Financial Management A Complete Study for CA/CMA/CS/CFA/ACCA

Time value of money (TVM) is the idea that money that is available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received.

PV = Present value, also known as present discounted value, is the value on a given date of a payment. r = the periodic rate of return, interest or inflation rate, also known as the discounting rate.

The present value of an annuity is the current value of future payments from an annuity, given a specified rate of return or discount rate

This method involves discounting net cash flow to their present value and then matching that present value with the capital expenditure required by the investment. The difference between these two amounts is net present value.

The other option is that you pay some down-payment and give the remaining amount in the form of equal installments at regular intervals. Note: In installment scheme the buyer pays more because in addition to installment a buyer has to pay an interest on it monthly or yearly.

Practice Activities - Questions

Ratio analysis is the comparison of line items in the financial statements of a business. Ratio analysis is used to evaluate a number of issues with an entity, such as its liquidity, efficiency of operations, and profitability.

A liquidity ratio is a financial ratio that indicates whether a company's current assets will be sufficient to meet the company's obligations when they become due.Liquidity ratios analyze the ability of a company to pay off both its current and long-term liabilities as they become due.

Debtor Collection Period indicates the average time taken to collect trade debts. In other words, a reducing period of time is an indicator of increasing efficiency. It enables the enterprise to compare the real collection period with the granted/theoretical credit period.

Summary of Cash Flow Analysis

Introduction to Cash Flow Analysis: Cash flow analysis is crucial to understanding a company's financial health. It helps to classify and analyze cash inflows and outflows, revealing the actual cash position of the business, unlike just looking at profits from the income statement.

Scenarios of Cash Flow vs. Profit:

• Cash = Profit: When sales are fully realized, and all expenses are paid, the cash generated matches the profit.

• Cash > Profit: Occurs when the company collects more cash than it pays out for expenses, resulting in a higher cash position.

• Cash < Profit: Happens when the company collects less cash than it pays out, leading to lower cash generation than profit.

Understanding Income vs. Cash: Profits reported in the income statement may not reflect actual cash generation due to non-cash items, deferred payments, or uncollected revenue. To understand true cash flow, it’s necessary to go beyond the income statement and consider cash inflows and outflows.

Cash Flow Influenced by Balance Sheet Items: Cash generation is not just confined to income and expenses; it is also impacted by balance sheet activities such as loan repayments, asset purchases, and equity transactions.

Classification of Cash Flows: Cash flows are divided into three main categories:

1. Operating Activities: Cash flows from the core business operations, including sales, expenses, and taxes related to operations.

2. Investing Activities: Cash flows from buying or selling long-term assets like machinery, real estate, or investments in securities.

3. Financing Activities: Cash flows related to raising or repaying capital, including equity, loans, debentures, interest payments, and dividends.

Example of Cash Flow Movements: A business can have scenarios where:

• Cash declines: Due to loan repayments or asset purchases.

• Cash increases: Due to raising equity, selling assets, or acquiring loans.

Importance of Cash Flow Statement: A cash flow statement provides detailed insights into how much cash is generated from operating, investing, and financing activities. It helps in assessing the company's ability to generate cash, manage investments, and handle financing needs.

Key Takeaways from Cash Flow Statement:

• Operating Activities: A positive cash flow indicates a healthy business, while a negative flow requires deeper analysis.

• Investing Activities: Reveals whether the company is heavily investing or selling off assets.

• Financing Activities: Shows whether the company is raising funds or repaying loans.

The cash flow statement concludes with the reconciliation of opening and closing cash balances, providing a clear picture of the company's cash position.

Summary of Cash Flows from Operating, Investment, and Financing Activities

Cash Flow from Operating Activities: Cash flow from operating activities involves cash inflows and outflows related to the core operations of a business.

• Cash inflows include:

  • Receipts from the sale of goods and services.

  • Receipts from operational activities like royalties, fees, and commissions.

• Cash outflows include:

  • Payments to suppliers for goods and services.

  • Payments to employees (wages, salaries).

  • Payments for expenses like utilities, power, and fuel.

  • Payments or refunds of taxes related to operational profits.

Cash Flow from Investing Activities: Cash flow from investing activities includes cash transactions related to the acquisition or disposal of long-term assets and investments.

• Cash outflows include:

  • Payments for purchasing fixed assets (machinery, buildings).

  • Payments for acquiring shares, warrants, or debt instruments with long-term holding intentions.

  • Loans made to third parties for long-term purposes.

• Cash inflows include:

  • Receipts from the sale of fixed assets or investments.

  • Proceeds from the disposal of shares, warrants, or debt instruments.

