Financial statement analysis | . Financial management analysis is an integral part of interpretations of results disclosed by financial statements. It supplies to decision makers crucial financial information and points out the problem areas which can be investigated financial statement analysis involves regrouping of the data suitably by arithmetic operations. Financial statements may be analyzed with a view to achieve the following purposes: 1) Profitability analysis: Users of financial statements may analyze financial statements to decide past and present profitability of the business. Prospective investors may do profitability analysis before taking a decision to invest in the shares of the company. 2) Liquidity analysis: Suppliers of goods moneylenders and financial institutions may do liquidity analysis to find out ability of the company to meet its obligations. Liquid assets are compared with the commitments in order to test liquidity position of a company. 3) Solvency analysis: It refers to analysis of long term financial position of a company. This analysis helps to the ability of a company to repay its debts. For this purpose, financial structure, interest coverage is analyzed. The various tools used for financial analysis are: § Fund flow Statement § Ratio Analysis § Common Size Statements § Comparative Financial Statements § Trend Analysis § Cash Budget § Working Capital § Leverages Fund Flow Statement Fund flow statement also referred to as statement of “source and application of funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital. The information required for the preparation of funds flow statement is drawn from the basic financial statements such as the Balance Sheet and Profit and loss account. “Funds Flow Statement” can be prepared on total resource basis, working capital basis and cash basis. The most commonly accepted form of fund flow is the one prepared on working capital basis. Ratio Analysis Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis. Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as: 1. Fraction 2. Percentages 3. Proportion of numbers These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them. Common Size Statements It facilitates the comparison of two or more business entities with a common base. In case of balance sheet, Total assets or liabilities or capital can be taken as a common base. These statements are called “Common Measurement” or “Component Percentage” or “100 percent” statements. Since each statement is reduced to the total of 100 and each individual component of the statement is represented as a % of the total of 100 which invariably serves as the base. Thus the statement prepared to bring out the ratio of each asset of liability to the total of the balance sheet and the ratio of each item of expense or revenues to net sales known as the Common Size statements. Comparative Financial Statements Comparative financial statements is statement of the financial position of a business so designed as to facilitate comparison of different accounting variables for drawing useful inferences. Financial statements of two or more business enterprises may be compared over period of years. This is known as “inter-firm comparison” Financial statements of particular business enterprise maybe compared over two periods of years. This is known as “inter-period comparison”. Trend Analysis Trend analysis is employed when it is required to analyze the trend of data shown in a series of financial statements of several successive years. The trend obtained by such an analysis is expressed as percentages. Trend percentage analysis moves in one direction either upwards or downwards, progression or regression. This method involves the calculation of percentages relationship that each statement bears to the same item in the base year. The base year maybe any one of the periods involved in the analysis but the earliest period id mostly taken as the base year. The trend percentage statement is an “analytical device for condensing the absolutely rupee data” by comparative statements. Cash Budget Cash budget is a forecast or expected cash receipts and payments for a future period. It consists of estimates of cash receipts, estimate of cash disbursements and cash balance over various time intervals. Seasonal factors must be taken into account while preparing cash budget. It is generally prepared for 1 year and then divided into monthly cash budgets. Working Capital Working capital is the amount of funds held in the business or incurring day to day expenses. It is also termed as short term funds held in the business. It is ascertained by finding out the differences between total current assets and total current liabilities. Working capital is a must for every organization. It is like a life blood in the body. It must be of sufficient amount and should be kept circulated in the different forms of current assets and current liabilities. The success of organization depends upon how successfully the circulation of short term fund is maintained smoothly and speedily. Working capital is also compared with the water flowing in the river as the water is always flowing it is pure water similarly working capital should be kept circulated in different short term assets. Leverages The employment of an asset or source of funds for which the first firm has to pay a fixed cost or fixed return may be termed as leverage. Operating leverages: is determined by the relationship between firms, sales revenue and its earnings before interest and taxes (EBIT) which are generally called as Operating profits. Operating leverage results from the existence of fixed operating expenses in the firm’s income stream. the operating leverage may be defined as the firm’s ability to use fixed operating cost to magnify the affects of charges In sales on its earnings before interest and taxes. Financial leverages: it relates to the financing activities of a firm. Financial leverage results from the presence of fixed financial charges in the firm’s income stream. Financial leverages concerned with the effects or changes in the EBIT in the earnings available to equity shareholders. It is defined as the ability of a firm to use fixed financial charges to magnify the effects or changes in EBIT on the earnings per share. Use of common size statement: 1. Common size analysis reveals the sources of capital and all other sources of funds and the distribution or use or application of the total funds in the assets of a business enterprise. 