Financial Statements and Cash Flow Analysis

2 Financial Statements Financial statements provide information about the financial activities and position of a firm. Important financial statements are: Balance sheet Profit & Loss statement Funds flow statement Cash flow statement

3 Balance Sheet Balance sheet indicates the financial condition of a firm at a specific point of time. It contains information about the firm’s: assets, liabilities and equity. Assets are always equal to equity and liabilities: Assets = Equity + Liabilities

4 Assets Assets are economic resources or properties owned by the firm. There are two types of assets: Fixed assets Current assets

5 Current Assets Current assets (liquid assets) are those which can be converted into cash within a year in the normal course of business. Current assets include: Cash and bank balance Accounts receivable (debtors) Inventory (stocks) Advances to suppliers Prepaid expenses

6 Fixed Assets Fixed assets are long-term assets. Tangible fixed assets are physical assets like plant. Intangible fixed assets are the firm’s rights and claims, such as patents, copyrights, goodwill etc. Gross block represent all tangible assets at acquisition costs. Net block is gross block net of depreciation.

7 Liabilities Liability is a firm’s obligation to pay cash or provide goods or services in the future. Two types of liabilities are: Current liabilities Long-term liabilities

8 Current Liabilities Current liabilities are payable within a year in the normal course of business. They include: Accounts payable (creditors) Outstanding expenses Advances from customers Provision for tax Provision for dividend

9 Long-term Liabilities Long-term liabilities are payable after a year. They include: Borrowings from financial institutions and banks etc. Debentures/bonds: * Non-convertible * Fully convertible * Partly convertible

10 Shareholders’ Funds or Equity Share capital is owners’ contribution divided into shares. A share is a certificate acknowledging the amount of capital contributed by the shareholder. Reserves and surplus or retained earnings are undistributed profits. Shareholders’ funds or equity is the sum of share capital plus reserves & surplus. It is also called net worth.

11 Balance Sheet Relationship Total assets (TA) equal net fixed assets (NFA) plus current assets (CA): TA = NFA + CA Net current assets (NCA) is the difference between current assets (CA) and current liabilities (CL): NCA = CA – CL

12 Balance Sheet Relationship Net assets (NA) equal net fixed assets (NFA) plus net current assets (NCA): NA = NFA + NCA Capital employed (CE) is the sum of net worth or equity (E) and borrowing/debt (D) and it is equivalent of net assets: CE = Net Worth + Borrowing = E + D Capital Employed = Net Assets

13 Functions of Balance Sheet Stewardship role Measurement of liquidity Measurement of solvency

14 Profit & Loss Statement Profit & Loss statement provides information about a firm’s: revenues, expenses, and profit or loss.

15 Nature of Revenues Revenue is the amount received or receivable within the accounting period from the sale of the firm’s goods or services. Operating revenue is the one that arises from main operations of the firm, and the revenue arising from other activities is called non- operating revenue.

16 Nature of Expenses Expense is the amount paid or payable within the accounting period for generating revenue. Examples: raw material consumed, salary and wages, power and fuel, repairs and maintenance, rent, selling and marketing expenses, administrative expenses. Expenses are expired costs and capital expenditures represent un-expired costs and appear as assets in balance sheet.

17 Depreciation Depreciation is a charge for the use of fixed assets; it is an expense. It is a non-cash expense since cash was paid at the time fixed assets were acquired. Expenditures incurred on acquiring assets are called capital expenditures. Depreciation is allocation of these expenditures over the life of assets that have helped in generating revenue.

18 Methods of Depreciation Depreciation may be provided on straight line basis or written down value basis (DWV). DWV basis is allowed for taxation in India.

19 Concepts of Profit Gross profit = sales – cost of goods sold (CGS) CGS = raw material consumed + manufacturing expenses of goods that have been sold PBDIT = Profit before dep., interest and tax = sales – expenses, except dep., interest and tax PBIT= Profit before interest and tax = PBDIT – DEP PBT= Profit before tax = PBIT – Interest PAT = Profit after tax = PBT – Tax

20 Functions of Income Statement Summary of revenues and expenses Measurement of profitability

21 Relationships: B/S and P&L A/C Net profit = Equity (end) – Equity (begin) Equity (end) = Equity (begin) + Net profit + Equity issued – Dividend Net profit = [Equity (end) – Equity (begin)] – [Equity issued – Dividend] Change in equity = Equity (end) – Equity (begin) = Net profit + Equity issued – Dividend

22 Economic Vs. Accounting Profit Accounting profit is a result of the arbitrary allocation of expenditures between expenses (revenue expenditure) and assets (capital expenditure). Economic profit is the net increase in the wealth of the firm, and it is measured in cash flow.

23 Standards of Financial Reporting Full disclosure Materiality Consistency Conservatism Fairness

24 Accounting Principles and Concepts Business entity concept Money measurement concept Going concern concept Cost concept Duality concept Accounting period concept Realisation concept Matching concept

25 Funds and Cash Flow Liquidity refers to resources currently available with the firm. It is reflected by the funds or cash flows rather than the stock of current assets and liabilities. Funds flow is a change in a firm’s net current assets while cash flow is a change in the firm’s cash position. Funds or cash flows occur due to changes in items in the balance sheet and profit & loss statement. Thus liquidity analysis involves measurement of changes in assets, liabilities and equity.

26 Sources and Uses of Funds and Cash Flows Sources of funds or cash flows: funds from operations sale of fixed assets issue of share capital borrowings Uses of funds are: losses purchase of fixed assets repayment of borrowings payment of dividends

27 Funds from Operations Funds flow from operations + PAT (– loss) + Depreciation + Other non-cash expenses – Non-cash incomes + Loss from the sale of fixed assets – Gain from the sale of fixed assets

28 Cash from Operations Cash flow from operations + PAT (– loss) + Depreciation + Other non-cash expenses – Non-cash incomes + Loss from the sale of fixed assets – Gain from the sale of fixed assets + Increases in net working capital – Decreases in net working capital

29 Uses of Funds and Cash Flow Statements Liquidity position Capital expenditures Dividends paid Retained earnings External financing Repayment of loans Non-performing assets