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Chapter 3 FINANCIAL STATEMENTS, TAXES, AND CASH FLOW.  Centre for Financial Management , Bangalore. OUTLINE Balance Sheet Profit and Loss Account Finance Topics Statement of Cash Flows Manipulation of Bottom Line Taxes

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Chapter 3

Chapter 3

FINANCIAL STATEMENTS, TAXES, AND CASH FLOW

 Centre for Financial Management , Bangalore


Chapter 3

  • OUTLINE

  • Balance Sheet

  • Profit and Loss Account

  • Finance Topics

  • Statement of Cash Flows

  • Manipulation of Bottom Line

  • Taxes

  • Free Cash Flow

 Centre for Financial Management , Bangalore


Chapter 3

IMPORTANT QUESTIONS

Managers, shareholders, creditors and other interested groups seek answers to the following important questions about a firm:

• What is the financial position of the firm at a given point of

time?

• How has the firm performed financially over a given period of

time?

• What have been the sources and uses of cash over a period of

time?

The accountant prepares the balance sheet, the profit and loss account, and the statement of cash flows to answer the above questions

 Centre for Financial Management , Bangalore


Chapter 3

BALANCE SHEET

Horizontal Form

Liabilities + Equity Assets

 Share capital  Fixed assets

 Reserves and surplus  Investments

 Secured loans  Current assets, loans and

 Unsecured loansadvances

 Current liabilities and provisions  Current assets

 Current liabilities  Loans and advances

 Provisions  Miscellaneous expenditures

and losses

 Centre for Financial Management , Bangalore


Chapter 3

  • BALANCE SHEET

  • Vertical (or Report) Form

  • Sources of Funds

  • (1) Shareholders’ funds:

  • (a) Capital

  • (b) Reserves and Surplus

  • (2) Loan funds:

  • (a) Secured loans

  • (b) Unsecured loans

  • Application of funds

  • (1) Fixed assets

  • (2) Investments

  • (3) Current assets, loans and advances

  • Less: Current liabilities and provisions:

  • Net current assets

  • (4) Miscellaneous expenditures and losses

 Centre for Financial Management , Bangalore


Chapter 3

BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

A. Account FormRs.in crore

Liabilities20 x 120 x 0Assets20 x 1 20 x 0

Share capital15.0015.00 Fixed assets33.0032.20

Equity15.0015.00 Investments 1.00 1.00

Preference – – Current assets, loans

Reserve & surplus11.2010.60 and advances23.4015.60

Secured loans14.3013.10 Miscellaneous

Unsecured loans 6.90 2.50 expenditures and losses 0.50 0.50

Current liabilities

and provisions10.50 8.10

57.9049.30 57.90 49.30

 Centre for Financial Management , Bangalore


Chapter 3

  • BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1

  • Rs.in crores

  • 20 x 1 20 x 0

  • Sources of Funds

  • (1) Shareholders’ funds:26.20 25.60

  • (a) Share Capital 15.00

  • (b) Reserves and surplus 11.20

  • (2) Loan funds:21.20 15.60

  • (a) Secured loans 14.30

  • (b) Unsecured loans 6.90

  • 47.40 41.20

  • Application of Funds

  • (1) Fixed assets33.00 32.20

  • (2) Investments1.00 1.00

  • (3) Current assets, loans and advances23.40 15.60

  • Less: Current liabilities and provisions:10.50 8.10

  • Net current assets12.90 7.50

  • (4)Miscellaneous expenditures and losses 0.50 0.50

  • 47.40 41.20


Chapter 3

  • LIABILITIES

  • Share Capital

  • Reserves & Surplus

  • Secured Loans

  • Unsecured Loans

  • Current Liabilities and Provisions

 Centre for Financial Management , Bangalore


Chapter 3

  • ASSETS

  • Fixed Assets

  • Investments

  • Current Assets, Loans, & Advances

  • Miscellaneous Expenditure & Losses

 Centre for Financial Management , Bangalore


Chapter 3

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1

(Rs.in crore)

Income

Sales 70.1

Other income (loss) –

70.1

Expenditure

Material and other expenditure 58.2

Interest 2.1

Depreciation 3.0

Profit before tax 6.8

Provision for tax 3.4

Profit after tax 3.4

Prior period adjustments 0.8

Profit available for appropriations 4.2

Appropriations 3.5

Balance carried forward 0.7

 Centre for Financial Management , Bangalore


Chapter 3

PROFIT & LOSS ACCOUNT OF HORIZON LTD, FOR THE YEAR ENDING ON MARCH 31, 20 X 1

(Rs. in crore)