2. Comparison of common size statements over a number of years will clearly indicate the changing proportions of the various components of assets, liabilities, costs, net sales and profits. 3. Comparison of common size statements of 2 or more enterprises in the same industry or that of an enterprise with the industry as a whole will assist corporate evaluation and ranking. Uses of comparative statement: 1. These statements are very useful to the financial analysts because they indicate the direction of the movement of the financial position and performance over the years. 2. These statements can also be used to compare the position of the firm every month or every quarter. They can be prepared to facilitate comparison with the financial position of other firms in the same industry or with the average performance of the entire industry. Such comparisons facilitate identification of ‘trouble spots’ in a company’s working and taking corrective measures. 3. Comparative statements present a review of the past activities and their cumulative effect on the financial position of the concern. Uses of trend analysis: 1. Trend analysis indicate the increase or decrease in an accounted item along with the magnitude of change in percentage which is more effective than absolute data. 2. The trend analysis facilitates an efficient comparative study of the financial performance of a business enterprise over a period of time. Uses of ratio analysis: 1. The relation between 2 or more financial data brought out by an accounting ratio is not an end in itself. They are means to get to know the financial position of an organization. 2. Industrial ratios may provide valuable information only when they are studied and compared with several other related ratios. 3. Ratio analysis will tend to be more meaningful when certain standards and norms are laid down so that what the ratios indicate can be compared with the said standards. | |||||||||||||||||||||
Trend analysis | Trend analysis is employed when it is required to analyze the trend of data shown in a series of financial statements of several successive years. The trend obtained by such an analysis is expressed as percentages. Trend percentage analysis moves in one direction either upward or downward progression or regression. This method involves the calculation of percentage relationship that each statement bears to the same item in the base year. The base year may be any one of the periods involved in the analysis but the earliest period is mostly taken as the base year. The trend percentage statement is an “analytical device for condensing the absolute rupee data” by comparative statements. Merits of Trend Analysis:· Trend percentages indicate the increase or decrease in an accounted item along with the magnitude of change in percentage, which is more effective than the absolute data. · The trend percentages facilitate an efficient comparative study of the financial performance of a business enterprise over a period of time. Demerits of Trend Analysis:· Any one trend by itself is not very analytical and informative. · If interpretation has to be done on percentages and ratios in isolation and not along with the absolute data from which the percentages have been derived, the inferences tend to be absurd and baseless. · Comparability of trend percentages is unfavorably affected when the accounts have not been drawn on a consistent basis year after year and when the price level is not constant. · During inflationary periods the data over a period of time becomes incomparable unless the absolute rupeee data is adjusted. · There is always the danger of selecting the base year which may not be representative, normal and typical. · Though the trend percentages provide significant information, undue importance and emphasis should not be laid down on the percentages when there is a small number in the base year. In such cases even a slight variation will be magnified by the percentage change. Uses· It indicates the increase or decrease in an accounted item along with the magnitude of change in percentage, which is more effective than absolute data. The trend percentage facilitates an effective comparative study of the financial performance of a business enterprise over a period of time During the calculation of trend analysis the following precautions should be taken: i) There should be consistency in the principles and practices followed by the organizations through out the period for which analysis is made. ii) The base year should be normal i.e. representative of the items shown in the statement. iii) It should be calculated only for the items which are having logical relationship with each other. iv) It should be studied after considering the absolute figures on which they are based. v) Figures of the current year should be adjusted in the light of price level changes as compared to the base year before calculating trend analysis. vi) The changes in financial data can understood clearly when the % of change interpreted concurrently with the absolute change. vii) The changes in incomes should always be studied in the light of changes in expect items. viii) Changes should be interpreted with some reservations. ix) The interpretation of the statements should be done in the light of all possible factors which might have brought about such changes. Thus the above precautions have to be taken during the calculations of trend analysis. | |||||||||||||||||||||
Ratio analysis | Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis. Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as: 1) Fraction 2) Percentages 3) Proportion of numbers These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them. ADVANTAGES OF RATIO ANALYSIS · Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies. · Ratios avoid distortions that may result the study of absolute data or figures · Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement. · Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently. · Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future. · Ratios are increasingly used in trend analysis. · Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity. · Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances. · Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers. LIMITATIONS OF RATIO ANALYSIS: An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks. Some of them are listed below: 1. Rations can sometimes be misleading if an analyst does not know the reliability and soundness of the figures from which they are computed and the financial position of the business at other times of the year. A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1 2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied. 3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year. Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations. 4. Changes in the price level make the interpretations of the ratios Invalid. The interpretation and comparison of ratios are also rendered invalid by the changing value of money. The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result. Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless. For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable. The return of the first firm is overstated because its plant and machinery have a low book value. 5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult. In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit, current assets etc. Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people. 6. Ratios are not reliable in some cases as they many be influenced by window / dressing in the balance sheet. 7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent. The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts. 8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future. While the ratios indicate what happened in the past Art outside analyst has to rely on the past ratios which may not necessarily reflect the firm’s financial position and performance in future. a) Expense ratio is a profitability ratio, related to sales which can be computed by dividing expenses by sales. Here the term expenses includes:- i) Cost of goods sold ii) Administrative expenses iii) Selling and distribution expenses iv) Financial expenses The expenses ratio is closely profit margin, gross as well as net. It is very important for analyzing the profitability of a firm. A low expenses ratio is favourable whereas a high expenses ratio is unfavourable. The implications of a high expenses ratio is that only a relatively small percentage share of sales is available for meeting financial liabilities like interest, tax & dividends and so on. Thus, an increase in a company’s expenses ratio would leave the company in a financial crunch. An analysis of the factors responsible for a low ratio may reveal changes in the selling price on the operating expenses. It is likely that individual items may behave differently. While some operating expenses may show a rising trend, others may record a fall. The specific expenses ratio for each of the item of operating may be calculated. These ratios would identify the specific cause. To, illustrate, an increase in selling expenses may be due to a number of reasons like: i) General rise in selling expenses. ii) Inefficiency of the Marketing department leading to uncontrolled promotional and other expenses. iii) Growing competition. iv) Ineffective advertising. v) Inefficient utilization of resources. b) Current ratio: The current ratio is the ratio of total current assets to total current liabilities. The calculation is done by using the formula: Current assets Current liabilities The current assets are those can be converted into cash within a short period of time during the ordinary course of business of a firm, whereas the current liabilities include liabilities which are short term obligations to be met within a year. Thus any change in the composition of current assets &/or liabilities will lead to a change in the current ratio. The current ratio of a firm its short term solvency i.e. the ability to meet short term obligations. The higher the larger is the amount of rupees available per rupee of current liability, the more is the firm’s ability to meet current obligations & assures greater safety of funds of short term creditors. The flow of funds through current assets and liabilities account is quite inevitably uneven. Current assets might shrink due to reasons like: - i) bad debts, ii) inventories becoming obsolete or unsaleable, iii) occurrence of unexpected losses in marketable securities etc. A firm should have a satisfactory and a reasonable current ratio [2:1 is considered to be satisfactory]. A satisfactory ratio depends upon the development of the capital market & the availability of long term funds to finance current assets, the nature of industry and so on. Thus the current ratio varies with variations in such factors. The nature of the industry is one of the major cases for difference in the current ratio. For instance, public utility companies generally have a very little need for current assets. The wholesale dealers, on the other hand, purchasing goods on a cash/credit basis for a very short period but selling to retailers on credit basis, require a higher current ratio. Ratio analysis is a tool of financial analysis used to interpret the financial statements so that the strengths & weaknesses of a firm as well as its historical performance & current financial condition can be determined. Ratios are used for comparison with related facts. Comparison involves i) trends ratio, comparison of ratios of a firm over time. ii) inter-firm comparison, iii) comparison of items within a single year’s financial statement of a firm & iv) comparison with standards or plans. Ratios e classified into 4 broad groups:- i) Liquidity ratio ii) Capital structure/leverage ratio iii) Profitability ratios & iv) Activity ratios. The use of following ratios is suggested:- Firstly, the liquidity ratio as adequate liquidity is quite important since it indicates the firm’s ability to meet current/short term obligations. Creditors are interested in the short term solvency of a firm. Current ratio is one important component/type or liquidity ratio. It measures firm’s short term solvency i.e. its ability to meet short term obligations by comparing the current assets and current liabilities. The higher the current ratio, the larger the amount of rupees available per rupee of current liability, the more is the firm’s ability to meet current obligations & assures greater safety of funds of short term creditors. Secondly the leverage/capital structure ratio. These ratios throw light on the long term solvency of a firm. It judges the soundness of a firm in terms of its ability to pay the interests regularly to long term creditors & repayment of principal on maturity. Among the leverage ratios, the debt-equity is one of the important ones. It shows