Financial management for Business CoursesPPT.ppt

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Financial Management
The maintenance and creation of
economic value or wealth.

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Financial Management
It measures and reports financial and
nonfinancial information that helps
managers make decisions to fulfill the
goals of an organization.

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Goal of the Firm
1) Profit Maximization?
This Goal Ignores:
a) Timing of Returns
b) Uncertainty of Returns

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Goal of the Firm
2) Shareholder Wealth
Maximization?
this is the same as:
a) Maximizing Firm Value
b) Maximizing Stock Price

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OBJECTIVES OF FINANCIAL
MANAGEMENT
Relevant To Making Decisions
Types Of Decisions
• Operating
• Investing
• Financing

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Management Accounting
 Management accounting measures and reports financial
and non-financial information that helps managers make
decisions to fulfill the goals of an organization
 Managers use management accounting information to
• choose, communicate and implement strategy
• coordinate product design, production and marketing
decisions
 Management accounting focuses on internal reporting
 Management accounting is future oriented

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Functions of Management
Accounting
Management accountants perform three
functions
Attention-directing--make visible
opportunities and problems on which
managers need to focus
Problem-solving--conduct comparative
analysis to identify the best alternatives in
relation to the organization’s goals
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Scorekeeping--accumulate data and report
reliable results to all levels of management

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Key Themes in Management
Decision Making
Key Success
Factors
 1.Cost and
2.Efficiency
 3.Quality
 4.Time
 5.Innovation
Continuous
Improvement
And
Benchmarking
Value-Chain
and
Supply-Chain
Analysis
Customer
Focus

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Financial and Management
Accounting
The primary questions about an organization’s
success that decision makers want to know are:
What is the financial picture of the organization
on a given day?
How well did the organization do during a given
period?

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Accounting
Accountants answer these primary questions with
three major financial statements.
• Balance sheet – shows financial picture on a given
day
• Income statement – shows performance over a given
period
• Statement of cash flows – shows performance over a
given period

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Accounting
Annual report - a document prepared by
management and distributed to current and
potential investors to inform them about the
company’s past performance and future
prospects
• The annual report is one of the most common
sources of financial information used by investors
and managers.

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Accounting
1. The major distinction between financial and
management accounting is the users of the
information.
• Financial accounting serves external users,
such as investors, creditors, and suppliers.
• Management accounting serves internal
users, such as top executives,
management, and administrators
within organizations.

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Management Accounting and
Financial Accounting
Help managers plan and
control business operations
Help investors, creditors, and others make
investment, credit, and other decisions
2. Purpose of Information

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Relevance
Reliability, objectivity, and focus on the past
3. Focus and Time Dimension

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Internal reports not restricted by GAAP
Financial statements restricted by GAAP
4. Type of Report

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No independent audit
Annual independent audit
5.Verification

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Detailed reports on
parts of the company
Summary reports primarily
on the company as a whole
6.Scope of Information

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Concern about how reports
will affect employees behavior
Concern about adequacy of disclosure
7.Behavioral Implications

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Fund Flow Statement
FFS is a method to study changes in the financial
position of a business enterprise between beginning
and ending financial statements dates. IT is a
statement showing sources and uses of funds for a
period of Time.
Anthony
“ The fund flow statement describes the sources
from which additional funds were derived and the
use to which these sources were put.”

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A summary of a firm’s changes in
financial position from one period to
another; it is also called a sources and
uses of funds statement or a statement
of changes in financial position.
Fund Flow Statement

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•Fund means working capital i.e.
excess of current assets over current
liabilities.
•Flow means movement and
includes both inflow and outflow of
working capital.
Fund Flow Statement

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 Includes important noncash transactions while
the cash flow statement does not.
 Is easy to prepare and often preferred by
managers for analysis purposes over the more
complex cash flow statement.
 Helps you to better understand the cash flow
statement, especially if it is prepared under the
“indirect method.”
Fund Flow Statement

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Uses of Fund Flow Statement
It helps in the analysis of financial operations
It throws light on many perplexing questions of
general interest
It helps in the formation of a realistic dividend
policy
It helps in the proper allocation of resources
It acts as a future guide
It helps in appraising the use of working capital
It helps knowing the overall creditworthiness of a
firm

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Statement of schedule of changes in working capital
Particulars Previous Year Current Year Effect of working Capital
Increase Decrease
Current Assets:
Cash in hand
Cash at bank
Bills Receivable
Sundry Debtors
Temp. Investments
Stocks/Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets
Current Liabilities:
Bills Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term Expenses
Dividends Payable
Proposed dividends
Provision for taxation
Total Current Liabilities
Working Capital(CA-CL)
Net increase or decrease
in working capital