  • Interest and dividend income from investments.

Cash Flow from Financing Activities: Cash flow from financing activities reflects transactions that affect the company's capital structure and funding.

• Cash inflows include:

  • Proceeds from issuing shares or debt instruments (debentures, bonds).

  • Proceeds from long-term or short-term borrowings (loans).

• Cash outflows include:

  • Repayment of loans or borrowings.

  • Redemption or buyback of equity shares.

  • Interest payments on loans.

  • Dividend payments to shareholders.

In summary, cash flow from operating activities focuses on day-to-day business operations, cash flow from investing activities deals with long-term investments, and cash flow from financing activities involves raising or repaying capital.

Summary of Cash Flow Statement (Indirect Method)

The Cash Flow Statement (Indirect Method) starts with the net profit or loss from the income statement and adjusts it for non-cash transactions and changes in working capital to arrive at the net cash provided by operating activities. It then categorizes cash flows into three activities:

1. Operating Activities (Indirect Method):

• Starting Point: Net profit or loss as per the income statement.

• Adjustments for Non-Cash Items: These include adding back non-cash expenses like depreciation, amortization, and provisions, and subtracting non-cash gains like profit from asset sales.

• Working Capital Adjustments: Changes in working capital (current assets and liabilities) are adjusted:

  • Increases in current liabilities (e.g., accounts payable) increase cash flow.

  • Increases in current assets (e.g., accounts receivable) reduce cash flow.

• Tax Payments: Taxes paid, refunds received, and other tax-related cash flows are considered part of operating activities.

2. Investing Activities:

Cash flows related to the purchase or sale of long-term assets and investments, including:

• Cash Outflows: For the purchase of fixed assets (machinery, land) or long-term investments (shares, bonds).

• Cash Inflows: From the sale of fixed assets or disposal of long-term investments.

• Interest and Dividends Received: If earned from investments, these are considered cash inflows from investing activities.

3. Financing Activities:

Cash flows that affect the company's capital structure:

• Cash Inflows: From issuing shares, debentures, or taking out loans.

• Cash Outflows: For repaying loans, redeeming debentures, or buying back shares.

• Interest Paid and Dividends: Payments on borrowings (interest) and dividends to shareholders are treated as cash outflows.

4. Final Calculation:

• Net Cash Flow: After summarizing cash flows from all three activities (operating, investing, and financing), you add or subtract these from the opening cash balance to determine the closing cash balance for the period.

The Indirect Method focuses on reconciling net profit with cash flows from operations, making it an effective tool for understanding how profit translates into cash and how non-cash activities and working capital changes affect the company’s cash position.

Summary of Cash Flow Statement - Direct Method

The Cash Flow Statement can be prepared using two methods: Direct and Indirect. In this summary, we focus on the Direct Method, which provides a detailed breakdown of cash flows.

Key Sections of the Cash Flow Statement under the Direct Method:

1. Cash Flow from Operating Activities:

   • Cash Receipts from Customers: All receipts from sales and operational activities (excluding unrealized sales).

   • Cash Payments to Suppliers and Employees: Outflows for operational expenses like goods, services, and salaries (shown in brackets to indicate outflows).

   • Cash Generated from Operations: The difference between receipts and payments.

   • Income Taxes Paid: Tax payments are deducted (shown in brackets).

   • Cash Flow Before Extraordinary Items: This figure excludes any extraordinary items.

   • Extraordinary Items: Inflows or outflows from one-off events (e.g., proceeds from a disaster) are shown separately.

   • Net Cash from Operating Activities: This is the final net cash position from operating activities, calculated after all adjustments.

2. Cash Flow from Investing Activities:

   • Cash Outflows: Payments related to purchasing fixed assets (shown in brackets).

   • Cash Inflows: Receipts from selling assets (shown as positive inflows).

   • Interest and Dividends Received: Any income from investments (shown as inflows).

   • Net Cash from Investing Activities: This could be either a positive or negative amount, depending on whether the company is investing or divesting.

3. Cash Flow from Financing Activities:

   • Proceeds from Issuing Shares or Borrowings: Cash inflows from issuing equity or raising loans.

   • Repayment of Loans: Cash outflows for repaying long-term borrowings (shown in brackets).

   • Interest Paid: Payments made as interest on borrowings (shown in brackets).

   • Dividends Paid: Payments made to shareholders as dividends (shown in brackets).

   • Net Cash from Financing Activities: The net cash position from financing activities.

4. Final Calculation:

   • Net Increase/Decrease in Cash and Cash Equivalents: The sum of net cash from operating, investing, and financing activities (A + B + C).

