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Statements of cash flows

Analysis & Interpretation

Problems & Solutions
Review Questions Ch 05
Alternative formats.

1. Indirect
Net Income
Adjustments to reconcile
net income to net cash:
(Increase) in receivables
Decrease in inventory
(Decrease) in payables
Net cash provided by
operating activities

ABC Company, Inc., and Subsidiaries

Cash Flow Statement
12 Months Ended December 31, 2003
2. Direct
Cash received from customers $400,000
Cash paid to suppliers
Cash paid to employees
Other cash operating
Net cash provided by
operating activities
$ 40,000

As direct method shows, the cash flow statement shows where the receipts and
payments of cash have come from/gone to. This information is not disclosed
in the other statements.
The indirect method discloses information about a companys working capital
but this can also be obtained from the other statements.
When using the direct method, accountants record transactions by the type of
activity. The operations section includes payments made by customers who
purchased on credit, cash sales of merchandise or services to clients, payments
made to vendors, employee wages, advertising, income tax payments and
interest that the company paid on its loans. Non-accounting managers may
find it easier to interpret data on a cash flow statement prepared by the direct

The direct method requires companies to collect additional information about

its activities and so is more informative of a companys position especially
with regard to its liquidity.


Only if the negative cash flows occur regularly and the positive flows are not
large enough to cover the shortfalls over the medium- to long-term

Ch 05 - Question 1 Direct plc
Extract from statement of cash flows for the year ended 30 September
Cash flows from operating activities
Cash received from customers (316,000 + 2,000 1,600)
Cash paid to suppliers (110,400 800 2,400)
Cash paid for other expenses
Cash paid for rent (14,400 + 1,200)
Cash paid for advertising (4,800 400)
Cash paid for interest (320 40)

China Trading Company
Statement of Cash Flows
for the year ended 31 August 20X9
Operating activities
Cash was provided from:
Cash from customers
Interest received
Cash was applied to:
Payment to suppliers
Payment to staff
Other operating expenses
Net cash flow operating activities
Investing activities
Cash was provided from:
Sale of surplus office equipment
Cash was applied to:
Purchase of Ford van
Net cash flow investing activities
Financing activities
Cash was provided from:
Funds from owner
Loan from owner
Cash was applied to:
Net cash flow financing activities
Net change in cash held
Opening cash held
Closing cash held






The recording of transactions to determine a profit or loss for a period is based
on accrual accounting the matching of revenues and expenses. Cash flow is
concerned with when cash receipts and cash payments are made and not the
underlying transaction.
You should advise Freddie to examine the cash tied up in his working capital (i.e. his
current assets and liabilities). He may find that he has a significant amount of
inventory that he has paid for, but has not been sold. He may also have a healthy sales
figure but may not have collected debts from customers, thus increasing cash tied up
in accounts receivable. He should also examine the timing of when he pays his own
suppliers (accounts payable). Apart from working capital, Freddie may have bought
new equipment or repaid a loan. An examination of a statement of cash flows will
answer these sorts of questions for Freddie.

Ch 05 - Question 7 Maytix p.129

(b) Using the direct method of presentation would result in the loss of the details of
movement on working capital and other non-cash adjustments but would provide
details of
Cash receipts from customers,
Cash paid to suppliers and employees.
This would be more useful information for certain users of financial statements, in
particular, parties who trade with the organisation as suppliers or customers, and may
also be more useful to employees. Investors may also find this presentation more
useful in assessing future cash flows. To aid these users, it may be more appropriate to
have separate figures for cash paid to customers and cash paid to employees. The
latter would certainly gain from any segmentation of this figure.
While appearing to be beneficial, this form of financial reporting is generally
considered in businesses to be market sensitive providing too much information for
current and potential competitors. The method also requires a considerable amount of
analysis by large groups of companies. So, while IAS 7 encourages the use of the
direct method, and the IASB has also contemplated making it compulsory, there is at
present, no requirement to use it.


