1 Cash Flow Statement and other financial analysis Companies obtain different types of capital. We can broadly categories them into long term funds and short term funds. We know that whenever long term funds such as issue of shares, preference shares, debentures and public deposits are issued they are expected to be invested in long term profit generating assets such as purchase of plant and machinery, building etc. If short term funds such as over drafts, cash credit are generated, it is expected such funds should be employed in short term purpose such as purchase of stock, payment to creditors etc. All long term funds are not fully utilized for long term or all short term funds are utilized for short term. Invariably, there are movements of funds which take place from long term to short term or short term to long term. Funds are also generated from profit by doing basic functions of the organization by buying and selling of goods and services or lost when company incurs trade losses. The funds that are generated/lost from trade activity is called fund from operation/loss from operation. These funds may be utilized for long term or for short term. All funds that are generated in cash forms are studied and see the flow of cash from long term to short term or vice versa are creating any cash crunch problem to the organization. If problem arises the organization should know which funds have to be brought in i.e. short term or long term funds. The cash flow statement is prepared to know the flow of funds and their financial impact on long term or short term. Each type of fund has some impact on the overall performance of the company. Debt Equity ratio, current ratio, liquid ratio, return on capital employed, WACC, profitability, liquidity, flexibility are affected. We use CFS as the means to study the impact and adjustments required by forecasting these changes. Balance sheets and income statements are forecasted for three to five years and study the flow of cash whether they are conducive to the firm. There are many activities that prevail in any organization with respect to cash inflows and outflows. They are broadly categorized into operating, financing, investing activities. There are non cash activities too such as making provision for depreciation. The operating activities are directly connected to the goods that are dealt in. They differ from business to business. For example:- In case of a furniture dealer, the basic function of a furniture dealer is buying and selling of furniture and earn profit out of such activity is known as operating activity. The dealer in real estate, business profit/loss on sale of land falls under operating activity. The share broker’s operating activity is to buy and sale of securities and receive interest and dividend. Such activity is an operating activity. In financial accounts, such profit from such activity is known as operating profit. Income tax point of view such profits are normally taxable unless they are expressly exempted. It is to be noted that a firm earns operating profit may not be financially sound in cash during the year(s) of sale. Some times, in order to increase sales, company might have increased the debtors’ credit period say from one month to three months. All sales made in the last part of the year may not have been realized in cash which might create cash crunch problems to the
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Cash Flow Statement and other financial analysis
Companies obtain different types of capital. We can broadly categories them into long
term funds and short term funds. We know that whenever long term funds such as issue
of shares, preference shares, debentures and public deposits are issued they are expected
to be invested in long term profit generating assets such as purchase of plant and
machinery, building etc. If short term funds such as over drafts, cash credit are generated,
it is expected such funds should be employed in short term purpose such as purchase of
stock, payment to creditors etc. All long term funds are not fully utilized for long term
or all short term funds are utilized for short term. Invariably, there are movements of
funds which take place from long term to short term or short term to long term.
Funds are also generated from profit by doing basic functions of the organization by
buying and selling of goods and services or lost when company incurs trade losses. The
funds that are generated/lost from trade activity is called fund from operation/loss from
operation. These funds may be utilized for long term or for short term.
All funds that are generated in cash forms are studied and see the flow of cash from long
term to short term or vice versa are creating any cash crunch problem to the organization.
If problem arises the organization should know which funds have to be brought in i.e.
short term or long term funds. The cash flow statement is prepared to know the flow of
funds and their financial impact on long term or short term.
Each type of fund has some impact on the overall performance of the company. Debt
Equity ratio, current ratio, liquid ratio, return on capital employed, WACC, profitability,
liquidity, flexibility are affected. We use CFS as the means to study the impact and
adjustments required by forecasting these changes. Balance sheets and income statements
are forecasted for three to five years and study the flow of cash whether they are
conducive to the firm.
There are many activities that prevail in any organization with respect to cash inflows
and outflows. They are broadly categorized into operating, financing, investing activities.
There are non cash activities too such as making provision for depreciation. The
operating activities are directly connected to the goods that are dealt in. They differ from
business to business. For example:- In case of a furniture dealer, the basic function of a
furniture dealer is buying and selling of furniture and earn profit out of such activity is
known as operating activity.
The dealer in real estate, business profit/loss on sale of land falls under operating activity.
The share broker’s operating activity is to buy and sale of securities and receive interest
and dividend. Such activity is an operating activity. In financial accounts, such profit
from such activity is known as operating profit. Income tax point of view such profits are
normally taxable unless they are expressly exempted. It is to be noted that a firm earns
operating profit may not be financially sound in cash during the year(s) of sale. Some
times, in order to increase sales, company might have increased the debtors’ credit
period say from one month to three months. All sales made in the last part of the year
may not have been realized in cash which might create cash crunch problems to the
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company temporarily. Some times all stocks have been purchased in cash inorder to
receive trade discount.There shall not be any cash profits due to employment of cash in
inventory.
(A) Relevance of Cash Flows:
Explain the relevance of cash flows to analyzing business activities.
Cash is the most liquid of assets and offers a firm liquidity and flexibility. The term cash
includes cash and cash equivalents, which are short-term highly liquid investments.