   • Cash and Cash Equivalents at the Beginning of the Period: Added to the above figure to get the final Cash and Cash Equivalents at the End of the Period.

This format highlights both inflows (positive amounts) and outflows (negative amounts, shown in brackets), helping to clearly understand how cash is generated or consumed in operations, investments, and financing activities.

Cash Flow statement uses the Cash basis of accounting. On the contrary, Fund Flow statement uses the Accrual Basis of Accounting. Cash Flow statement shows the inflows and outflows of cash, but Fund Flow Statement shows the sources and application of funds.

The statement of cash flow shows how a company spends its money (cash outflows) and from where a company receives its money (cash inflows). The cash flow statement includes all cash inflows a company receives from its ongoing operations and external investment sources

Summary: Introduction to Fund Flow Analysis

Fund Flow Analysis is a crucial tool to understand the movement of funds within a business, supplementing traditional financial statements like the balance sheet and profit and loss statement. Here's a breakdown of its importance and purpose:

1. Limitations of Financial Statements:

   • The balance sheet shows the financial position at a specific date, and the profit and loss statement communicates the book profits during the year. However, these statements do not directly show the movement of funds, i.e., how much was mobilized or utilized.

   • To address this gap, a Fund Flow Statement is prepared, which tracks the sources and uses of funds within the business.

2. Importance of Long-term vs Short-term Funds:

   • Long-term funds: Businesses with more long-term funds enjoy better liquidity, meaning they can meet short-term obligations without difficulty. This provides long-term financial stability.

   • Short-term funds: Relying heavily on short-term funds can negatively affect liquidity. Since these funds need to be repaid quickly, the business must continuously generate resources, and any mismatch in cash flow can lead to liquidity issues.

3. Liquidity and Solvency:

   • A business with more long-term funds will have stronger long-term stability.

   • A business that depends on short-term funds may face liquidity pressure, impacting both stability and solvency.

4. Significance of Fund Flow Analysis:

   • Fund flow analysis helps to understand the nature of funds (long-term vs short-term) and their timing.

   • By distinguishing between the sources and uses of funds, businesses can maintain operational stability and avoid liquidity issues.

This introduction emphasizes the importance of analyzing fund movements to ensure long-term financial health and liquidity management.

Fund flow analysis is the analysis of flow of fund from current asset to fixed asset or current asset to long term liabilities or vice-versa. Funds flow statement is an assertion of sources and uses of funds.

The content outlines a simplified approach to preparing a financial statement by using an imaginary company's balance sheet, focusing on classifying liabilities and assets into long-term and short-term categories based on time. The key points are:

1. Balance Sheet Structure:

   • Liabilities: Capital, profits, long-term loans, and current liabilities.

   • Assets: Capex, long-term investments, and current assets.

2. Classification:

   • Long-term Funds (Sources): Capital, long-term loans.

   • Long-term Uses: Capex, long-term investments.

   • Short-term Sources: Current liabilities.

   • Short-term Uses: Current assets.

3. Working Capital:

   • The difference between current assets (150) and current liabilities (100) gives a working capital of 50.

4. Financial Statement:

   • Sources of Funds: Captures long-term sources (total 250).

   • Uses of Funds: Captures long-term uses (total 200), leading to a surplus of 50.

5. Analysis:

   • The surplus of 50 has been used to fund the working capital (50). The balance between long-term sources and uses ensures positive working capital, indicating a healthy financial position for the company.

6. Conclusion:

   • A positive working capital (50) reflects a well-managed financial situation, as the surplus from long-term funds has been effectively deployed to support short-term needs.

This analysis helps to understand how long-term sources fund long-term uses, and any surplus is utilized for working capital, maintaining financial stability.

The content explains the importance of maintaining a balance between long-term sources and uses of funds using a diagrammatic approach. It illustrates two scenarios:

1. Positive Working Capital:

   • Sources of Funds (Left Side): Represents long-term sources.

   • Uses of Funds (Right Side): Represents long-term uses.

   • When long-term sources exceed long-term uses, the surplus is referred to as networking capital. This surplus is used to fund current assets, ensuring a healthy financial position.

   • Organizations should strive for this situation, where positive working capital supports short-term needs.

2. Negative Working Capital:

   • In this case, long-term uses are larger than long-term sources, leading to a deficit.

   • The deficit is funded by diverting short-term funds to long-term uses, creating negative working capital. This occurs when current liabilities exceed current assets.

   • This is a risky situation, as short-term obligations require repayment, but long-term assets cannot be liquidated easily to meet these obligations. Organizations in this scenario face financial trouble.