Review Questions Ch 27
see p.681
see p.681
A potential ordinary share is a financial instrument or other contract
that may entitle its holder to ordinary shares. They relate to the
situation where a company may have convertible bonds, warrants or
share options on issue. These issues can be converted at some future
time into ordinary shares, so until they are converted, they represent
potential ordinary shares.
see p.682
2. Issues at full market value provide funds that can be used to increase future
earnings. With a rights issue, part of the issue is similar to a bonus issue which
does not provide additional funds to assist future earnings. Therefore, the nonfunding part of the issue needs to be addressed separately when calculating the
EPS figure.
3. Managers engage in income smoothing activities because they know that
volatile earnings streams usually lead to lower market valuations.
Examples of income smoothing techniques include:
deferring revenue during a good year if the following year is expected to be a
challenging one,
delaying the recognition of expenses in a difficult year because performance is
expected to improve in the near future,
Changing the way depreciation is charged, or inventories are valued.
4. The EPS is calculated by dividing the total earnings by the total number of
shares (earnings per share.) The PE ratio is the price per share divided by the
earnings per share. The PE is a good measure of value as it indicates how
much investors are willing to pay per dollar of earnings for the share.
However, it is only useful for comparing companies in the same industry.


Ch27 Question 1 Alpha plc p.699

Review Questions Ch 28
(a) Uses see p.708 making comparisons to assess efficiency and
effectiveness of company operations and between companies
Limitations see p.726
(b)(i) EBIT/Sales, Return on equity, Return on capital employed
(ii) Current ratio, liquidity ratio
(iii) Asset utilisation inventory turnover, total asset turnover, accounts
receivable turnover
(c) Accounting policies used, changes in policies, relationship between
components of the ratio
2. When comparing different companies within an industry, in particular, it is
essential that there is commonality between the companies. If they use
different depreciation methods, there may be different tax benefits. By using
EBITDA, these differences are removed, so the resulting figures will give
more comparable ratios.
3. An increasing current ratio generally means current assets have increased. This
may be because of increased inventories (possibly caused by a slower
turnover), or increased accounts receivable (slower collection of amounts
owing by debtors). Both of these suggest less efficient control of working

Ch 28 Question 4 Saddam Ltd p.734

(a) Profitability ROCE

Camel Ltd is the most profitable of the three companies.
An inspection of the secondary ratios shows that this is due to efficient
utilisation of assets since its net profit ratio is well below that of the other two
Examination of gross profit percentages confirms the observation that Camel
Ltd seems a high volume, low margin business compared to the others.
Ali Ltd has a current ratio that is out of line with the other two, being very
much higher, suggesting surplus investment in working capital.
The acid test ratio reinforces this view, and also indicates that Baba Ltd
appears to have a liquidity problem with current liabilities considerably
greater than cash and debtors (despite having the greatest number of weeks
debtors outstanding of the three companies).
Baba Ltd also has considerably more weeks of stock outstanding than the
other two companies which may be linked with the high level of creditors.
Ali Ltd also has stock levels well in excess of Camel Ltd explaining, in part
at least, the high current ratio.
Camel Ltd is paying out a higher proportion of profits in dividends, which
may have the effect of raising shareholder loyalty and the bid price.

Baba Ltd appears to have considerable liquidity problems arising out of

excess investment in stock.
Camel Ltd is a lean enterprise which is able to survive on a lower gross profit
margin because of superior asset utilisation. Why is the gross profit margin
Before a final decision is made, the absolute figures in the financial statements
should be studied and questions raised such as the following:
Are the activities of the firms really the same?
What are the relative turnovers?
What is the growth over a period of years?
What are the trends of all the ratios?
How old are the assets?
Are asset ages distorting ROCE comparisons between the companies?

