Ratio Analysis:

Analysis of Fin Statements II

Financial Analysis
 Assessment of the firm’s past, present and future financial conditions
 Done to find firm’s financial strengths and weaknesses
 Primary Tools:
 Financial Statements
 Comparison of financial ratios to past, industry, sector and all firms
Financial Statements

Balance Sheet
Income Statement
Cashflow Statement
Statement of Retained
Earnings
Objectives of Ratio Analysis
 Standardize financial information for comparisons
 Evaluate current operations
 Compare performance with past performance
 Compare performance against other firms or industry standards
 Study the efficiency of operations
 Study the risk of operations
Ratio Analysis
Ratio Analysis

1. Liquidity – the ability of the firm to pay its way

2. Investment/shareholders – information to enable
decisions to be made on the extent of the risk and
the earning potential of a business investment
3. Gearing – information on the relationship between
the exposure of the business to loans as opposed to
share capital
4. Profitability – how effective the firm is at generating
profits given sales and or its capital assets
5. Financial – the rate at which the company sells its
stock and the efficiency with which it uses its assets
Liquidity
Acid Test
 Also referred to as the ‘Quick ratio’
 (Current assets – stock) : Curr. liabilities
 1:1 seen as ideal
 The omission of stock gives an indication of the cash the firm
has in relation to its liabilities (what it owes)
 A ratio of 3:1 therefore would suggest the firm has 3 times as
much cash as it owes – very healthy!
 A ratio of 0.5:1 would suggest the firm has twice as many
liabilities as it has cash to pay for those liabilities. This might
put the firm under pressure but is not in itself the end of the
world!
Current Ratio
 Looks at the ratio between Current Assets and Current
Liabilities
 Current Ratio = Current Assets : Current Liabilities
 Ideal level? – 1.5 : 1
 A ratio of 5 : 1 would imply the firm has £5 of assets to cover
every £1 in liabilities
 A ratio of 0.75 : 1 would suggest the firm has only 75p in
assets available to cover every £1 it owes
 Too high – Might suggest that too much of its assets are tied up
in unproductive activities – too much stock, for example?
 Too low - risk of not being able to pay your way
Investment/Shareholders
 Investment/Shareholders
 Earnings per share – profit after tax / number of shares
 Price earnings ratio – market price / earnings per share –
the higher the better generally for company. Comparison
with other firms helps to identify value placed on the
market of the business.
 EV / EBITDA Ratio - Enterprise Value / EBITDA ratio - the
higher the better generally for company . It measures the
operational performance of the firm.
 Dividend yield – ordinary share dividend / market price x
100 – higher the better. Relates the return on the
investment to the share price.
Gearing
Gearing

 Gearing Ratio = Long term loans / Capital employed x

100
 The higher the ratio the more the business is exposed to
interest rate fluctuations and to having to pay back
interest and loans before being able to re-invest
earnings
Profitability
Profitability

 Profitabilitymeasures look at how

much profit the firm generates from
sales or from its capital assets
 Different measures of profit – gross
and net
 Gross profit – effectively total revenue
(turnover) – variable costs (cost of sales)
 Net Profit – effectively total revenue
(turnover) – variable costs and fixed costs
(overheads)
Profitability

 Gross Profit Margin = Gross profit /

turnover x 100
 The higher the better
 Enables the firm to assess the impact
of its sales and how much it cost to
generate (produce) those sales
 A gross profit margin of 45% means
that for every £1 of sales, the firm
makes 45p in gross profit
Profitability
 Net Profit Margin = Net Profit / Turnover x 100
 Net profit takes into account the fixed costs
involved in production – the overheads
 Keeping control over fixed costs is important – could
be easy to overlook for example the amount of
waste - paper, stationery, lighting, heating, water,
etc.
 e.g. – leaving a photocopier on overnight uses enough electricity
to make 5,300 A4 copies. (1,934,500 per year)
 1 ream = 500 copies. 1 ream = £5.00 (on average)
 Total cost therefore = £19,345 per year – or 1 person’s salary
Profitability