the relationships between borrowed bunds and owner’s capital to measure the long term financial solvency of the firm. This ratio reflects the relative claims of the creditors & shareholders against the assets of the firm. Alternatively, it includes the relative proportions of debt & equity in financing the assets of the firm. It can be expressed as follows: Debt-Equity ratio= Long term debt Shareholder’s equity Or Total debt Shareholder’s equity. The D/E ratio is thus, the ratio of the amount invested by outsiders to the amount invested by the owners of the business. It is an important tool of financial analysis to appraise the financial structure of a firm. It has important implications from the view point of creditors, owners & the firm itself. A high ratio shows a large share of financing by the creditors of the firm while a lower ratio implies smaller claim by creditors. It indicates the margin of safety to creditors. For ex: If the D/E ratio is 2:1, it implies for every rupee of outside liability, the firm has two rupees of the owner’s capital. Hence there is a safety of margin of 66.67% available to the creditors of the firm. Conversely if the D/E ratio is 1:2, it implies low safety of margin for the creditors. A high D/E ratio has equally serious implications from the firm’s point of view. It would affect the flexibility of operations of the firm, restrict the borrowings etc. the shareholders would however gain in 2 ways:- i) with a limited stake they would be able to retain control of the firm. ii) The returns would be magnified. A low D/E ratio would have just the opposite implications. Thirdly, the profitability ratios. The creditors (long term/short term), the owners & the management of the company. The management is eager to measure its operations efficiently. Similarly, owners invest their in the expectation of reasonable returns. Both these factors depend ultimately on the profits earned by it which can be measured by its profitability ratios. Profitability ratios can be determined on the basis of either sales or investments. 1) Related to sales: a) Profit margin [gross & net]:- It measures the relationship between profit & sales of a firm. b) Expenses ratio: - It measures the relationship between expenses like administration, selling & distribution, financial etc & the sales of the firm. 2) Related to investments:- a) Return on investments i) Return on assets [compare net profits & assets]. ii) Return on capital employed [compare profits & capital employed] Return on shareholder’s equity [measure the returns on owner’s funds] I. SOLVENCY RATIOS: These ratios analyze short term and immediate financial position of a business organization and indicate the ability of the firm to meet its short term commitments (Current Liabilities) out of its short term resources (Current Assets) also known as Liquidity or Credit Ratios. Solvency Ratios includes: 1) Long Term Solvency ratios:- a) Proprietary Ratios Þ Proprietary Ratio is a test of financial and credit strength of the business. It relates shareholders funds to total assets i.e. Total funds. This ratio determines the long term or ultimate solvency of the company. Proprietary Ratio = Proprietors Funds Total Funds b) Debt Equity Þ it expresses the relation between the external equities and internal equities or the relationship between borrowed capital and owners capital. Debt Equity Ratio = Debt c) Capital Gearing Ratio Þ Capital Gearing Ratio brings out the relationship between two types of capital i.e. capital carrying fixed ratio of interest or fixed dividend and capital that does not carry fixed rate of interest or fixed dividend. Capital Gearing Ratio = Securities bearing fixed rate of interest Shareholders fund 2) Short Term Solvency ratios: - a) Current Ratio Þ Current Ratio is also known as the ‘Working Capital Ratio’, ‘Solvency Ratio’ or ‘2 in 1 Ratio’. This ratio expresses the relationship between current assets and current liabilities. Current Ratio = Current Assets Current Liabilities b) Quick Ratio Þ Quick ratio is also known as ‘Liquid Ratio’ or ‘Quick Assets Ratio’ or ‘Acid Test Ratio’ or ‘Near Money Ratio’ or ‘1 to 1 Ratio’. This ratio is designed to indicate the liquid financial position of an enterprise. Thus, the ratio shows the firms ability to meet its immediate obligations promptly. It measures the relationship between quick assets and quick liabilities. Quick Ratio = Quick Assets Quick Liabilities II. PROFITABILITY RATIOS: These ratios are intended to reflect the overall efficiency of the organization, its ability to earn a reasonable return on capital employed or on shares issued and the effectiveness of its investment policies. Profitability Ratios includes: 1) Product a) Gross Profit Ratio Þ Gross profit brings out the relationship between gross profit and net sales. It is also known as ‘Turnover Ratio’ or ‘Margin’ or ‘Gross Margin Ratio’ or ‘Rate of Gross Profit’. It is expressed as % of net sales. Gross profit = Gross Profit ´ 100 Sales b) Net Profit Ratio Þ Net Profit Ratio indicates the relationship between net profit and net sales. Net profit can be either operating net profit or net profit after tax or net profit before tax. This ratio is known as ‘Margin or Sales Ratio’. Net Profit can be calculates as:- Net Profit After Tax ´ 100 Net Sales Net Profit Before Tax ´ 100 Net Sales c) Operating Ratio Þ Operating Ratio is the relationship between cost of activities and net sales. This ratio brings out the relationship between total costs of goods sold to net sales. Operating Ratio = Operating Cost ´ 100 Net Sales 2) Investment a) Return on Capital Employed Þ This ratio explains the relationship between total profits earned by the business and total investments made or total assets employed. This ratio thus measures the overall efficiency of business operations. This ratio is alternatively known as ‘Return on Total Sources’. Return on capital employed = Net profit before interest and tax ´100 Capital employed b) Return on Proprietors Fund Þ This ratio is alternatively known as ‘Return on Proprietors Equity’ or ‘Return on shareholders investment’ or ‘Investors Ratio’. The ratio indicates the relationship between net profit earned and total proprietors funds. Return on Proprietors Fund = Net Profit After Tax ´ 100 Proprietors Funds c) Return on Equity Share Capital Þ This ratio indicates the rate of earning on the equity or ordinary share capital. This is expressed as a % or in absolute monetary