Month: July 2020

Cash and cash equivalents (CCE) are the most liquid current assets found on a business’s balance sheet. Cash equivalents are short-term commitments “with temporarily idle cash and easily convertible into a known cash amount”. An investment normally counts to be a cash equivalent when it has a short maturity period of 90 days or less, and can be included in the cash and cash equivalents balance from the date of acquisition when it carries an insignificant risk of changes in the asset value; with more than 90 days maturity, the asset is not considered as cash and cash equivalents. Equity investments mostly are excluded from cash equivalents, unless they are essentially cash equivalents, for instance, if the preferred shares acquired within a short maturity period and with specified recovery date.

Cash is the money in the form of currency. Currency includes currency notes and coins. Any currency notes and coins held by an enterprise are part of the term “cash”.

Demand deposit is a type of an account from which funds can be withdrawn at any time without having to inform the bank or depository institution. Most of the checking and saving accounts are demand deposits.

One of the company’s crucial health indicators is its ability to generate cash and cash equivalents. So, a company with relatively high net assets and significantly less cash and cash equivalents can mostly be considered an indication of non-liquidity. For investors and company’s cash and cash equivalents are generally counted to be “low risk and low return” investments and sometimes analysts can estimate company’s ability to pay its bills in a short period of time by comparing CCE and current liabilities. Nevertheless, this can happen only if there are receivables that can be converted into cash immediately.

First, owners and investors can contribute money to the business in exchange for a percentage ownership in the company. Second, the company can generate money from selling goods or services to customers as part of its ongoing operations. Third, the business can borrow money from banks, financial institutions, and other lenders.

Controlling cash flow and financing is a crucial part of running any business. A business can be profitable and still not be able to pay its bills on time because money was not managed properly. Profitability does not always equate to large amount of free cash flow. Investors and creditors need to know where the company’s cash comes from and where it goes. That’s why management details each cash activity for the period on the statement of cash flows.

However, companies with a big value of cash and cash equivalents are targets for takeovers (by other companies), since their excess cash helps buyers to finance their acquisition. High cash reserves can also indicate that the company is not effective at deploying its CCE resources, whereas for big companies it might be a sign of preparation for substantial purchases. The opportunity cost of saving up CCE is the return on equity that company could earn by investing in a new product or service or expansion of business.

Examples of cash are:

• Coins
• Currency
• Cash in checking accounts
• Cash in savings accounts
• Bank drafts
• Money orders
• Petty cash

Cash Equivalent

Cash equivalents are investments that can be readily converted to cash. Common examples of cash equivalents include commercial paper, treasury bills, short term government bonds, marketable securities, and money market holdings. An item should satisfy the following criteria to qualify for cash equivalent.

• The investment should be short term. They should mature in less than three months. If they mature in more than three months they will be classified as other investments.
• They should be highly liquid. This means that they should be easily sold in the market. The buyers of these investments should be easily available.
• They should be convertible to known amounts of cash. This means that their market price should be available and this market price should not be subject to significant fluctuations.
• They should not be too risky. There should be very little risk of changes in their value. This means that equity shares cannot be classified as cash equivalents. But preferred shares purchased shortly before the redemption date can be classified as cash equivalents.

In short, cash and cash equivalents mean the cash and those assets which are immediately convertible to cash. Cash and cash equivalents are the most liquid assets of any business. Cash and cash equivalents are very important for the liquidity of a business. A company should have sufficient cash and cash equivalents to meet its urgent liabilities when they fall due. 

Examples of cash equivalents are:

• Commercial paper
• Marketable securities
• Money market funds
• Short-term government bonds
• Treasury bills

Businesses can report these two categories of assets on the balance sheet separately or together, but most companies choose to report them together.

GAAP allows this financial statement presentation because some investments are so liquid and risk adverse that they are considered cash. Take T-bills for example. These investments are backed by the U.S. government and will always be paid. It’s not like a private short-term bond or loan where the company can default or go bankrupt. T-bills are a safe, guaranteed investment that can be cashed in at any time. Thus, GAAP recognizes these investments as if they were actual currency.

If the T-bills can’t be cashed in because of debt covenants or some other agreement, like in our debt restriction example above, the restricted T-bills must be reported in a separate investment account from the non-restricted T-bills on the balance sheet.

Accounts receivable is not considered cash because it isn’t currency. It is, however, considered an equivalent because it is highly liquid and easily converted into cash in a short period of time. Thus, it would be included in equivalents calculation.

CDs are short-term securities that are easily converted into a known amount of cash in a short period of time. Certificates of Deposit are always included in cash equivalents.

Sources of Cash Flow Statements:

Cash flow statement is not a substitute of income statement, i.e., a profit and loss account, and a balance sheet. It provides additional information and explains the reasons for changes in cash and cash equivalents, derived from financial statements at two points of time.