 Return on Capital Employed (ROCE) = Profit / capital

employed x 100
Profitability

 The higher the better

 Shows how effective the firm is in using its capital to
generate profit
 A ROCE of 25% means that it uses every £1 of capital to
generate 25p in profit
 Partly a measure of efficiency in organisation and use of
capital
Financial
Asset Turnover

 Asset Turnover = Sales turnover / assets employed

 Using assets to generate profit
 Asset turnover x net profit margin = ROCE
Stock Turnover

 Stock turnover = Cost of goods sold / stock expressed as

times per year
 The rate at which a company’s stock is turned over
 A high stock turnover might mean increased efficiency?
 But: dependent on the type of business – supermarkets
might have high stock turnover ratios whereas a shop
selling high value musical instruments might have low stock
turnover ratio
 Low stock turnover could mean poor customer satisfaction
if people are not buying the goods (Marks and Spencer?)
Debtor Days

 Debtor Days = Debtors / sales turnover x 365

 Shorter the better
 Gives a measure of how long it takes the business to
recover debts
 Can be skewed by the degree of credit facility a
firm offers
Before looking at the ratios there are a number of cautionary points concerning
their use that need to be identified :

a. The dates and duration of the financial statements being compared should be
the same. If not, the effects of seasonality may cause erroneous conclusions to
be drawn.

b. The accounts to be compared should have been prepared on the same bases.
Different treatment of stocks or depreciations or asset valuations will distort the
results.

c. In order to judge the overall performance of the firm a group of ratios, as

opposed to just one or two should be used. In order to identify trends at least
three years of ratios are normally required.
SOME IMPORTANT NOTES
 Liabilities have Credit balance and Assets have Debit balance
 Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from the date
of Balance Sheet
 Current Assets are those which undergo change in their shape/form
within 12 months. These are also called Working Capital or Gross
Working Capital
 Net Worth & Long Term Liabilities are also called Long Term Sources
of Funds
 Current Liabilities are known as Short Term Sources of Funds
 Long Term Liabilities & Short Term Liabilities are also called Outside
Liabilities
 Current Assets are Short Term Use of Funds
 SOME IMPORTANT NOTES
 Assets other than Current Assets are Long Term Use of Funds
 Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
 If there is profit it shall become part of Net Worth under the head
Reserves and if there is loss it will become part of Intangible Assets
 Investments in Govt. Securities to be treated current only if these are
marketable and due. Investments in other securities are to be treated
Current if they are quoted. Investments in allied/associate/sister units or
firms to be treated as Non-current.
 Bonus Shares as issued by capitalization of General reserves and as such
do not affect the Net Worth. With Rights Issue, change takes place in Net
Worth and Current Ratio.
EXERCISE 1

LIABILITES ASSETS
Capital 180 Net Fixed Assets 400
Reserves 20 Inventories 150
Term Loan 300 Cash 50
Bank C/C 200 Receivables 150
Trade Creditors 50 Goodwill 50
Provisions 50
800 800

a. What is the Net Worth : Capital + Reserve = 200

b. Tangible Net Worth is : Net Worth - Goodwill = 150
c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50

e. Current Ratio : C A / C L = 350 / 250 = 1.17 : 1
f. Quick Ratio : Quick Assets / C L = 200/250 = 0.66 : 1
 EXERCISE 2
LIABILITIES 2005-06 2006-07 ASSETS 2005- 2006-
06 07
Capital 300 350 Net Fixed Assets 730 750
Reserves 140 160 Security 30 30
Electricity
Bank Term Loan 320 280 Investments 110 110
Bank CC (Hyp) 490 580 Raw Materials 150 170
Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods 140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advances 30 190

Goodwill 50 50
Total 1600 1760 1600 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70)
820 /800 = 1.02
3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Exercise 3.

LIABIITIES ASSETS
Equity Capital 200 Net Fixed Assets 800
Preference Capital 100 Inventory 300
Term Loan 600 Receivables 150
Bank CC (Hyp) 400 Investment In Govt. 50
Secu.
Sundry Creditors 100 Preliminary Expenses 100
Total 1400 1400
1. Debt Equity Ratio will be : 600 / (200+100) = 2:1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200
= 11 : 2

4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

 Exercise 4.

LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550
Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15)
: 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW

= 100 / ( 362 – 30)
= 100 / 332 = 0.30 : 1
 Exercise 4. contd…
LIABILITIES ASSETS
Capital + Reserves 355 Net Fixed Assets 265
P & L Credit Balance 7 Cash 1
Loan From S F C 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid Expenses 1
Provision of Tax 9 Intangible Assets 30
Proposed Dividend 15
550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12

= 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ?

Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say
Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100

2 = (5 x100) /Sales
Therefore Sales = 500/2 = Rs.250 Lac
Exercise 6. A Company has Net Worth of Rs.5 Lac, Term
Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and
Current Assets are Rs.25 Lac. There is no intangible Assets
or other Non Current Assets. Calculate its Net Working
Capital.
Answer
Total Assets = 16 + 25 = Rs. 41 Lac
Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac
Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L

= 25 – 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net
Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities

hence the NWC would be NIL ( since NWC = C.A - C.L )

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What

is the amount of Current Assets ?

Answer : 4a - 1a = 30,000
Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000
Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per

month, monthly average interest on TL is Rs.5000/-. If the amount
of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What
would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment

= (270000 + 30000 + 60000 ) / 60000 + 120000
= 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is
1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of
Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long
Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac
i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current
Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net
Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity
Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs.
Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being

Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10
Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10
i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which
should be Rs. 10 Lac
Exercise 12. From the following financial statement calculate (i) Current Ratio (ii)
Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v)
Average Creditors’ payment period.
C.Assets
Sales 1500 Inventories 125
Cost of sales 1000 Debtors 250
Gross profit 500 Cash 225
C. Liabilities
Trade Creditors 200

(i) Current Ratio : 600/200 = 3 : 1

(ii)Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1
(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times
(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61
days
(v)Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365
(200/100) x 365 = 73 days
Summary of Financial Ratios
 Ratios help to:
 Evaluate performance
 Structure analysis
 Show the connection between activities and performance
 Benchmark with
 Past for the company
 Industry
 Ratios adjust for size differences
 Limitations of Ratio Analysis
 A firm’s industry category is often difficult to identify
 Published industry averages are only guidelines
 Accounting practices differ across firms
 Sometimes difficult to interpret deviations in ratios
 Industry ratios may not be desirable targets
 Seasonality affects ratios
FINANCIAL RATIO ANALYSIS
RATIO - MEANING

 Relationship or Proportion that one amount bears to

another, the first number being the ‘Numerator’ & the
later ‘Denominator’

OR
 Relationship b/w two figures expressed Mathematically
Advantages/Importance/Significance
- Ratio Analysis

 Analytical Tool for measuring performance.

 Ratios makes Comparison Easy.
 Inter firm Comparison possible.
 Ascertainment of Short term Liquidity & Long term
Solvency position possible.
 Analysis about the STRENGTHS & WEAKNESSES of the
firm’s operations.
 Analyze Past Performance & make further
projections.

TYPES OF
LIQUIDITY

 RATIOS
CAPITAL STRUCTURE OR LEVERAGE

 TURNOVER/ACTIVITY/PERFORMANCE

 PROFITABILITY

 MARKET INDICATORS
LIQUIDITY
 CURRENT RATIO

 QUICK/ ACID TEST RATIO

 ABSOLUTE LIQUID/SUPER QUICK RATIO

 STOCK TO WORKING CAPITAL RATIO

 INVENTORY TURNOVER RATIO

 ACCOUNTS RECEIVABLE TURNOVER RATIO


CURRENT RATIO
CURRENT ASSETS, LOANS & ADVANCES
CURRENT LIABILTIES & PROVISIONS

 QUICK/ACID TEST RATIO

CURRENT ASSETS, LOANS & ADVANCES-
INVENTORIES
CURRENT LIABILTIES & PROVISIONS- BANK O/D
 ABSOLUTE LIQUID/SUPER QUICK RATIO
ABSOLUTE LIQUID ASSETS*
CURRENT LIABILTIES

* Cash in hand + Cash at Bank + Short term

Investments
 STOCK TO WORKING CAPITAL RATIO
Inventory or Stock** x 100
Working Capital
** (opening stock + closing stock)
2
From the given Balance Sheet calculate Current ,
Liquid,
Absolute Liquid & Stock to Working Capital ratios.
Balance Sheet
LIABILTY Rs. ASSETS Rs.

