Financial Management-Tenth Edition

CHAPTER 24

FINANCIAL STATEMENTS AND CASH FLOW ANALYSIS

Chapter Objectives

• Introduce financial statements—balance sheet and profit and loss account

• Distinguish between accounting profit and economic profit
• Discuss the meaning of funds flow and working capital flow
• Highlight the need for analyzing the changes in a firm's funds and cash flow
position
• Explain the mechanism of preparing funds flow and cash flow statements
• Emphasize the need and utility of preparing a comprehensive statements of
financial position that explains changes in cash flow from operations, investment
activities and financing activities

Chapter At A Glance

• Balance sheet is a statement of a firm’s assets, liabilities and equity on a specific

date. Assets are economic resources that help generate revenues. Liabilities are
the firm’s obligations to creditors. Equity is the investment made by owners in the
firm.

• Both the balance sheet and the profit and loss statement do not explain the
changes in assets, liabilities and owner’s equity. The statement of changes in
financial position is prepared to show these changes. Two common forms of such
statement are: (a) the funds flow statement, and (b) the cash flow statement.

• The term “fund” can be defined at least in three ways: It may mean (i) cash, (ii)
working capital (the difference between current assets and current liabilities) or
(iii) financial resources (arising from both current and noncurrent items). The
funds flow statement provides an analysis of changes in the firm’s working capital
position. The cash flow statement is prepared to analyse changes in the firm’s
Financial Management-Tenth Edition

cash position. Both these statements can be recast to incorporate additional

financial information that does not affect cash or working capital but influences
the financing and asset mix of the firm.

• The main source of funds—working capital or cash—is the firm’s operations.

Funds from operations are calculated by adjusting the figure of net profit for non-
fund or non-cash items such as depreciation. Depreciation is added to net profits
to arrive at funds from operation. To determine cash from operations, changes in
current assets and current liabilities are also adjusted in net profits. Increase in
current assets and decrease in current liabilities reduce cash while decrease in
current assets and increase in current liabilities increase cash.

• Other sources of working capital or cash include sale of fixed assets, issue of
share capital and borrowings. The typical examples of uses of funds are
acquisition of fixed assets, repayment of debt and payment of cash dividend.

• Funds flow and cash flow statement are important managerial tools for financial
analysis. They help the firm to know its liquidity position, capital expenditures
incurred, dividend paid and extent of external financing. A projected funds or
cash flow statement guides the firm to plan the matching of inflow and outflow of
funds or cash.

Key Concepts

Assets Fixed assets Retained earnings

Balance sheet
Cash flow statement
Current assets
Current liabilities
Equity
Financial resources
Funds flow
Funds flow statement
Funds from operation
Liabilities
Profit and loss statement
Redeemable preference
shares
Statement of changes in
financial position
Working capital flow
Working capital from
operation