20 x 1 20 x 0

Net sales70.1 62.3

Cost of goods sold55.2 47.5

Stocks42.1

Wages and salaries 6.8

Other manufacturing expenses 6.3

Gross profit14.9 14.8

Operating expenses 6.0 4.9

Depreciation 3.0

General administration 1.2

Selling 1.8

Operating profit 8.9 9.9

Non-operating surplus/deficit – 0.6

Profit before interest and tax 8.9 10.5

Interest 2.1 2.2

Profit before tax 6.8 8.3

Provision for tax 3.4 4.1

Current tax 2.1 2.9

Deferred tax 1.3 1.2

Profit after tax 3.4 4.2

Prior period adjustments 0.8 0.7

Amount available for appropriation 4.2 4.9

Appropriations 3.5 4.0

Balance carried forward 0.7 0.9

 Centre for Financial Management , Bangalore


Chapter 3

  • PROFIT AND LOSS ACCOUNT ITEMS

  • Net Sales

  • Cost of Goods Sold

  • Gross Profit

  • Operating Expenses

  • Operating Profit

  • Non-operating Gains and Losses

  • Profit Before Interest and Taxes

  • Interest

  • Profit before Tax

  • Income Tax Provision

  • Profit After Tax

  • Prior Period Adjustments

  • Amount Available for Appropriation

  • Appropriations

  • Balance Carried Forward

 Centre for Financial Management , Bangalore


Chapter 3

  • BALANCE SHEET AND FINANCE TOPICS

  • • Share capital

    • Equity

    • Preference

  • • Reserves and surplus

  • • Secured loans

    • Debentures

    • Loans and advances

  • • Unsecured loans

  • • Current liabilities and provisions

    • Trade creditors

    • Provisions

  • • Fixed assets (net)

    • Gross block

    • Less: depreciation

  • • Investments

  • • Current assets, loans and advances

    • Cash and bank

    • Receivables

    • Inventories

  • • Miscellaneous expenditure and losses

Capital structure

and cost of capital

Working capital

financing policy

Capital budgeting

Portfolio management

Cash management

Credit management

Inventory management


Chapter 3

  • PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS

  • Net sales

  • Cost of goods sold

    • Stocks

    • Wages and salaries

    • Other manufacturing expenses

  • Gross profit

  • Operating expenses

    • Selling and administration expenses

    • Depreciation

  • Operating profit

  • Non-operating surplus/deficit

  • Earnings before income and tax

  • Interest

  • Profit before tax

  • Tax

  • Profit after tax

  • Dividends

  • Retained earnings

Revenue risk

Gross profit margin

Depreciation policy

Business risk

Financial risk

Tax planning

Return on equity

Dividend policy


Chapter 3

NET CASH FLOW

When we looked at the profit and loss account, the emphasis was on profit after tax (also called the bottom line). In finance, however, the focus is on cash flow.

A firm’s cash flow generally differs from its profit after tax because some of the revenues/expenses shown on its profit and loss account may not have received /paid in cash during the year. The relationship between net cash flow and profit after tax is as follows:

Net cash flow = Profit after tax – Non cash revenues

+ Non cash expenses

 Centre for Financial Management , Bangalore


Chapter 3

NET CASH FLOW

An example of non cash revenue is accrued interest income that has not yet been received. It increases the bottom line but is not matched by a cash inflow during the accounting period – the cash inflow would occur in a subsequent period. An example of a non cash expense is depreciation.

In practice, analysts defined the net cash flow as:

Net cash flow = Profit after tax + Depreciation + Amortisation

However, note that the above expression will not reflect net cash flow accurately if there are significant noncash items beyond depreciation and amortisation.

 Centre for Financial Management , Bangalore


Chapter 3

  • ACCOUNTING INCOME VERSUS ECONOMIC INCOME

  • Accounting income diverges from economic income due to the following reasons:

