advances 23.40 Miscellaneous expenditures and losses 0.50

15.60 0.50

57.90 49.30

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BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

Rs.in million

20 x 1 I. Sources of Funds (1) Shareholders funds: (a) Share capital (b) Reserves and surplus (2) Loan funds: (a) Secured loans (b) Unsecured loans

20 x 0

26.20
15.00 11.20 21.20

25.60

15.60

14.30 6.90
47.40 41.20

II. Application of Funds (1) Fixed assets (2) Investments (3) Current assets, loans and advances

Less: Current liabilities and provisions: Net current assets (4) Miscellaneous expenditures and losses

33.00 1.00 23.40 57.40 10.50 12.90 0.50 47.40

32.20 1.00 15.60 48.80 8.10 40.70 0.50 41.20

LIABILITIES Share Capital

Reserves & Surplus

Secured Loans Unsecured Loans Current Liabilities and Provisions
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ASSETS Fixed Assets Investments Current Assets, Loans, & Advances Miscellaneous Expenditure & Losses

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PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs.in crore) Income Sales Other income (loss) Expenditure Material and other expenditure Interest Depreciation Profit before tax Provision for tax Profit after tax Prior period adjustments Profit available for appropriations Appropriations Balance carried forward
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70.1

70.1

58.2 2.1 3.0 6.8 3.4 3.4 0.8 4.2 3.5 0.7

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs. in crore)
Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Depreciation General administration Selling Operating profit Non-operating surplus/deficit Profit before interest and tax Interest Profit before tax Provision for tax Current tax Deferred tax Profit after tax Prior period adjustments Amount available for appropriation Appropriations Balance carried forward 20 x 1 70.1 55.2 20 x 0 62.3 47.5

42.1 6.8 6.3

14.9 6.0 3.0 1.2 1.8 8.9 8.9 2.1 6.8 3.4 2.1 1.3 3.4 0.8 4.2 3.5 0.7 9.9 0.6 10.5 2.2 8.3 4.1 2.9 1.2 4.2 0.7 4.9 4.0 0.9 14.8 4.9

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PROFIT AND LOSS ACCOUNT ITEMS

Net Sales Cost of Goods Sold Gross Profit Operating Expenses Operating Profit Non-operating Gains and Losses

Profit Before Interest and Taxes

Interest Profit before Tax Income Tax Provision Profit After Tax Prior Period Adjustments Amount Available for Appropriation Appropriations Balance Carried Forward
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BALANCE SHEET AND FINANCE TOPICS

Share capital Equity Preference Reserves and surplus Secured loans Debentures Loans and advances Unsecured loans Current liabilities and provisions Trade creditors Provisions Fixed assets (net) Gross block Less: depreciation Investments Current assets, loans and advances Cash and bank Receivables Inventories Miscellaneous expenditure and losses Capital structure and cost of capital

Working capital financing policy

Capital budgeting Portfolio management

Cash management Credit management Inventory management

PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS

Net sales Cost of goods sold Stocks Wages and salaries Other manufacturing expenses Gross profit Operating expenses Selling and administration expenses Depreciation Operating profit Non-operating surplus/deficit Earnings before income and tax
Interest Profit before tax Tax Profit after tax Dividends Retained earnings Revenue risk

Gross profit margin

Depreciation policy

Business risk Financial risk

Tax planning
Return on equity Dividend policy

STATEMENT OF CASH FLOWS

Operating Cash inflows from operations

Cash outflows from operations

Cash flow from operations

+

Investing

Cash inflows from investing activities

Cash outflows from investing activities

Cash flow from investing activities +

Financing

Cash inflows from financing activities

Cash outflows from financing activities

Cash flow from financing activities = Net cash flow for the period

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CASH FLOW STATEMENT

LIABILITIES
CAPITAL RESERVES & SURPLUS

ASSETS
FIXED ASSETS

INVESTMENTS LOANS INVENTORIES CURRENT LIABILITIES AND PROVISIONS DEBTORS

CASH
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SOURCES
FINANCING
OPERATING FINANCING OPERATING

USES
CAPITAL
RES. & SURPLUS LOANS CURRENT LIABILITIES & PROVISIONS FIXED ASSETS INVESTMENTS INVENTORIES DEBTORS

CAPITAL
RES. & SURPLUS LOANS CURRENT LIABILITIES & PROVISIONS FIXED ASSETS INVESTMENTS INVENTORIES DEBTORS

INVESTMENT INVESTMENT OPERATING OPERATING

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CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD 1.4.20X0 TO 31.3.20X1
(Rs. in crore) (A) Cash Flow from Operating Activities Net profit before tax and extraordinary items Adjustments for Interest paid Depreciation Operating profit before working capital changes Adjustments Debtors Inventories Advances Trade credit Advances Provisions Cash generated from operations Income tax paid Cash flow before extraordinary items Extraordinary item Net cash flow from operating activities 6.8 2.1 3.0 11.9 (4.6) (3.3) 0.5 1.5 0.7 0.2 6.9 (3.4) 3.5 3.5 (Contd.)
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(Contd.) (Rs.in crore) (B) Cash Flow from Investing Activities Purchase of fixed assets Net cash flow from investing activities (C) Cash Flow from Financing Activities Proceeds from term loans Proceeds from inter-corporate deposits 1.2 4.4 (3.8) (3.8)