Share Capital 2,00,000 Fixed Assets 1,60,000

Reserves 80,000 Current Assets:

CURRENT Stock 1,20,000

LIABILITIES:
Creditors 80,000 Debtors 60,000

Bills Payable 40,000 Short term 40,000

Investments
Cash 20,000

4,00,000 4,00,000
 Current Ratio= 2,40,000 = 2: 1
1,20,000
 Quick Ratio = 2,40,000 – 1,20,000 = 1: 1
1,20,000
 Absolute Ratio = 60,000 = 0.5
1,20,000
 Stock to Working Capital
= 1,20,000 x 100 = 100%
1,20,000
CAPITAL STRUCTURE OR
LEVERAGE
 Shareholders Equity Ratio
 Long Term Debt to Shareholders Net Worth Ratio
 Capital Gearing Ratio
 Debt-Equity Ratio
 Fixed Assets to Long term Funds Ratio
 Proprietary or Net Worth Ratio
 Current Assets to Net Worth
 Shareholders Equity Ratio
= Shareholders Equity*
Total Assets( tangible)
*(Equity Share Capital + Preference Share Capital + Reserves
& Surplus) – (Accumulated losses like preliminary expenses,
discount on issue of shares, debentures, etc. appearing on
the Assets side of Balance Sheet).

 Long Term Debt to Shareholders Net Worth Ratio

= Long Term Debt
Shareholders Net Worth*
* Capital + free Reserves – Intangible Assets
 Capital Gearing Ratio
= Fixed Interest Bearing Securities*
Equity Shareholder's Funds**
*Debentures + Long Term Loans + Preference Share
Capital
** Equity Share Capital + Reserves & Surplus
 Debt- Equity Ratio
= Debt*
Equity**
*All external Long term loans + Debentures
**Share Capital and all Reserves & Surplus
 Fixed Assets to Long Term Funds Ratio
= Fixed Assets
Long Term Funds*
*Share Capital, Reserves & Surplus & Long Term Loans
 Proprietary or Net Worth Ratio
= Shareholders Net Worth*
Total Assets**
*(Equity Share Capital + Preference Share Capital +
Reserves & Surplus) – (Accumulated losses or
Fictitious Assets like preliminary expenses, discount
on issue of shares, debentures, etc. appearing on the
Assets side of Balance Sheet).
** Fixed Assets + Current Assets – Fictitious Assets
 Current Assets to Net Worth
= Current Assets
Net Worth
TURNOVER/ACTIVITY/PERFORMANCE
 Inventory Turnover Ratio
 Inventory Ratio
 Debtors Turnover Ratio
 Debtors Collection Period or Debtors Velocity
 Bad debts to Sales Ratio
 Creditors Turnover Ratio
 Creditors Payment Period or Creditors Velocity
 Fixed Assets Turnover Ratio
 Total Assets Turnover Ratio
 Working Capital Turnover Ratio
 Sales to Capital Employed
 INVENTORY TURNOVER RATIO
COST OF GOODS SOLD
AVERAGE INVENTORY