terms. Alternatively, this may be expressed as an amount of return per equity share but as a % of the equity capital, it is easily understood. This ratio is also known as ‘The Rate of Return on Equity Capital’. Return on Equity Share Capital = NPAT – Preference Dividend Equity Shares Capital d) Earning per share Þ Earning peer share is calculated to find out overall profitability of the organization. Earnings per share represent earnings of the company whether or not dividends are declared. If there is only one class of shares, then EPS are determined by dividing net profit by the no. of equity shares. If there are both equity and preference shares the net profit should be reduced by the amount necessary to pay preference dividend. Earnings per share = NPAT – Preference Dividend No. of Equity shares e) Dividend Payout Ratio Þ The purpose of this ratio is to find out the proportion of earning used for payment of dividend and the proportion of earning retained. The ratio is the relationship between earning per equity share and dividend per equity share. Dividend Payout Ratio = Dividend per equity share Earning per equity share | |||||||||||||||||||||
CFS | Cash flow statement is a statement of inflows and outflows of cash and cash equivalents. It starts with the opening balance of cash and cash equivalents at the start of the accounting period. It then gives in a summary form, the inflows and outflows relating to the following three classifications of activities : (i) Operating activities : They are the principal revenue producing activities of the enterprise. (ii) Investing activities : They deal with the acquisition and disposal of long-term assets and long term investments. (iii) Financing activities : They reflect changes in the size and composition of capital in the case of a company this would preference capital and borrowings of the enterprise. The cash flows arising from extraordinary items are disclosed separately under each of the above three classifications. Likewise where the amount of significant cash and cash equivalent balances held by an enterprise are not available for use by the enterprise, the same should be disclosed separately together with a commentary by the management. In the case of manufacturing company (i) Inflows of cash receipts from operating activities : (a) Cash receipts from the sales of goods; (b) Royalties, fees, commission and other revenue; (c) Refunds of income-tax. (ii) Outflows of investing activities : (a) Cash payments for acquisition of fixed assets; (b) Cash payments for acquisition of shares, warrants or debts instruments of other enterprises and interests in joint ventures (other than payments for instruments considered to cash equivalents and those for dealing or trading purposes); (c) Cash advances and loans to third parties. AS 3 (Revised) on Cash Flow Statements requires that the cash flow statement should report cash flows by operating, investing and financing activities. (i) Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. Cash receipts from sale of goods and cash payments to suppliers of goods are two examples of operating activities. (ii) Investing activities are acquisition and disposal of long-term assets and other investments not included in cash equivalents. Payment made to acquire machinery and cash received for sale of furniture are examples of investing activities. (iii) Financial activities are those activities that result in changes in the size and composition of the owner’s capital (including preference share capital in the case of a company) and borrowings of the enterprise. Cash proceeds from issue of shares and cash paid to redeem debentures are two examples of financing activities. As per para 18 of AS 3 (Revised) on Cash Flow Statements, an enterprise should report cash flows from operating activities using either : (a) the direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed; or (b) the indirect method, whereby net profit or loss in adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. The direct method provides information which may be useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method. Under the direct method, information about major classes of gross cash receipts and gross cash payments may be obtained either : (a) from the accounting records of the enterprise; or (b) by adjusting sales, cost of sales (interest and similar income and interest expense and similar charges for a financial enterprise) and other items in the statment of profit and loss for : (i) changes during the period in inventories and operating receivables and payables; (ii) other non-cash items; and (iii) other items for which the cash effects are investing or financing cash flows. Under the indirect method, the net cash flow from operating activies is determined by adjusting net profit or loss for the effects of : (a) changes during the period in inventories and operating receivables and payables; (b non-cash items such as depreciation, provisions, deferred taxes and unrealised foreign exchange gains and losses; and (c) all other items for which the cash effects are investing or financing cash flows. Alternatively, the net cash flow from operating activities may be presented under the indirect method by showing the operating revenues and expenses, excluding non-cash items disclosed in the statement of profit and loss and the changes during the period in inventories and operating receivables and payables. Differences between cash flow statement and fund flow statement (i) Cash flow statement deals with the change in cash position between two points of time. Fund flow statement deals with the changes in working capital position. (ii) Cash flow statement contains opening as well as closing balances of cash and cash equivalents. The fund flow statement does not contain any such opening and closing balance. (iii) Cash flow statement records only inflow and outflow of cash. Fund flow statement records sources and application of funds. (iv) Fund flow statement can be prepared from the cash flow statement under indirect method. However, a cash flow statement cannot be prepared from fund flow statement. (v) A statement of changes in working capital is usually prepared alongwith fund flow statement. No such statement is prepared along with the cash flow statement. In making plans for the more immediate future (short-range financial planning) the management is vitally concerned with a statement of cash flows which provides more detailed information. Such