Also, managerial skills, product potential, etc. have to be assessed, which are not
shown in the financial statements.
(b) Why the statement of financial position is unlikely to show the true market
value of the business
The accounting policy in the United Kingdom is to state fixed assets at cost less
depreciation or at historical cost (HC) modified by revaluation of all or selected
classes of fixed assets.
The true market value of a listed company is available from the market capitalisation
figure based on current share prices.
The true market value of an unquoted company is not readily available and would
require future cash flows to be evaluated.
Ch 28 Question 7 Euroc Ltd p.736
SUBJECT: Financial performance of Choggerell
The following report is based on a series of financial ratios calculated from the
financial statements of Choggerell for the financial years 2006, 2007 and 2008.
The overall performance of Choggerell as evidenced by its return on equity has
There was a significant improvement from 2006 (13%) to 2007 (22%) due to
improvements in profitability on trading (net income to sales revenue).
That improvement in overall efficiency was not maintained in 2008 and return on
equity declined to 19%. This time the decrease was due to a significant decline in
assets utilisation which is now at its lowest for the 3-year period. Profitability on
trading was maintained although there was a marginal decline.
Earnings per share have followed a similar pattern to return on equity. There was a
very significant rise in earnings per share for 2007 but this was followed by a small
decline in 2008. Dividends per share, however, have been maintained in 2008 after a
significant increase in 2007.
Changes in the profitability on trading over the 3-year period seem to be attributable
to steadily increasing margins on sales (decreasing cost of sales relative to sales).

However, progress here seems to have been offset by increases in operating expenses
(operating expenses to sales revenue).
Control of working capital does not seem to have been optimal. The current and acid
test ratios have fluctuated but were the lowest for the 3 years in 2008. Stock turnover
has been falling for the past 3 years and the period of credit taken by customers has
increased significantly. This suggests possible liquidity problems, and there seems to
have been a significant overdraft at the end of 2006 and 2008. The period of credit
taken from suppliers has increased significantly in 2008 and is now an average of 2
months which may invite pressure from suppliers for faster payment.
The fall in efficiency in the use of assets to generate sales (sales revenue to total
assets) and the increasing net assets per share would therefore appear to be a result of
increasing non-current assets and possible poor working capital management.
Recommendations for improving the performance of Choggerell
The overall performance of Choggerell could be improved by
Better control of operating expenses. Reducing operating expenses would
increase profitability on sales and hence overall return on equity.
Careful monitoring of non-current assets utilisation. Increasing sales revenue
to non- current assets would increase sales revenue to total assets and hence
overall return on equity.
Careful cash flow management to avoid widely fluctuating cash balances and
the reliance on bank overdrafts.
It has been assumed that all the data is comparable; i.e. that similar accounting
policies have been used over the 3 years.
It has only been possible to look at trends within Choggerell over the past 3
years. It would be useful to compare Choggerells performance with its
competitors particularly the leading firms in the same industry sector with a
view to knowing what is achievable.
It would be useful to know more about the sector Choggerell operates in and
general economic conditions. This would help identify what changes are
attributable to changes in sector performance and general economic conditions
and changes attributable to good or bad management.
The available information is very limited. It would be useful to have additional
information about the quality of Choggerells management, its risk exposure
and the prospects for the industry sector
Review Questions Ch 29
1. You should be looking for comparable and consistent changes from year to
year in the components of the Balance Sheet. If there are any unusual changes,
the reasons should be ascertained and remedial action taken if necessary.
The capital structure of the company should also be carefully looked at to
ascertain whether debt or equity is the major funding source.
2. Are the companies in the same industry and undertaking similar types of
operation. Eg. Two companies in the transport industry one is an airline, the
other is a railway company. Their modes of operation are very different and so
the one could not be benchmarked against the other. Bench-marking

companies need to be operating in very similar fields to those of the

companies being compared to the bench-markers.
3. See p.754, 758/9
Ch 29 Question 2 Amalgamated Engineering p.774

(c) Main points in the report should cover the following. Most important points are
marked with an asterisk
*Given unchanged sales volume (cannot tell from HC accounts without date
on specific price movements), price rises have been below the level of general
inflation (4.8%). Is this deliberate policy or just poor management? If
deliberate, it appears not to have improved sales.
Cost of materials and labour also increased below the level of inflation (5%
and 5.6% respectively).
More efficient use?
Overheads increased by 10% in line with inflation (both production and
administrative) led to falling margins (gross and net). Further information by
product might help see if one particular area is a problem or if it is right
across the board.
Increased interest has caused profit before tax to fall by 20% although interest
cover still looks ok. (Is this relevant? Interest is paid from cash.)
*Trends are worrying falling margins and rising interest seem to indicate
problems in the near future. How long can the firm continue to hold the
dividend? (Need more years data long-term picture. Is this a recent trend or
Working capital rising trade receivables and inventories are up a lot.
*Reflected in worsening liquid ratio quite a large fall. (Again, need more
years data. What is norm?)
*Inventory turnover is getting worse 3.85 months inventory on hand (20X5
3.06). Need more information here slow-moving inventory? Or is it just poor
management of working capital?