 INVENTORY RATIO
Inventory/ Current Assets

 DEBTORS OR ACCOUNTS RECEIVABLE TURNOVER RATIO

NET CREDIT SALES/AVG. ACCOUNTS RECEIVABLE

 DEBTORS COLLECTION PERIOD OR DEBTORS VELOCITY

Average Debtors x 365 (in days)
Net Credit Sales
 Bad debts to Sales Ratio
Bad Debts x 100
Sales
 Creditors Turnover Ratio
Net Credit Purchase
Average A/c’s Payable
 Creditors Payment Period or Creditors Velocity
Average A/c’s Payable x 365 (in days)
Credit Purchases
 Fixed Assets Turnover Ratio
Sales/ Fixed Assets
 Total Assets Turnover Ratio
Sales/ Total Assets
 Working Capital Turnover Ratio
Sales/ Working Capital
 Sales to Capital Employed
Sales/ Capital Employed
PROFITABILITY
 Gross Profit Margin= Gross Profit x 100
Net Sales
 Net Profit Ratio
= Net Profit before Interest & Tax x 100
Sales
 Net Profit Margin= NetProfit x 100
Net Sales
 Cash Profit Ratio = Cash Profit* x 100
Sales
* Net Profit + Depreciation
 Return on Total Assets = Net Profit After tax x
100
Total Assets
 Return on Shareholders Funds or Return on Net
Worth
= Net Profit after Interest & Tax x 100
Net Worth*
* Equity Capital + Reserves & Surplus
 Return on Equity
= Profit after tax x Net Sales x Total Assets
Net Sales Total Assets Net Worth
ROE= Net Profit Margin x Total Assets Turnover
Ratio x Total Assets to Net Worth
 Operating Ratio or Operating Cost Ratio
= Operating Cost* x 100
Net Sales
*Cost of Goods sold + Operating Expenses
 Interest Cover Ratio
= Profit Before Interest, Depreciation & Tax
Interest Expense
 Dividend Cover Ratio
(i) Equity Dividend Cover
= Net Profit after Tax- Preference Dividend
Equity Dividend
(ii) Preference Dividend Cover
= Net Profit after Tax
Preference Dividend
 Debt Service Coverage Ratio (DSCR)
= Profit After tax+ Depreciation+ Interest on Loan
Interest on Loan+ Loan Repayment in a year
 MARKET INDICATORS OR MARKET BASED RATIOS
 Earnings per Share (EPS)
= Net Profit after Tax- Preference Dividend
No. of Equity Shares
 Price Earnings Ratio (P/E Ratio)
= Current Market Price of Equity Share
Earnings per Share
 Market Price to Book Value Ratio (P/BV Ratio)
= Market Price Per Share
Book Value Per Share
 Cash Earnings Per Share Ratio
= Net Profit after tax+ Depreciation
No. of Equity Shares
 Dividend Payout Ratio (D/P Ratio)
= Dividend Per Share
Earnings Per Share
 Book Value Ratio
= Equity Share Capital+ Reserves- P&L A/c Debit
Balance
Total no. of Equity Shares
 Dividend Yield Ratio
= Dividend Per Share x 100
Market Price
Statement of Cash Flows
 Cash Flow Statement
 Flow statement
 Periodic
 Provides information regarding the liquidity of a firm
 explains the reasons for increase or decrease in cash balance
from one balance sheet date to the next
 classifies the reasons for the change as an operating, investing
or financing activity.
 amount of net income in a period is usually different than the
amount of increase in cash in the same period
 reconciles net income with cash flow from operations.
 Classification of Cash Flows

Operations -- cash flows related to selling goods and

services; that is, the principle business of the firm.
Investing -- cash flows related to the acquisition or sale
of noncurrent assets.
Financing -- long term and short term cash flows related
to liabilities and owners’ equity; dividends are a
financing cash outflow.
What is Cash?

 Cash includes cash and cash equivalents

 Cash equivalents:
 treasury bills maturing in 90 days or less;
 investment funds;
 foreign currency on hand;
 checking account and free savings account
External Uses of CFS

 To assess the ability of a firm to manage cash

flows
 To assess the ability of a firm to generate cash
through its operations
 To assess the company’s ability to meet its
obligations and its dividend policy
 To provide information about the effectiveness
of the firm to convert its revenues to cash
 To provide information to estimate or
anticipate the company’s need for additional
financing
Internal Uses of CFS

 Along side with cash budget CFS is used:

 To assess liquidity
 Determine if short-term financing is necessary

 To determine dividend policy

 Decide to distribute; or increase or decrease

 To evaluate the investment and financing decisions

Cash flow from operating
activities
 Examples (IAS No.7):
 cash received from customers through sale of
goods or services performed;
 cash received from non-operating activities such
as dividends from investments, interest revenue,
commissions, and fees;
 cash payments to suppliers or employees;
 cash payments for taxes and other expenses;

In effect, the income statement is changed from

accrual basis to cash basis
Investing Activities

Examples of investing activities include:

 cash payments to acquire property, plant,
and equipment (PPE), other tangible or
intangible assets, and other long-term assets;
and sale of such assets
 loans extended to other companies; and
collection of such loans;
Financing Activities