  • Use of the accrual principle

  • Omission of changes in value

  • Depreciation

  • Treatment of R & D and advertising expenditures

  • Inflation

  • Creative accounting

 Centre for Financial Management , Bangalore


Chapter 3

COMPONENTS OF CASH FLOWS

Cash outflows

from operations

Cash flow

from operations

Cash inflows

from operations

Operating

=

+ –

Cash inflows

from investing

activities

Cash outflows

from investing

activities

Cash flow

from investing

activities

Investing

=

+ –

Cash inflows

from financing

activities

Cash outflows

from financing

activities

Cash flow

from financing

activities

Financing

=

=

Net cash flow

for the period

 Centre for Financial Management , Bangalore


Chapter 3

CASH FLOW STATEMENT

LIABILITIESASSETS

CAPITALFIXED ASSETSRESERVES & SURPLUSINVESTMENTSLOANS

INVENTORIES

CURRENT LIABILITIESDEBTORS

AND PROVISIONS CASH

 Centre for Financial Management , Bangalore


Chapter 3

SOURCES USES

• FINANCING CAPITAL CAPITAL

• OPERATING RES. & SURPLUS RES. & SURPLUS

• FINANCING LOANS LOANS

• OPERATING CURRENT LIABILITIES CURRENT LIABILITIES & PROVISIONS & PROVISIONS

• INVESTMENT FIXED ASSETS FIXED ASSETS

• INVESTMENT INVESTMENTS INVESTMENTS

• OPERATING INVENTORIES INVENTORIES

• OPERATING DEBTORS DEBTORS

 Centre for Financial Management , Bangalore


Chapter 3

CASH FLOW STATEMENT FOR HORIZON LTD, FOR THE PERIOD 1.4.20X0 TO 31.3.20X1

(Rs. in crore)

(A)Cash Flow from Operating Activities

Net profit before tax and extraordinary items 6.8

Adjustments for

Interest paid 2.1

Depreciation 3.0

Operating profit before working capital changes 11.9

Adjustments

Debtors (4.6)

Inventories (3.3)

Advances 0.5

Trade credit 1.5

Advances 0.7

Provisions 0.2

Cash generated from operations 6.9

Income tax paid (3.4)

Cash flow before extraordinary items 3.5

Extraordinary item –

Net cash flow from operating activities 3.5

(Contd.)

 Centre for Financial Management , Bangalore


Chapter 3

(Contd.)

(Rs.in crore)

(B)Cash Flow from Investing Activities

Purchase of fixed assets (3.8)

Net cash flow from investing activities (3.8)

(C)Cash Flow from Financing Activities

Proceeds from term loans 1.2

Proceeds from inter-corporate deposits 4.4

Interest paid (2.1)

Dividend paid (2.8)

Net cash flow from financing activities 0.7

(D) Net Increase in Cash and Cash Equivalents0.4

Cash and cash equivalents as on 1.04.20x0 0.6

Cash and cash equivalents as on 31.03.20x1 1.0

 Centre for Financial Management , Bangalore


Chapter 3

MANIPULATION OF THE BOTTOM LINE

1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE

FOLLOWING YEAR

2. ALTER THE ‘OTHER INCOME’ FIGURE BY PLAYING WITH NON-OPERATIONAL IETMS

3. FIDDLE WITH THE METHOD & RATE OF DEPRECIATION

4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.

5. MAKE INADEQUATE PROVISIONS . . LIABILITIES

6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS

7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.

8. REVALUE ASSETS . . CREATE . . IMPR’N . . RESERVES

9. LENGTHEN … ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.

WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEP’N . . COMPETENT MGT

INCREASE MGRL COMPEN’N

QUALITY PROMPTNESS

OF CANDOUR IN ANALYSING PAST PERFORMANCE

REPORTING MEANINGFUL DISCUSSION . . PROSPECTS

 Centre for Financial Management , Bangalore


Chapter 3

  • TAXES

  • Taxes may be divided into two broad categories : direct

  • taxes and indirect taxes.

  • A tax is a direct tax if the impact and incidence of the tax

  • is on the same person. Example : Income tax

  • A tax is an indirect tax if the impact is on one person but

  • through the process of shifting, the incidence is on

  • another. Example : Excise duty

 Centre for Financial Management , Bangalore


Chapter 3

CORPORATE INCOME TAX

• A company’s taxable income is determined by taking into

account its revenues, expenses, and deductions on account

of various incentives and reliefs. The taxable income is

subject to a tax rate of 30 percent for domestic companies

and 40 percent for foreign companies.

• While computing the taxable income, among other things,

bear in mind the provisions relating to the following -

depreciation, interest expense, dividend payment, dividend

income, unabsorbed business loss and depreciation,

exemptions and deductions, minimum alternate tax, and

advance tax.

 Centre for Financial Management , Bangalore


Chapter 3

  • CORPORATE INCOME TAX

  • • A variety of exemptions and deductions are granted

  • under the Income Tax Act.

  • If the income tax payable on the total income of a

  • company, as computed under the Income Tax Act,

  • is less than 10.0 percent of its book profit, the tax

  • payable shall be deemed to be 10.0 percent of such book

  • profit.

  • Advance tax is payable on the current income of the

  • company in four installments during the financial year.