*Trade receivables turnover ratio has got worse (20X5 7.64; 20X6 5.87). In
their state they need to be collecting more quickly. Is there one or a few debts
causing this, or is it general sloppiness?
Flow of funds company is investing in new equipment, and so is presumably
not contracting operations. Need information as to the use the equipment is
being put to, and future capital expenditure plans.
*Purchases of assets (+ payment of tax + dividend) have been partly paid for
by selling off short-term investments. This is a one-off instance a bad sign.
Could use previous 5 years funds flow statements trends quite important.
*The increased overdraft is financing the increased stocks and debtors.
Gearing ratio is OK but the problem at the moment is one of liquidity.
Could argue that the overdraft appears to be a permanent feature of this firm.
The gearing ratio looks worse if the overdraft is included (+ an overdraft of
1,500,000 makes it look even more unhealthy). (Gearing ratios calculated
using book values may not be too useful could recalculate using market
values of debt and equity, where quoted.)
General points
*Why does the firm want to increase the overdraft? Seems to be to finance
working capital. Could be risk for the bank if the firms profitability is in a
long-term decline. (Does not mean dont lend could charge more interest.)
*Or could secure the overdraft market value of the land and buildings is well
in excess of the debentures.
*How will the firm pay off the overdraft? Need to ask for cash forecasts for
next few years (firm should have if not, poor management). Historical cost
accounts are generally of little help with respect to forward-looking data.
More data on management. Old, young? Likely to let firm stagnate? Also,
need to see strategic plans in what direction is the firm going? Do they
(d) Response to director
(i) Debt Service Coverage Ratio
This ratio requires the figures for interest, tax, depreciation and amortisation
charge to calculate EBITDA.
The ratio gives the bank an indication of the companys ability to meet its
capital debt repayments as well as annual interest payments from its cash flow
from operations.
(ii) Cash flow from operations to current liabilities
This ratio requires the cash flow from operations to figure in the cash flow
The ratio gives additional information to the current and acid test ratios that
are static in the sense that both the numerators and denominators are based on
year end figures that are capable of manipulation or management, e.g. running
down stocks or exceptional cash receipts at the year end.
(iii) Cash recovery ratio
This ratio requires the figures for cash flow from operations, and proceeds
towards sale of fixed assets from the cash flow statement.

The ratio gives an indication of the payback time, i.e. how quickly the
company will recoup its investment in fixed assets from its cash flow. The
manager would naturally regard a shorter period as less risky.

Handout Exercise 5 Wholesale Distributors Ltd p.323
The answer should be set out in the form of a report to the Directors of Wholesale
Distributors Ltd, and include the following:
a Comments on operating results:
Improvement in level of sales and gross profit margin comments on possible
reasons for this such as more efficient buying power and/or changed sales mix.
Control of expenses differentiate between levels of fixed and variable
expenses in each category.
Improvement in net profit returns against sales, assets and equity.
b Comments on financial position:
Improved working capital, but current ratio has fallen and liquidity ratio barely
altered why might this be?
Changes in average collection period and average payments period both
deteriorated. Possible causes of this, and adverse effects to company e.g.
credit ratings
Inventory turnover has declined.
Indication of what the levels of accounts receivable, accounts payable and
inventories should be if past trends had been maintained and how a return to
these levels would affect liquidity and working capital.
Age of non-current assets are these coming to the end of their economic
lives? Does this affect capacity and ability to achieve future sales etc. goals?
c Recommendations:
Tighten credit policy and collection methods.
Reduce inventories
Improve payments processes and reduce reliance on short-term financing.