Examples of financing activities are :

 cash received from issuing share capital;
 cash proceeds from issuing bonds, loans,
notes, mortgages and other short or
long-term borrowings;
 cash repayment of loans and other
borrowings; and
 cash payments to shareholders as
dividends.
 Classification of Cash in-flows and outflows
From sales of goods and To wages salary
services to customers payments
From receipt of customer To suppliers for
advances purchases of inventories
Operating Activities
From receipt of interest To other operating
revenue or dividends or expenses
rent revenue or similar To interest payments
revenue items To tax payments
To advance payments to
suppliers
From sale of PPE and other To purchase PPE and
long-term assets other long-term assets
Investing Activities
From collection of loans To make loans and to
collect such loans

From sale of common or

preferred stock Financing Activities To repay debt
From issuance of short To pay dividends
or long term debt
 Format of the Cash Flow Statement

Name of the Company

Cash Flow Statement
For the period …

Cash from operating activities A

Cash from investing activities B
Cash from financing activities C
Net Change in Cash D = (A+B+C) increase or (decrease)
+ Beginning Cash balance CB, from the beginning balance sheet
Ending Cash balance =CB + D should equal to ending cash
balance in the ending balance sheet
Non-cash Investing and Financing Activities
 Determination of Cash Flows
From Operating Activities
Direct Method
Income Statement items are converted to cash flows
individually

Indirect Method
Net income or loss is adjusted for accruals such as accounts
receivable and payable, and for non-cash expenses such as
depreciation
reconciliation of the accrual based and cash based
accounting
 Comparison of Methods
 Direct method of presentation calculates cash flow from
operations by subtracting cash disbursements to supplies,
employees, and others from cash receipts from customers.
 The indirect method calculates cash flow from operations by
adjusting net income for non-cash revenues and expenses.
 Most firms present their cash flows using the indirect method.

Only operating activities section is different between the

methods, investing and financing sections are the same.
How to prepare cash flow
statement
 Firms could prepare their own cash flow statement
directly from the cash account.
 however, we need two consecutive balance sheets and
the income statement that covers the period between
the two balance sheets
 Algebraic Formulation*

Assets = Liabilities + Shareholders’ Equity

or A = L + SHE
Assets are either cash (C) or not (Non-Cash)
Thus reorganizing
C + Non Cash Assets (NCA) = L + SE
 C +  NCA =  L +  SE
Where  means the change in the balance of the item
from the previous period.
Solving for change in cash:
 C =  L +  SE -  NCA

Based on Stickney and Weil, 10th ed. Financial Accounting Slides http://www.swlearning.com/accounting/stickney/tenth_edition/stickney.html
 Algebraic Formulation (Cont.)

 C =  L +  SE -  NCA

The change in cash,  C, is the increase or decrease

in the cash account.
This amount must equal changes in liabilities plus
changes in shareholders’ equity minus changes in
assets other than cash.
Thus, we can identify the causes in the change in the
cash account by studying the changes in non-cash
accounts.
Indirect Method – cash flow from operations

Adjusting Net Income of the period (accrual) to cash

basis income
INCREASE DECREASE
Increase in non-cash Decrease in non-cash
assets shows that cash assets shows that
Assets was spent, they provided cash
so cash outflow. so cash inflow.

Increase in liabilities
Liabilities Decrease in liabilities
cash savings;
and or SHE shows
increase in SHE cash
Shareholders’ cash paid;
received;
equity so cash outflow
so cash inflow
Indirect Method- operating activities- Adjustments to net
income

Net income
+ noncash expenses: depreciation, amortization,
uncollectible account expense,etc
+ loss on sale of asset
+ increases in current liabilities
+ decreases in current assets
- gain on sale of asset
- decrease in current liabilities
 increase in current assets

= Cashflow from operating activities

 Noncash Expenses

 Noncash expenses, such as depreciation expense,

are added back – because they were deducted to
measure net income but did not require any cash
payment in the current period
 They are not truly sources of cash, even though
they are associated with cash inflows but reversal
of an accrued expense
Portakal Company
Prepare Cash Flow Statement
increase
Accounts with Debit Balances 2008 2007 (decrease)
Cash 37.500 39.250 (1.750)
Notes Receivable (from loans to other companies) 69.000 50.000 19.000
Accounts Receivable 53.700 39.900 13.800
Merchandise Inventory 158.000 120.000 38.000
Prepaid Operating Expenses 2.100 1.800 300
Interest Receivable 1.400 600 800
Land 110.000 65.000 45.000
Property,Plant and Equipment-PPE-net 377.000 380.000 (3.000)
808.700 696.550 112.150