Key Message: Companies should aim to maintain more long-term sources than long-term uses to ensure positive working capital. Avoid using short-term funds for long-term purposes to prevent negative working capital, which leads to financial instability.

Summary: Identifying Long-term Sources and Users of Funds

1. Balance Sheet Structure:

   • Liabilities and assets are categorized into long-term and short-term:

     • Long-term liabilities are referred to as long-term sources.

     • Short-term liabilities are short-term sources.

     • Long-term assets are long-term users.

     • Short-term assets are short-term users.

2. Changes in Long-term Sources:

   • Increase in long-term sources (e.g., raising long-term loans or issuing debentures):

     • Indicates inflow of long-term funds.

     • Shown under sources of funds in financial statements.

   • Decrease in long-term sources (e.g., repayment of loans, buyback):

     • Indicates an outflow of funds.

     • Shown under users of funds.

3. Changes in Long-term Users:

   • Increase in long-term users (e.g., buying assets like plant and machinery):

     • Indicates outflow of funds.

     • Shown under users of funds.

   • Decrease in long-term users (e.g., selling assets or long-term investments):

     • Indicates inflow of funds.

     • Shown under sources of funds.

4. Net Working Capital (NWC):

   • NWC is calculated by comparing short-term sources and short-term users:

     • Increase in current year NWC compared to the previous year:

       • Indicates the use of long-term funds for working capital.

       • Shown as use of funds.

     • Decrease in current year NWC compared to the previous year:

       • Indicates that funds from NWC are used for long-term purposes.

       • Shown as source of funds.

5. Conclusion:

   • Increase in long-term sources or decrease in long-term users results in inflow of funds.

   • Decrease in long-term sources or increase in long-term users results in outflow of funds.

   • NWC changes also play a critical role in determining whether funds are a source or use.

In the next session, a specific format of a fund flow statement will be introduced for clearer understanding.

Summary: Preparing a Fund Flow Statement Format

1. Horizontal Format Overview:

   • Sources of funds on the left side (long-term sources).

   • Uses of funds on the right side (long-term uses).

2. Long-term Sources of Funds:

   • Funds from Operations: The primary long-term source, generated from the business entity’s operations.

   • Other Sources:

     • Issue of equity shares.

     • Raising debentures or preference shares.

     • Long-term loans.

     • Sale of long-term assets like land, machinery, or investments.

3. Long-term Uses of Funds:

   • Funds Lost in Operations: If the company has a loss in operations, it replaces funds from operations on the right-hand side.

   • Other Uses:

     • Buyback of equity.

     • Repayment of debentures, preference capital, or long-term loans.

     • Purchase of long-term assets or investments.

     • Payment of taxes and dividends: These are typically short-term but can be classified as long-term uses since they represent profit sharing (taxes to the government, dividends to owners).

4. Surplus or Deficit:

   • If long-term sources exceed long-term uses, the surplus contributes to positive working capital.

   • If long-term uses exceed long-term sources, the deficit leads to negative working capital.

5. Reconciliation through Working Capital:

   • To cross-check, prepare a statement of changes in working capital by comparing current and previous year current assets and current liabilities.

   • If the current year’s net working capital is higher than the previous year’s, it indicates positive working capital.

   • If it is lower, it indicates negative working capital.

6. Funds from Operations (FFO):

   • Start with retained profit and add back:

     • Proposed dividends (to show profit before dividends are paid).

     • Transfers to general reserve.

     • Preference dividends.

     • Provision for taxes (since tax payments are shown as a use of funds, FFO should be before taxes).

     • Depreciation or amortization (non-cash items).

   • This calculation provides the funds generated from operations, which becomes the first item in the source side of the fund flow statement.

This structured approach ensures a comprehensive and accurate fund flow statement, highlighting the generation and use of long-term funds, changes in working capital, and alignment with financial operations.

Summary: Information Required for Preparing a Financial Statement

1. Two Years of Financial Statements:

   • Balance Sheet: Required for both the current and previous year.

   • Income Statement: Required only for the current year. Previous year's income statement is not necessary.

2. Common Problem:

   • Often, only the balance sheet for the current and previous year is provided, with no income statement.

   • In such cases, the balance sheet and given adjustments must be used to extract relevant information that would normally come from the income statement.

3. Why the Income Statement is Needed:

   • It helps calculate funds from operations, which is essential for preparing the fund flow statement.

   • To calculate funds from operations, start with the retained profit and then add:

     • Equity dividend (proposed),

     • Preference dividend,

     • Transfer to general reserve,

     • Provision for taxes,

     • Depreciation and amortization.

4. Alternative Approach:

   • If the income statement is not available, items in the balance sheet must be linked and analyzed to find funds generated from operations.