A cash flow statement, also known as the statement of cash flows, is a financial statement that summarizes the amount of all cash inflows and outflows of the company.

The cash flow statement is a mandatory part of a company’s financial reports since 1987.

The Statement of Cash Flows is one of the 3 key financial statements that reports the money generated and spent throughout a particular amount of period within the organization.

The procedure for preparing a cash flow statement is different from the procedure followed in respect of profit and loss account and balance sheet. It is prepared with the help of financial statements.

The basic information required for the preparation of a cash flow statement is obtained from the following three sources:

(i) Comparative balance sheets at two points of time, i.e. in the beginning and at the end of the accounting period.

(ii) Income statement of the current accounting period or the profit and loss account.

(iii) Some selected additional data to extract the hidden transactions.

Steps for Preparation of Cash Flow Statement:

The preparation of a cash flow statement involves the following steps:

Step 1: Compute the net increase or decrease in cash and cash equivalents by making a comparison of these accounts given in the comparative balance sheets.

Step 2: Calculate the net cash flow provided (used in) operating activities by analyzing the profit and loss account, balance sheet and additional information. There are two methods of converting net income into net cash flows from operating activities: the direct method and the indirect method. These methods have been discussed separately in this chapter.

Step 3: Calculate the net cash flow from investing activities.

Step 4: Calculate the net cash flow from financing activities.

Step 5: Prepare a formal cash flow statement highlighting the net cash flow from (used in) operating, investing and financing activities separately.

Step 6: Make an aggregate of net cash flows from the three activities and ensure that the total net cash flow is equal to the net increase or decrease in cash and cash equivalents as calculated in Step 1.

Step 7: Report significant non-cash transactions that did not involve cash or cash equivalents in a separate schedule to the cash flow statement e.g., purchase of machinery against issue of share capital or redemption of debentures in exchange for share capital.

For a business organization, the cash flow statement is the foremost vital financial statement to prepare. It traces the flow of funds (or working capital) into and out of the business throughout an accounting period.

For a small business, a cash flow statement ought to be in all probability to be ready as often as possible.

Three Sections of a Statement of Cash Flows:

1. Cash from operating activities,
2. Cash from investing activities,
3. Cash from financing activities.

Cash from operating activities

Cash Flow from Operations usually includes the money flows related to sales, purchases, and other expenses. In other words, it reflects how a lot of money is generated from a company’s products or services.

These operating activities include Receipts from sales of product and services, Interest payments, Income tax payments, Payments made to suppliers of product and services, Salary and wage, Rent payments etc.

Cash from investing activities

Cash Flow from investment Activities includes the cash flows related to buying or selling property, plant, and equipment, other non-current assets, and other financial assets.

Usually, cash flow from investment activities is a “cash out” item, because money is used to spend for new instrumentation, buildings, or short-term assets such as marketable securities.

Cash from financing activities

Cash flows from financing activities generally include cash flows associated with borrowing and repaying bank loans, and issuing and buying back shares.

The payment of a dividend is also treated as a finance income. If a company issues a bond to the general public, the company receives cash financing; but, when interest is paid to bondholders, the company is reducing its cash.

Here is an example of statement of cash flow:

Importance of Cash Flow Statement:

It is equally as important as like as the profit-and-loss statement and balance sheet for cash flow analysis.

Without a cash flow statement, it may be tough to have a correct image of a company’s performance.

The income statement can tell you the way a lot of interest you paid on a loan and therefore the record can tell you the way a lot of you owe, but solely the cash flow statement can tell you the way a lot of money was consumed servicing that loan.

The income statement can record sales and profits however it’s the income statement that may provide you with a warning if those sales aren’t generating enough money to cover expenses.

Funds from operations is the cash flows generated by the operations of a business, usually a real estate investment trust (REIT). This measure is commonly used to judge the operational performance of REITs, especially in regard to investing in them. Funds from operations does not include any financing-related cash flows, such as interest income or interest expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets. Thus, the calculation of funds from operations is:

Funds from operations = Net income – Interest income + Interest expense + Depreciation – Gains on asset sales + Losses on asset sales

After preparing the schedule of changes in net working capital, the second step is to determine the amount of funds (loss) from business operations. It refers to the funds or loss, which is generated or suffered in the business as a result of its regular operations during the period. The funds from operation is an important source of fund, while loss from operation is one of the important applications of funds. The funds or loss from operation is determined by adjusting the firm’s net income in a statement called the statement of funds from operations. In this statement, the items such as non-operating incomes and non-cash expenses are adjusted while determining the amount of funds (loss) from operations.

Non-cash expenses such as depreciation and amortization of intangible assets do not result in actual cash outflow. Non-operating expenses are those which are not treated as regular expenses of the business. These expenses matter while ascertaining the business income, but are irrelevant in determining the funds (loss) from operations. Therefore non-operating incomes should be deducted from and non-operating and non-cash expenses should be added back to the business income shown by the income statement.