The Statement of cash flows helps in assessing:
Liquidity, which represents how near assets and liabilities are to being cash.
Solvency, which represents the firm’s ability to pay liabilities when due.
Financial flexibility, which represents the firm’s ability to react and adjust to
opportunities and difficulties.
The statement of cash flows provides information to answer questions such as:
How much cash was generated from operations?
What was the cash used for?
What was the source of the cash invested in Property Plant & Equipment ?
How was the cash received from a bond issue used?
How was the firm able to pay dividends when the company experienced an
operating loss?
How was the firm able to retire its long-term debt?
How were investments financed?
Why did cash decrease when the firm experienced record profits?
(B) The Statement of Cash Flows:
Indian Accounting Standard 3 require that a Statement of Cash Flows (SCF),
accompany the income statement and balance sheet.
The SCF explains the change in cash and cash equivalents during the year,
classified by operating (i.e., earning) activities, financing activities, and investing
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activities.
SFAS 95 encourages the use of direct or inflow-outflow method, which makes
adjustments for balance sheet changes directly to revenue and expense
components of income statement, rather than to net income.
Operating Cash Flows:
Describe the elements of operating cash flows.
1. Cash flows from operations (CFO) reflect flows related to the normal operating
activities of the business.
2. These items essentially flow through the firm’s income statement and working
capital accounts. Working capital accounts are current assets and current
liabilities.
3. Cash flow from operations includes cash collection from customers and cash
payments to merchandise suppliers, for salaries, and for interest.
4. Interest and dividend revenue and interest expense are considered
are considered financing activities.
5. All income taxes arc considered operating activities, even if some arise from
financing or investing.
Investing Cash Flows:
Describe elements of investing cash
1. Cash flows from investing (CF1) reflect investing activities. These are the
acquisition of noncurrent assets (outflows) and the retirement of these assets
(inflows).
2. These items are found in the non current portion of the asset section of the
halance
sheet. Cash How from investing includes cash received from the sale of properly
plain & equipment and long-term investments in addition to the cash paid out to
purchase these noncurrent assets.
3. Investing cash flows also include cash flows from investments in joint ventures
and affiliates, long-term investment in securities.
Financing cash flows:
Describe the elements of Financing cash flows.
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1. Cash flows from financing (CFF) reflect cash received from issuing or cash paid out
retiring long-term debt (including the current portion of long-term debt), stock
(common and preferred), or in paying dividends and interest paid on such loan funds.
2. These items are found in the long-term capital section of the balance sheet and the
statement of retained earnings (RE).
3. CFF includes dividends paid to stockholders but not interest paid to creditors because
interest paid to short term funds are not considered. But if it is long term it is
considered under the head CFF.
4.
Classify a particular item as an operating cash flow, an investing cash flow, or a
financing cash flow.
The following is the format of the basic statement of cash flows:
Example:
Using the following income statement (I/S) and balance statement (B/S) items for 2009,
calculate the firm’s SCF:
(Rs.)
Sale of land 20,000
Collections from customers 70,000
Payment of interest 1,000
Cash payment of dividends 6,000
Cash received from issue of long term debt 40,000
Payment of wages 10,000
Purchase of equipment 90,000
Payment to suppliers 5,000
Cash balance on 31st march 2008 25,000
STATEMENT OR CASH FLOWS (SCF)
FOR THE PERIOD 31/12/2008 TO 31/12/2009
Cash Flow from Operations (CFO)
+ Cash Flow from Investing (CFI)
+ Cash Flow from Financing (CFF)
= Change in the cash account
+ Beginning of period cash
= Ending cash balance
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The Statement of Cash Flow for the Year ending 31/03/09 is:
Cash Flow from Operations (CFO):
Collections from customers Rs.70,000
Payment of wages (10,000)
Payment to suppliers ( 5,000)
CFO Rs.54,000
Cash Flow from Investing (CFI):
Sale of land Rs.20,000
Purchase of Equipment (90.000)
CFI (Rs.70,000)
Cash Flow from Financing (CFF):
Issuance of long-term debt Rs.40,000
Payment of dividends
Payment of interest
( 6.000)
(1000)
CFF Rs.34.000
Net Increase in cash: Rs.18,000
Cash balance on 31/03/2008 25.000
Cash balance on 31/03/2009 Rs.43,100
The ending balance of the cash account is a managerial finance decision and thus has
little analytical significance. The cash flow tells us that the investing significantly in
equipment financed by cash thrown-off from operating and by issuing long-term debt.
For analytic purposes the cash payment of interest can be reclassified as a cash flow from
financing thereby increasing CFO to Rs.55,000 and decreasing CFF to Rs.33,000.
[c] Direct and Indirect Methods
When using the indirect method, start at the bottom of the income statement with net
income and back into cash flow from operations by adjusting reported net income.
When using the direct method, start at the top of the income statement with sales then
work with the individual components of net income directly related to cash flows (e.g.
revenue, cost of goods sold, salary expense, and interest expense).
Note: These methods are equivalent since they both yield the same cash flow from
operations. These two methods differ only in the detail of presentation.
Calculating Operating Cash Flows Using the Indirect Method
Start with net income and adjust for all non-cash expenses and non-cash gains and