a statement is useful for the management to assess its ability to meet obligations, to trade creditors, to pay bank loans, to pay interest to debenture holders & dividend to its shareholders. Furthermore the projected cash flow statements prepared month-wise or so can be useful in presenting information of excess in some months & shortage of cash in others . By making available such information in advance, the statement of cash flows enables the management to revise its plans. Cash flow statements summarizes sources of cash inflows & uses of cash outflows of the firm during a particular period of time. In the preparation of cash flow statement all the item that increase/decrease cash are included but all those items that donot have any effect on cash are excluded. Hence, it is essentially a tool of short term financial planning. Cash flow information is useful in assessing the ability of company. In making plans for the more immediate future (short-range financial planning), the management is vitally concerned with a statement of cash flows, which provides more detailed information. Such a statement is useful for the management to assess its ability to meet obligations to trade creditors, to pay bank loans, to pay interest to debenture holders & dividend to its shareholders. Furthermore the projected cash flow statements prepared month-wise or so can be useful in presenting information of excess in some month & shortage of cash in others. By making available such information in advance, the statement of cash flows enables the management to revise its plans. Cash flow statements summarize sources of cash inflows & uses of cash outflows of the firm during a particular period of time. In the preparation of cash flow statement all the item that increase /decrease cash are included but all those items which have no effect on cash are excluded. Hence, it is essentially a tool of short term financial planning. Cash flow information is useful in assessing the ability of the enterprise to generate cash & cash equivalent & enables users to develop models to assess & compare the present value of the future cash flows of different enterprises. | |||||||||||||||||||||
FFS | Fund flow statement also referred to as statement of “source and application of funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital. The information required for the preparation of funds flow statement is drawn from the basic financial statements such as the Balance Sheet and Profit and loss account. “Funds Flow Statement” can be prepared on total resource basis, working capital basis and cash basis. The most commonly accepted form of fund flow is the one prepared on working capital basis. CASH FLOW - A Cash Flow Statement is a statement which shows inflows and outflows of cash and cash equivalents of an enterprise during a particular period. It provides information about cash flows, associated with the period’s operations and also about the entity’s investing and financing activities during the period. FUND FLOW – Fund Flow Statement also referred to as the statement of “Source and Application of Funds” provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital., A fund flow statement is different from cash flow statement in the following ways – i). Funds flow statement is based on the concept of working capital while cash flow statement is based on cash which is only one of the element of working capital. Thus cash flow statement provides the details of funds movements. ii). Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement records inflows or outflows of cash, the difference of total inflows and outflows is the net increase or decrease in cash and cash equivalents. iii). Funds Flow statement does not contain any opening and closing balance whereas in cash flow statement opening as well as closing balances of cash and cash equivalents are given. iv). Funds Flow statement is more relevant in estimating the firm’s ability to meet its long-term liabilities, however, cash flow statement is more relevant in estimating the firms short-term phenomena affecting the liquidity of the business. v). The Cash Flow statement considers only the actual movement of cash whereas the funds flow statement considers the movement of funds on accrual basis. vi). In cash flow statement cash from the operations are calculated after adjusting the increases and decreases in current assets and liabilities. In funds flow statement such changes in current items are adjusted in the changes of working capital. vii). Cash flow statement is generally used as a tool of financial analysis which is utilized by the management for short- term financial analysis and cash planning purposes, whereas funds flow statement is useful in planning intermediate and long-term financing. What are the Advantages of Fund Flow Statements? Advantages of fund flow are as follows: § management of various companies are able to review their cash budget with the aid of fund flow statements § Helps in the evaluation of alternative finance and investments plan § Investors are able to measure as to how the company has utilized the funds supplied by them and its financial strengths with the aid of funds statements. § It serves as an effective tool to the management of economic analysis § It explains the relationship between the changes in the working capital and net profits. § Help in the planning process of a company § It is an effective tool in the allocation of resources § Helps provide explicit answers to the questions regarding liquid and solvency position of the company, distribution of dividend and whether the working capital is effectively used or not. § Helps the management of companies to forecast in advance the requirements of additional capital and plan its capital issue accordingly. Helps in determining how the profits of a company have been invested: whether invested in fixed assets or in inventories or ploughed back. Q) Uses of fund flow statements: Ans.) Ø Fund flow statements are prepared for internal & external uses. Ø They are designed to assess the funds available, forecast cash requirements & to evaluate the investments & financial decisions of a business entity. Ø There are many parties who are interested in the funds flow statements. Shareholders, investors, bankers, creditors & the management are among them. Ø Primarily, the funds flow statements is to identify the sources & applications of funds. Q) Importance & short comings of fund flow statement: Ans.) Funds flow statement is a financial statement, which shows as to how a business entity has obtained its funds & how it has applied or employed its funds between the opening & closing balance sheet dates(during the particular year/period. Importance of funds flow statement: Funds flow statement is an important analytical tool for external as well as internal uses of financial statements. The users of funds flow statement can be listed as under: 1. Managements of various companies are able to review cash budgets with the aid of funds flow statements. They are extensively used by the management in the evaluation of alternative finance & investments. In the evaluation of alternative finance & investment plans, funds flow statement helps the management in the assessment of long-range forecasts of cash requirements & availability of liquid resources. The management can judge the quality of management decisions. 