Non-operating and non-cash expenses

• Depreciation for the year
• Amortization of Goodwill, Copyright, Patent, Trademark, Preliminary expenses
• Discount on issue of share and debenture written off
• Loss on sale of fixed assets or investment
• Loss of revaluation of fixed assets
• Premium on redemption of debentures and preference share

Incomes and gains which are not earned from the normal business operations are called non-operating incomes. These incomes are included while ascertaining the business income, but are excluded while determining the funds (loss)from operations. The following are the examples of non-operating incomes.

• Gain on sale of fixed assets or investment
• gain on revaluation of fixed assets
• Discount on redemption of debentures and preference share
• Compensation received
• Interest received
• Refund of tax
• Transfer fees received
• Appreciation on fixed assets

Preparation of Statement Of Funds From Operation

Funds from operations can be determined by using one of the two following methods.

1. Add Back Method

Under this method,net profit is taken as the base. All the non-operating and non-cash expenses are added to net profit and non-operating incomes are deducted.

Funds from operations = Net profit+Non-operating and non-cash expenses-Non operating Incomes.

2. Profit And Loss Adjustment Account Method

Funds from operations can also be determined by preparing an account called profit and loss adjustment account begins with opening balance of profit on its credit side and closing balance on the debit side. Instead of opening and closing balance of profit and loss account, only the amount of net profit for the year can also be brought down to the debit side of this account. Then the items of non-operating expenses and non-cash expenses are adjusted to the debit side and the items of non-operating incomes are adjusted to the credit side to determine the amount of funds (loss) from operations.

Generally, the statement consists of two sections: the source (where the money has come from) and the application (where the money has gone).

The sources of funds originate from:

• A decrease in liabilities or an increase in assets
• Net income after tax
• The disposal or revaluation of fixed assets
• Proceeds of loans obtained
• Proceeds of shares that were issued
• Repayments received on loans previously granted by the company
• Any increase in net working capital

The application of funds includes:

• Losses to be met by the company
• The purchase of fixed assets/investments
• The full or partial payment of loans
• Granting of loans
• Liability for taxes
• Dividends paid or proposed
• Any decrease in net working capital

Sources of Funds

Items to be shown under the head Sources of Funds are as follows:

• Issue of Shares and Debentures for Cash: The total amount received from the Issue of Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be shown here as there is no inflow of Cash
• Long Term Loans: The Amount received on raising Long Term Loans is shown under this head. Short Term Loans are not to be shown here as their treatment has already been done while preparing the Statement of Changes in Working Capital.
• Sale of Investments and other Fixed Assets: The Total Amount received on the sale of Investments and other Fixed Assets is to be shown under this head.
• Funds from Operations: The Funds generated from Operations as computed in Step II are also required to be shown here.
• Decrease in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement

Application of Funds

Items to be shown under Application of Funds are as follows:

• Purchase of Fixed Assets and Investments: The Cash Payment made for purchase of Fixed Assets and Investments is an application of Funds. But if the purchase if made by issue of shares or debentures, such a transaction will not constitute application of funds. Similarly, if the purchases are on credit, these will not constitute fund applications.
• Redemption of Debentures, Preference Shares and Repayment of Loan: Payment made including Premium (less: Discount) is to be taken as fund application
• Payment of Dividend & Tax: Payment of Dividend and Tax are to be taken as applications of fund if the provisions are excluded from Current Liabilities and Current Provisions are added back to profit to determine the “Funds from Operations”
• Increase in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement

Steps for Preparing Funds Flow Statement:

The steps involved in preparing the statement are as follows:

1. Determine the change (increase or decrease) in working capital.
2. Determine the adjustments account to be made to net income.
3. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital.
4. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.

General Rules for Preparing Funds Flow Statement:

The following general rules should be observed while preparing funds flow statement:

1. Increase in a current asset means increase (plus) in working capital.
2. Decrease in a current asset means decrease (minus) in working capital.
3. Increase in a current liability means decrease (minus) in working capital.
4. Decrease in a current liability means increase (plus) in working capital.
5. Increase in current asset and increase in current liability does not affect working capital.
6. Decrease in current asset and decrease in current liability does not affect working capital.
7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital.

Format of Funds Flow Statement:

A funds flow statement can be prepared in statement form or ‘T’ form.

Both the formats are given below:

Schedule of Changes in Working Capital:

Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).

This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.