Interest paid
Dividend paid Net cash flow from financing activities

(2.1)
(2.8) 0.7

(D) Net Increase in Cash and Cash Equivalents

Cash and cash equivalents as on 1.04.20x0 Cash and cash equivalents as on 31.03.20x1

0.4
0.6 1.0

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MANIPULATION OF THE BOTTOM LINE

1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE FOLLOWING YEAR 2. ALTER THE OTHER INCOME FIGURE BY PLAYING WITH NON-OPERATIONAL IETMS 3. FIDDLE WITH THE METHOD & RATE OF DEPRN 4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR. 5. MAKE INADEQUATE PROVISIONS . . LIABILITIES 6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS 7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES. 8. REVALUE ASSETS . . CREATE . . IMPRN . . RESERVES 9. LENGTHEN ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE. WHY ? PROJECT IMAGE OF LOW RISK PROMOTE PERCEPN . . COMPETENT MGT INCREASE MGRL COMPENN QUALITY PROMPTNESS

OF
REPORTING

CANDOUR IN ANALYSING PAST PERFORMANCE

MEANINGFUL DISCUSSION . . PROSPECTS Centre for Financial Management , Bangalore

TAXES Taxes may be divided into two broad categories : direct

taxes and indirect taxes.

A tax is a direct tax if the impact and incidence of the tax

is on the same person. Example : Income tax

A tax is an indirect tax if the impact is on one person but through the process of shifting the incidence is on another. Example : Excise duty

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CORPORATE INCOME TAX

A companys taxable income is determined by taking into account its revenues, expenses, and deductions on account of various incentives and reliefs. The taxable income is subject to a tax rate of 35 percent for domestic companies and 40 percent for foreign companies. While computing the taxable income, among other things, bear in mind the provisions relating to the following depreciation, interest expense, dividend payment, dividend income, unabsorbed business loss and depreciation, exemptions and deductions, minimum alternate tax, and advance tax.
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CORPORATE INCOME TAX 1. Depreciation is charged on blocks of assets which represent a group of assets within the broad class of assets such as buildings, plant, machinery, and furniture, for which a common rate of depreciation is applicable.

2. While interest on borrowings is a tax-deductible expense, dividend on share capital is not. 3. Unabsorbed business loss of any year can be carried forward and set off against income under the head of business of subsequent years.

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CASH FLOW SUMMARY

A. The cash flow identity Cash flow from assets = Cash flow to lenders + Cash flow to shareholders B. Cash flow from assets Cash flow from assets = Operating cash flow Net capital spending Change in net working capital where Operating cash flow Capital spending = PBIT Taxes + Depreciation = Ending net fixed assets Beginning net fixed assets + Depreciation Change in net working capital = Ending net working capital Beginning net working capital C. Cash flow to lenders Cash flow to lenders = Interest paid Net new borrowing D. Cash flow to shareholders Cash flow to shareholders = Dividends paid Net new share capital raised
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SUMMING UP
The balance sheet shows the financial position (or condition) of a firm at a given point of time. It provides a snapshot and may be regarded as a static picture. The income statement (referred to in India as the profit and loss account) reflects the performance of a firm over a period of time. The cash flow statement portrays the flow of cash through the business during a given accounting period.
Assets are classified into following categories : (i) fixed assets, (ii) investments, (iii) current assets, loans and advances, and (iv) miscellaneous expenditures and losses. Liabilities are classified into the following categories : (i) share capital, (ii) reserves and surplus, (iii) secured loans, (iv) unsecured loans, and (v) current liabilities and provisions.

The important items in the profit and loss account are: (i) net sales, (ii) cost of goods sold, (iii) gross profit, (iv) operating expenses, (v) operating profit, (vi) non-operating surplus/deficit, (vii) profit before interest and tax, (viii) interest, (ix) profit before tax, (x) tax and (xi) profit after tax.
The important topics in finance can be keyed to the balance sheet and the profit and loss account.
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 From a financial point of view, a firm basically generates cash and spends cash. The activities that generate cash are called sources of cash and the activities that absorb cash are called uses of cash. Increase in owners' equity and liabilities and decrease in assets represent sources of cash. Decrease in owners equity and liabilities and increase in assets, on the other hand represent uses of cash. To understand how cash flows have been influenced by various decisions, it is helpful to classify cash flows into three categories: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Corporate managements have discretion in influencing the occurrence, measurement and reporting of revenue, expenses, assets and liabilities. They may use this latitude to manage the bottom line. Taxes can be one of the major cash outflows for a firm. The magnitude of the tax burden is determined by the tax code, which is subject to change.

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 Taxes may be divided into two broad categories: direct taxes and indirect taxes. A tax is referred to as a direct tax if the impact and incidence of the tax is on the same person. Income tax, wealth tax, and gift tax are examples of direct taxes. A tax is regarded as an indirect tax if the impact and incidence of the tax is on different persons. Excise duty, sales tax, and customs duty are the three important indirect taxes. We have a balance sheet identity which says that the value of a firm's assets is equal to the value of its liabilities plus the value of its equity. In the same manner we have a cash flow identity which says that : Cash flow from assets = Cash flow to lenders + Cash flow to shareholders

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