Financial Management - Cash Flow Analysis

 

FINANCIAL MANAGEMENT

Cash Flow Analysis

 

Part A: Discussion of basic theories including various methods and techniques of preparing the Cash Flow Statement and explanation of important definitions and points relevant to analysing the cash flows of a business enterprise effectively in order to preparing the Cash Flow Statement most appropriately.

Part B: 5 Illustrations with solutions.

Part A

Definitions

 

Cash flow means change in cash balance between two balance sheet dates. In other words, cash flow is the difference between the opening cash balance and the closing cash balance of an accounting year. If the closing cash balance of the accounting year is higher than the opening cash balance, it is termed as positive cash flow. On the other hand, if the closing cash balance is smaller than the opening cash balance, it is termed as negative cash flow.

 

Cash flow analysis means analysis of the cash flow in order to find out –

(a)  If there is a positive cash flow, then what are the reasons / factors which contributed to the increase in cash balance during the accounting year?

(b)  If there is a negative cash flow, then what are the reasons / factors which contributed to the decrease in cash balance during the accounting year?

 

Cash flow statement is a statement prepared for the purpose of cash flow analysis as per AS-3 (Accounting Standard – 3) issued by the Institute of Chartered Accountants of India (ICAI). As per the AS-3 a cash flow statement should consist of following three components:

 

1. Cash flows from operating activities

 

Cash flows from operating activities primarily arise from the principal revenue-producing activities of the enterprise. Therefore, they generally result from the transactions that are considered for determining net profit or net loss. Thus, examples of cash flows from operating activities are:

i.         Cash receipts from the sale of goods and the rendering of services;

ii.        Cash receipts from royalties, fees, commission and other revenue;

iii.      Cash payments to suppliers of goods and services;

iv.      Cash payments to and on behalf of the employees (e.g., salaries, wages, PF contribution, ESI   contribution, etc.).

 

2. Cash flows from investing activities

 

Cash flows arising out of acquisition and disposal of fixed assets and long term investments are classified under investing activities. Examples of these cash flows are as follows:

i.         Cash payments to acquire fixed assets (including intangible assets);

ii.        Cash receipts from disposal of fixed assets (including intangible assets);

iii.      Cash payments to acquire shares, debentures etc. of other companies;

iv.      Cash receipts from disposal of shares, debentures etc. of other companies;

v.       Receipt of dividend and interest in cash;

vi.      Cash payments for research and development;

vii.    Cash payments for construction of fixed assets.

 

3. Cash flows from financing activities

 

Cash flows arising out of raising and redemption of capital are classified under financing activities. Examples of these cash flows are as follows:

i.         Cash receipts from issue of shares;

ii.        Cash payments for buy back of equity shares;

iii.      Cash payments for redemption of preference shares;

iv.      Cash receipts from issue of debentures;

v.       Cash payments for redemption of debentures;

vi.      Raising of long term loans in cash;

vii.    Repayment of long term loans in cash;

viii.   Payment of dividend and interest in cash.

 

Methods of preparing the cash flow statement

There are two methods for preparing the cash flow statement: Direct Method and Indirect Method.

Some Important Points / Explanations:

 

1.   Meaning of cash and cash equivalents

 

Cash comprises (a) cash in hand and (b) cash at bank in the form of demand deposits. Cash equivalents are short term highly liquid investments having a short maturity period of, say, three months or less from the date of acquisition, which can be readily converted into known amount of cash and which are not subject to any significant risk of changes in value. Examples of cash equivalents are (a) marketable securities such as treasury bills, commercial papers etc., which can be converted into known amounts of cash readily and (b) short-term investments.

 

2.   Current Investments

 

Current investments are considered as part of working capital. If, however, they are stated to be marketable securities or short-term investments, they are included in cash and cash equivalents.

 

3.   Treatment of bank overdraft and cash credit

 

Bank overdraft and cash credit are to be treated as short-term borrowings (under current liabilities) as part of financing activities and not as cash and cash equivalents.

 

4.   Provision against current assets

 

Very often provision is made for doubtful debts and obsolescence or loss in the value of inventory. In such cases the concerned item of current asset should be shown net of provision in the “changes in working capital”.

 

5.   Treatment of bad debts

 

Bad debts written off during the year may be added back to the closing balances of provision for doubtful debts and trade receivables. Alternatively, the adjustment of writing off of bad debts may be ignored and the solution can be given on the basis of the closing balances of provision for doubtful debts and trade receivables as appearing in the balance sheet without adding back the bad debts written off during the year to the said closing balances.

 

6.   Purchasing a business by issue of fully paid shares

 

If assets and liabilities of another company are purchased by issuing fully paid shares, the entire amount of issue of shares against the business purchase should be ignored i.e. should not be considered as a cash inflow under financing activities. Similarly, acquisition of fixed assets in such cases should also be ignored i.e. should not be considered as a cash outflow under investing activities. But the current assets or current liabilities acquired in such cases should be added with the respective opening balances and should be considered accordingly under operating activities.

 

7.   Treatment of proposed dividend

 

(a)    Dividend proposed for the previous year will be an outflow for cash, unless otherwise stated, on the assumption that the proposed amount has been approved by the shareholders in the AGM.

 

(b)    No effect is given to Proposed Dividend for the current year as it is not provided for and is a contingent liability.

 

(c)     Any unpaid dividend is transferred to Dividend Payable A/c / Unpaid Dividend A/c which is shown in the Balance Sheet of the current year as Other Current Liabilities under Current Liabilities.

 

8.   Interest on debentures and loans

 

The International Accounting Standard Board (IASB) in their IAS-7: Cash Flow Statement has considered interest expenses as part of operating activities. In this case, interest expenses are not to be added back under “Cash flows from operating activities”. It would be simply ignored.

 

But, The Institute of Chartered Accountants of India (ICAI) in AS-3: Cash Flow Statement has considered interest expenses as part of financing activities. In this case, interest expenses have to be added back under “Cash flows from operating activities” and payment of interests has to be shown as outflow of cash under “Cash flows from financing activities”.

 

In the above format interest on debentures and loans has been considered as part of financing activities. If nothing specific is instructed in the problem in this regard, interest expenses should be considered as part of financing activities.

Part B