The format of schedule of changes in working capital is as follows:

In the preparation of funds flow statement, the first step is to find out the net amount of increase or decrease of working capital, as increase in net working capital is a use of funds and decrease in net working capital is a source. Since net working capital is excess of current assets over current liabilities, the increase or decrease in the net working capital can be found out by comparing the current assets and current liabilities contained in the balance sheets of two following dates. For this purpose, a statement is prepared which is called statement or schedule of changes in net working capital. This statement helps to identify the change in position of the working capital. While preparing the statement of changes in working capital, the following points are considered.

* Increase in current assets , increase in net working capital
* Decrease in current assets , decrease in net working capital
* Increase in current liabilities , decrease in net working capital
* Decrease in current liabilities, increase in net working capital

The statement or schedule of changes in net working capital can be prepared by using one of the following forms.

1. Using only current account

The statement or schedule of changes in net working capital can be prepared by using only current account, viz. account of current assets and current liabilities. While preparing the statement, the current assets and current liabilities of the previous year are compared with those of the current year and changes (increase or decrease) therein are determined. If the total of increase is more than that of decrease, there is an increase in net working capital, or vice versa.

2. Using both current and non-current accounts

The statement or schedule of changes in net working capital can also be prepared by using both current as well as non-current accounts. Current account is the account of current assets and current liabilities and non-current account of non-current assets and non-current liabilities and owner’s equity. Increase in an item of current assets or decrease in an item of current liabilities from previous year to this year is debited, while increase in an item of current liabilities or decrease in an item of current assets is credited to current account. On other hand, increase in an item of non-current assets or decrease in an item of non-current liabilities from the previous year to this year is debited, while increase in an item of non-current liabilities and owner’s equity and decrease in an item of non-current assets is credited to non-current account.

The preparation of statement of changes in networking capital under this method is advantageous as compared to the previous method as it is easy to prepare funds flow statement there from.

Changes in Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)

Or

Change in a Net Working Capital = Change in Current Assets – Change in Current Liabilities

• Step 1: Find the Current Assets for the current year and previous year

From the point of the current asset of view, we consider the below:

• • • Inventory
    • Accounts Receivable
    • Prepaid Expenses
• Step 2: Find the Current Liability for the Current Year and Previous Year

From the current liabilities, we consider the below:

• • • Accounts Payable & Accrued Expenses
    • Interest Payable
    • Deferred Revenue
• Step 3: Find Working Capital for the Current Year and Previous Year

• • • Working Capital (Current Year) = Current Assets (current year) – Current Liabilities (current year)
    • Working Capital (Current Year) = Current Assets (current year) – Current Liabilities (current year)
• Step 4: Calculate Changes in Net Working Capital using the formula below –

• • • Changes in Net Working Capital Formula = Working Capital (Current Year) – Working Capital (Previous Year).

Uses of Funds Flow Statement:

By highlighting the changes in the distribution of the resources of an undertaking, the funds flow statement enables the financial manager to have a clear perspective of the organization’s financial strengths and weaknesses. It provides answers to a number of difficult questions.

(a) It explains the financial consequences of business operations. For example, a business may be earning huge profits, but its liquidity position would be highly unsatisfactory.

The funds statement will explain the causes for such situation by showing what has become of the profits earned. Further, the statement would explain the direction of flow of funds into productive or non-productive activities.

When a balance sheet presents a distorted picture of an undertaking because of a number of non-fund transactions, the funds statement would be an illuminating document.

(b) Debt capital is very essential for increased profitability of any enterprise. But the creditors may like to ascertain the credit worthiness and the funds generating capacity of the organization.

They may like to know in what way the management has utilized the funds in the past and how the funds would be utilized in future. The funds flow statement would enable the finance manager to answer such questions in a befitting manner.

(c) It acts as an instrument for allocation of the company’s scarce resources. A proposed funds statement will help to find out how the management is going to allocate the resources for meeting future productive programmes of the business.

When the projected funds statement is tied to the capital budget, it will help management to maintain the financial health of the organization.

(d) It is a test for evaluating the effective use of working capital by the management. Information on the adequacy or inadequacy of working capital will enable the management to decide what possible steps it should take for effective use of surplus working capital, or in the case of inadequate working capital to make suitable arrangements to make up the deficiency.

Limitations of Funds Flow Statement:

Despite its multiple managerial uses, the funds flow statements suffer from certain limitations.

1. As this statement ignores non-fund items, it becomes a crude device compared to the income statement and balance sheet.
2. The statement does not reveal shifts among the items making up the current assets and current liabilities. It does not tell whether any loss of working capital has unduly weakened the financial position.

Only an examination of the balance sheet at the end of the period will show the end of these changes. Therefore, funds flow statement cannot supplant but only supplement the conventional financial statements, either in whole or in part.

3. The information used for the preparation of funds flow statement is essentially historical in nature, though attempts are made to project the funds statement for the future period.

Despite these limitations, the information supplied by the funds flow statement is really an invaluable aid to management in planning capital expenditure, devising dividend and other financial policies.