 Centre for Financial Management , Bangalore


Chapter 3

  • CORPORATE INCOME TAX

  • Depreciation is charged on blocks of assets which represent a group of assets within the broad class of assets such as buildings, plant, machinery, and furniture, for which a common rate of depreciation is applicable.

  • While interest on borrowings is a tax-deductible expense, dividend on share capital is not.

  • Unabsorbed business loss of any year can be carried forward and set off against income under the head of business of subsequent years.

 Centre for Financial Management , Bangalore


Chapter 3

  • INDIRECT TAXES

  • The three most important indirect taxes are the excise duty, the sales tax, and the customs duty.

  • The excise duty is a levy on the goods manufactured in

  • the country.

  • Sales tax is a levy on “sale of goods.”

  • Customs duty is a levy on the import of goods into India

  • or the export of goods out of India.

 Centre for Financial Management , Bangalore


Chapter 3

FREE CASH FLOW

Free cash flow is the cash flow available for distribution to investors (lenders and shareholders) after the firm has made investments in fixed assets and working capital to support its operations.

 Centre for Financial Management , Bangalore


Chapter 3

CASH FLOW SUMMARY

  • The cash flow identity

    • Cash flow from assets = Cash flow to lenders + Cash flow to shareholders

  • Cash flow from assets

    • Cash flow from assets = Operating cash flow – Net capital spending –

    • Change in net working capital

    • where

    • Operating cash flow = PBIT – Taxes + Depreciation

    • Capital spending = Ending net fixed assets – Beginning

    • net fixed assets + Depreciation

    • Change in net working capital = Ending net working capital –

    • Beginning net working capital

  • Cash flow to lenders

    • Cash flow to lenders = Interest paid – Net new borrowing

  • Cash flow to shareholders

    • Cash flow to shareholders = Dividends paid – Net new share capital

    • raised

 Centre for Financial Management , Bangalore


Chapter 3

  • SUMMING UP

  • The balance sheet shows the financial position (or condition) of a firm at a given

  • point of time. It provides a snapshot and may be regarded as a static picture.

  • The income statement (referred to in India as the profit and loss account) reflects

  • the performance of a firm over a period of time. The cash flow statement

  • portrays the flow of cash through the business during a given accounting period.

  • Assets are classified into following categories : (i) fixed assets, (ii) investments,

  • (iii) current assets, loans and advances, and (iv) miscellaneous expenditures and

  • losses. Liabilities are classified into the following categories : (i) share capital,

  • (ii) reserves and surplus, (iii) secured loans, (iv) unsecured loans, and (v) current

  • liabilities and provisions.

  • The important items in the profit and loss account are: (i) net sales, (ii) cost of

  • goods sold, (iii) gross profit, (iv) operating expenses, (v) operating profit, (vi)

  • non-operating surplus/deficit, (vii) profit before interest and tax, (viii) interest,

  • (ix) profit before tax, (x) tax and (xi) profit after tax.

  • The important topics in finance can be keyed to the balance sheet and the profit

  • and loss account.

 Centre for Financial Management , Bangalore


Chapter 3

  • From a financial point of view, a firm basically generates cash and spends cash.

  • The activities that generate cash are called sources of cash and the activities that

  • absorb cash are called uses of cash. Increase in owners' equity and liabilities and

  • decrease in assets represent sources of cash. Decrease in owners’ equity and

  • liabilities and increase in assets, on the other hand represent uses of cash.

  • To understand how cash flows have been influenced by various decisions, it is

  • helpful to classify cash flows into three categories: cash flows from operating

  • activities, cash flows from investing activities, and cash flows from financing

  • activities.

  • Corporate managements have discretion in influencing the occurrence,

  • measurement and reporting of revenue, expenses, assets and liabilities. They

  • may use this latitude to manage the bottom line.

  • Taxes can be one of the major cash outflows for a firm. The magnitude of the tax

  • burden is determined by the tax code, which is subject to change.

 Centre for Financial Management , Bangalore


Chapter 3

  • Taxes may be divided into two broad categories: direct taxes and indirect taxes.

  • A tax is referred to as a direct tax if the impact and incidence of the tax is on the

  • same person. Income tax, wealth tax, and gift tax are examples of direct taxes.

  • A tax is regarded as an indirect tax if the impact and incidence of the tax is on

  • different persons. Excise duty, sales tax, and customs duty are the three

  • important indirect taxes.

  • We have a balance sheet identity which says that the value of a firm's assets is

  • equal to the value of its liabilities plus the value of its equity. In the same

  • manner we have a cash flow identity which says that :

  • Cash flow from assets = Cash flow to lenders + Cash flow to shareholders

 Centre for Financial Management , Bangalore


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