2. Investors are able to measure as how the company has utilized the funds supplied by them & its financial strength with the aid of funds statements. They gauge can the company capacity to generate funds from operations. On the basis of comparative study of the past with the present, investors can locate & identify possible drains on funds in the near future. 3. Funds statement serve as effective tools to the management for economic analysis as it supplies additional information, which cannot be provided by financial statements, based on historical data. 4. Fund statement explains the relationship between changes in working capital & net profits. Funds statement clearly shows the quantum of funds generated from operations. 5. Funds statement helps in the planning process of a company. They are useful in assessing the resources available and the manner of utilization of resources. 6. Funds statement explains the financial consequences of business activities. They provide explicit & clear awareness to questions regarding liquid & solvency positions of the company, distribution of dividend & whether the working capital has been effective or otherwise. 7. Management of companies can forecast in advance the requirements of additional capital & can plan its capital issue accordingly. 8. Fund statement provides clues to the creditors & financial institutions as to the ability of a company to use funds effectively in the best interest of the investors, creditors & the owners of the company. 9. Funds statement indicates the adequacy or inadequacy of working capital. 10. The information contained in fund flow statement is more reliable, dependable & consistent as it is prepared to include funds generated from operations & not net profit after depreciation. 11. Funds flow statement clearly indicate how profits have been invested, whether investments in fixed assets or inventories or ploughed back.
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Banking co’s | Acceptances and endorsements: A bank has a more acceptable credit as compared to that of its customers. On this account, it is often called upon to accept or endorse bills on behalf of its customers. In such a case, the bank undertakes a liability towards the party which agrees to receive such a bill in payment of a debt or agreed to discount the bill after the same has been accepted by the bank. As against this liability, the bank has a corresponding claim against the customer on whose behalf it has undertaken to be a party to the bill, either as an acceptor or as an endorser. Such liabilities which are outstanding at the close of the year and the corresponding assets are disclosed as contingent liability in the financial statements. As a safeguard against the customer not being able to meet the demand of the bank in this respect, usually the bank requires the customer to deposit a security equivalent to the amount of the bill accepted on his behalf. A record of the particulars of the bills accepted as well as of the securities collected from the customers is kept in the Bills Accepted Register. A bank may not treat this book as part of the system of its account. In such a case no further record of the transactions is kept until the bill matures for payment. If the bill, at the end of its term, has to be retired by the bank and the amount cannot be collected from the customer on demand, the bank reimburses itself by disposing of the security deposited by the customer. Classification of investments by a banking company. The investment portfolio of a bank would normally consist of both approved securities (predominantly government securities) and other securities (shares, debentures, bonds etc.). Banks are required to classify their entire investment portfolio into three catogories : held-tomaturity, available-for-sale and held-for-maturity. Securities acquired by banks with the intention to hold them upto maturity should be classified as ‘held-to-maturity’. Securities acquired by banks with the intention to trade by taking advantage of short–term price interest rate movements should be classifed as held-for trading/maturity. Securities which do not fall within the above two categories should be classified as available-for-sale’. Non-Performing Assets.: An asset is classified as non-performing asset (NPA) if dues in the form of principal and interest are not paid by the borrower for a period of 90 days. If any advance or credit facilities granted by a bank to a borrower becomes non-performing, then the bank will have to treat all the advances/credit facilities granted to that borrower as non-performing without having any regard to the fact that there may still exist certain advances/credit facilities having performing status. Income from the non-performing assets can only be accounted for as and when it is actually received. In concept, any credit facility (assets) becomes non-performing when it eases to generate income. The RBI has issued guidelines to commercial banks regarding the classification of advances between performing and non-performing assets. A term loan is treated as a non-performing assets (NPA) if interest and/or instalments of principal remains over due for a period of more than 90 days. A cash credit/overdraft account is treated as NPA if it remains out of order for a period of more than 90 days. An account is treated an ‘out of order’ if any of the following conditions is satisfied : (a) the outstanding balance remains continuously in excess of the sanctional limit/drawing power. (b) though the outstanding