Accounts with Credit Balances

Accounts Payable 45.000 38.000 7.000
Accrued Wages Payable 3.000 2.400 600
Income Taxes Payable 6.000 4.500 1.500
Unearned Revenues 2.500 1.250 1.250
Bank Notes Payable - long term 215.000 200.000 15.000
Common Stock; TL 15 par value 405.000 375.000 30.000
Additional Paid in Capital 70.000 50.000 20.000
Retained Earnings 62.200 25.400 36.800
808.700 696.550 112.150
 Portakal Company 0
Income Statement 2008

Sales Revenue 750.000

Cost of Goods Sold (375.000)
Depreciation Expense (43.000)
Salary and Wages Expense (125.000)
Administrative Expenses (80.000)
Loss on Sale of Equipment (4.000)
Other Operating Expenses (5.000)
Interest Revenue 4.000
Interest Expense (20.000)
Income Tax Expense (28.000)
Net Income 74.000

The company paid TL 50.000 of Bank Notes and borrowed new bank loan.
The company declared and paid cash dividends.
The company sold equipment with a cost of TL 12000 and accumulated depreciation of TL
6000 for TL 2000 receving a note in return to be collected in 2009.
The company purchased equipment for TL 46.000; paid TL 44.000 in 2008 and gave a
note for Jan. 2009.
The company issued common stock during the year .
Portakal Company 2008
Cash Flow Statement

Cashflow from Operating Activities

Net Income 74000
Add back noncash:
Depreciation Expense 43.000
Loss on Sale of Equipment 4.000
121.000
adjustments that increase cash:
increase in Acct.Payable 7.000
Increase in Acc.Wages Payable 600
increase in Income Taxes payable 1.500
increase in unearned revenued 1.250
10.350
adjustments that decrease cash:
increase in Accts Rec. (13.800)
increase in Merch. Inv. (38.000)
Increase in Prepaid Expense (300)
increase in interest recev. (800)
(52.900)

Cashflow from operations 78.450

Cashflow from investing
Sale of PPE (note will be received in 2009)
Purchase of PPE (44.000)
Loans extended( to other companies) (19.000)
Purchase of land (45.000)
Cashflow from investing (108.000)
Cashflow from financing
Bank Notes Payable - long term 65.000
Common Stock; TL 15 par value 30.000
Additional Paid in Capital 20.000
Payment of Bank loan (50.000)
Payment of Dividends (37.200)
Cashflow from financing 27.800

Net Change in Cash (1.750)

 Effects of a Sale of
a Long-Term Assets on Cash Flows

 A few transactions complicate the derivation of a cash

flow statement from a comparative balance sheet, for
example, the sale of a long-term (or fixed) asset.
 Recall the journal entry for the sale of an asset:

Cash nnnn
Accumulated Depreciation nnnn
Asset nnnn
Gain (or loss) on sale nnnn
 Sale of an Asset

 Each of the four parts of the above journal entry require

an adjustment in the cash flow statement.
 The first line, cash, adds a line to the investing section.
 The second line, a debit to accumulated depreciation,
increases the depreciation expense above the change in
the change in the accumulated depreciation account.
 The third line, a credit to the asset, increases the amount
of cash invested in long-lived assets above the change in
the fixed asset accounts.
 The fourth line, a gain or loss, is reversed out in the
operating sections since this is not a cash flow.
 Comparison of Cash Flow to Net Income

 Net income is an accrual based concept and purports to

show the long-term.
 Cash flows purport to show the short term.
 Consider the outlook for both short-term and long-term
and consider that each is either good or poor.
 A strong growing firm would show both good long-term
and good short-term outlooks.
 A failing firm would show both poor long-term and poor
short term outlooks.
 What about a firm with good cash flows (short-term) but
poor net income (long-term)?
 What about a firm with poor cash flows (short-term) but
good net income (long-term)?