Professional Documents
Culture Documents
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.
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.
Trend Percentage:
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.
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?
others
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
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
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.
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
Amity Directorate of Distance and Online Education
Accounting for Managers 85
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.
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
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.
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
Amity Directorate of Distance and Online Education
86 Accounting for Managers
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.
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
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
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
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.
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:
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.
Amity Directorate of Distance and Online Education
Accounting for Managers 89
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?
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.
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.
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
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
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.
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.
Turnover
Fixed Asset Turnover =
Fixed AsselS
Turnover
Current Asset Turnover =
Current Assets
Sales
Working CapitalTurnover =
Working Capital
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.
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.
We should expect, smaller than Gearing 1 and they are still, therefore, insignificant
by the end of the two years.
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 ,
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
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.
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 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.
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.
Here are the P/E ratios of five businesses in the Telecommunications sector:
Note:
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.
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-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.
7.14Summary
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.
6) One way to determine the number of days' sales in the average inventory is to
divide 360 by the inventory ratio.
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
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
Instructions
Compute the following listed ratios for 2006 showing supporting calculations.
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
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.
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
1. Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses
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.
Receipts for the sale of loans, debt or equity instruments in a trading portfolio
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:
Deferred tax
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)
Payments of dividends
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.
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.
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
1. Revenue.
Jan Feb War
Revenu
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
'2ill r elftlla.w"' 5
BOO 1800 2800
Expenses
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
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.
Revenu
Debtors Pavments
0 600 850
Expenses
Rates lO lO lO
Eleciricit'y 60 60 60
+ravelling 80 80 150
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.
Revenu
Notes
Cash Sales 600 1200 1750
Expenses
Electricity 60 60 60
+ravelling eo eo 150
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
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:
Taxes paid:
Tax expense per the income statement
Plus beginning balance in taxes payable
Minus ending balance in taxes payable
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
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:
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.
lnieresipai (2,000)
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.
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:
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.
.. .
., "
(4,035,000) (3,724,000) (3,011,000)
r-
Vt>tJOO<." <:>AtJ<:>OOUOOU O <;>->
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)
"'"'' ;,.. '""''"' ..... """''"' a,.aonnn a..A .::117 nnn a.. Al\7 nnn
equivalents
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.
a)
b)
c)
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) Why were the net current assets of the firm down, though the net income was
up or vice versa?
(c) How was the sale proceeds of plant and machinery used?
(d) How was the sale proceeds of plant and machinery used?
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.
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.
1. Funds Flow Statement is concerned with all items constituting funds (Working
Capital)for the business while Cash Flow Statement deals only with cash
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.
1. Report Form
Funds Flow Statement
For the year ending 31st march, 2008
Total
Application of fl.!n s:
Total
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
(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.
i. Depreciation an Depletion
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.
(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'.
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.
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
2. The Fund Flow Statement is prepared just to judge the .... of the business.
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 .
Further Readings
1. Accounting Principles . Robert N Anthony.
6. Cost Accounting : lall, B. M. and I.C. Jain : Principles and Practice, Prentice Hall of
India, Delhi.