balance is less than the sanctioned limit/drawing power— (i) there are credits continuously for more than 90 days as on the date of balance sheet or (ii) credits during the aforesaid periods are not enough to cover the interest debited during the same period. Bills purchased and discounted are treated as NPA if they remain overdue and unpaid for a period of more than 90 days. Necessary provision should be made for non-performing assets after classifying them as sub-standard, doubtful or loss asset as the case may be. Banks have to classify their advances into four broad groups: (i) Standard Assets—Standard assets is one which does not disclose any problems and which does not carry more than normal risk attached to the business. Such an asset is not a NPA as discussed earlier. (ii) Sub-standard Assets—Sub-standard asset is one which has been classified as NPA for a period not exceeding 12 months. In the case of term loans, those where instalments of principal are overdue for period exceeding one year should be treated as sub-standard. In other words, such an asset will have well-defined credit weaknesses that jeopardise the liquidation of the debt and are characterised by the distinct possibility that the bank will sustain some loss, if deficiencies are not corrected. (iii) Doubtful Assets—A doubtful asset is one which has remained NPA for a period exceeding 18 months. In the case of term loans, those where instalments of principal have remained overdue for a period exceeding 18 months should be treated as doubtful. A loan classified as doubtful has all the weaknesses inherent in that classified as sub-standard with added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable. (iv) Loss Assets—A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspectors but the amount has not been written off, wholly or partly. The classification of advances should be done taking into account (i) Degree of well defined credit worthiness and (ii) Extent of dependence on collateral security. The above classification is meant for the purpose of computing the amount of provision to be made in respect of advances and not for the purpose of presentation of advances in the balance sheet. | |||||||||||||||||||||
Insurance co’s | Unexpired Risks Reserve: In most cases policies are renewed annually except in some cases where policies are issued for a shorter period. Since insurers close their accounts on a particular date, not all risks under policies expire on that date. Many policies extend into the following year during which the risk continues. Therefore on the closing date, there is unexpired liability under various policies which may occur during the remaining term of the policy beyond the year and therefore, a provision for unexpired risks is made at normally 50% in case of Fire Insurance and 100% of in case of Marine Insurance. This reserve is based on the net premium income earned by the insurance company during the year Re-insurance.: If an insurer does not wish to bear the whole risk of policy written by him, he may reinsure a part of the risk with some other insurer. In such a case the insurer is said to have ceded a part of his business to other insurer. The reinsurance transaction may thus be defined as an agreement between a ‘ceding company’ and ‘reinsurer’ whereby the former agreed to ‘cede’ and the latter agrees to accept a certain specified share of risk or liability upon terms as set out in the agreement. A ‘ceding company’ is the original insurance company which has accepted the risk and has agreed to ‘cede’ or pass on that risk to another insurance company or a reinsurance company. It may however be emphasised that the original insured does not acquire any right under a reinsurance contract against the reinsurer. In the event of loss, therefore, the insured’s claim for full amount is against the original insurer. The original insurer has to claim the proportionate amount from the reinsurer. There are two types of reinsurance contracts, namely, facultative reinsurance and treaty reinsurance. Under facultative reinsurance each transaction has to be negotiated invididually and each party to the transaction has a free choice, i.e., for the ceding company to offer and the reinsurer to accept. Under treaty reinsurance a treaty agreement is entered into betweenceding company and the reinsurer whereby the volume of the reinsurance transactions remain within the limits of the treaty. Premium income : The payment made by the insured as consideration for the grant of insurance is known as premium. The amount of premium income to be credited to revenue account for a year may be computed as : Rs. Premium received on risks undertaken during the year (direct & re-insurance accepted) – Add : Receivable at the end of year (direct & re-insurance accepted) – Less : Receivable at the beginning of year (direct & re-insurance accepted) – Less : Premium on re-insurance ceded: – Paid during the year – Add : Payable at the end of year – Less : Payable at the beginning of year – Premium income – Claims expenses : A claim occurs when a policy falls due for payment. In the case of alife insurance business, it will arise either on death or maturity of policy that is, on the expiry of the specified term of years. In the case of general insurance business, a claim arises only when the loss occurs or the liability arises. The amount of claim to be charged to revenue account may be worked out as under : Rs. Claims settled during the year—direct & re-insurance accepted – (including legal fees, survey charges etc.) Add : Payments to co-insurers – Less : Received from co-insurers and re-insurers – Net payment – Add : Estimated liability at the end of the year – (After deducting recoverable from co-insurers and re-insurers) Less : Estimated liability at the beginning of the year – (after deducting recoverable from co-insurers and re-insurers) Claims expense – Commission expenses : Insurance Regulatory and Development Authority Act, 1999 regulates the commission payable on policies to agents. Commission expense to be charged to revenue account is computed as follows : Rs. Commission paid (direct & re-insurance accepted) – Add : Commission payable at the end of the year – (direct & re-insurance accepted) Less : Commission payable at the beginning of the year – (direct & re-insurance accepted) Commission expense – | |||||||||||||||||||||
Friday 16 September 2011
BBI-FRA Notes set 1
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