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SOURCES AND APPLICATIONS OF FUNDS
SOURCES APPLICATIONS
Funds from operations Funds lost in operations
Issue of Share Capital Redemption of Preference Share
Capital
Issue of Debentures and Repayment of Long-term Loans
Raising of Long-term Loans and Redemption of debentures
Sales of Non-Current Assets Purchase of Non-current Assets
Non-trading Receipts Payment of Dividend and tax
Decrease in Working capital Non-Trading Payments

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Introduction to Statement
of Cash Flows
The statement of cash flows gives a direct picture
of where cash came from and where cash went.
Preparation of the statement of cash flows
• List the activities that increased (inflow) or decreased
(outflow) cash.
• Place each inflow or outflow into the proper
categories.

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of Cash Flows
The statement of cash flows provides a thorough
explanation of the changes that occurred in a
firm’s cash balance during the entire accounting
period.
• The statement of cash flows reports cash receipts and
payments of a company during a given period for
operating, financing, and investing activities.
• “Cash” includes cash and cash equivalents.

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of Cash Flows
Income does not measure an entity’s performance
in generating cash, especially if the income is
measured using the accrual basis.
In a way, accountants use both the accrual and
cash bases.
• The accrual basis is used in the income statement.
• The cash basis is used in the statement of cash flows.

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of Cash Flows
Statement of cash flows - reports the cash receipts
and cash payments of an entity during a particular
period
• It summarizes activity over a period of time, so it
must be labeled with the exact period covered.
• It details the changes in the cash account,
much like the income statement which
shows changes in retained earnings.

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CASH AND CASH
EQUIVALENTS
Generally items that are cash or can be
converted into cash within 90 days or less
Cash on hand, cash in bank, certificates of
deposit, money market funds, Treasury notes

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Purposes of Cash Flow Statement
Statement of cash flows.
• shows the relationship of net income to changes in
cash balances.
• It reports past cash flows as an aid to:
– Predicting future cash flows
– Evaluating the way management generates and uses cash
– Determining a company’s ability to pay interest and
dividends and to pay debts when they are due
• It identifies changes in the mix of productive assets.

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The statement of cash flows, along with the
income statement, explains why balance sheet
items have changed during the period.
• The balance sheet shows the status of a
company at a point in time.
• The statement of cash flows and the
income statement show the
performance of a company over a
period of time.
December 2003

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The relationship among the balance sheet, income
statement, and statement of cash flows:
Balance Sheet
December 31,
20X3
Balance Sheet
December 31,
20X2
Income Statement
Statement of Cash Flows

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Typical Activities Affecting Cash
Cash is affected by two primary areas of a firm.
• Operating management - largely concerned with the
major day-to-day activities that generate revenues and
expenses
• Financial management - largely concerned with where
to get cash and how to use cash for the
benefit of the entity

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 Operating activities - transactions that affect the income
statement
 Investing activities - activities that involve (1) providing
and collecting cash as a lender or as an owner of
securities and (2) acquiring and disposing of plant,
property, equipment, and other long-term productive
assets
 Financing activities - activities that include obtaining
resources as a borrower or issuer of securities and
repaying creditors and owners

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OPERATING ACTIVITIES
SALES (MARKETING)
MANUFACTURING
PURCHASING
ADMINISTRATION
COMPLIANCE WITH GOVERNMENT
REGULATIONS

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INVESTING ACTIVITIES
PURCHASE AND SALE OF PROPERTY,
PLANT, AND EQUIPMENT
PURCHASE AND SALE OF STOCK OF
OTHER COMPANIES

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FINANCING ACTIVITIES
ISSUING AND REPURCHASING OF A
FIRM’S OWN STOCK
BORROWING AND REPAYMENT OF
LOANS
PAYMENT OF DIVIDENDS

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Cash inflows
 Collections from customers
 Interest and dividends
collected
 Other operating receipts
Cash outflows
 Cash payments to suppliers
 Cash payments to employees
 Interest and tax payments
 Other operating cash payments
Typical operating activities

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Cash inflows
 Sale of property, plant, and
equipment
 Sale of securities that are not
cash equivalents
 Receipt of loan repayments
Cash outflows
 Purchase of property, plant, and
equipment
 Purchase of securities that are
not cash equivalents
 Making loans
Typical investing activities

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Cash inflows
 Borrowing cash from
creditors
 Issuing equity securities
 Issuing debt securities
Cash outflows
 Repayment of amounts
borrowed
 Repurchase of equity shares
(including treasury stock)
 Payment of dividends
Typical financing activities

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Investing and Financing
Activities
Analysis of balance sheet items for investing and
financing activities:
• Increases in cash (cash inflows) stem from
– Increases in liabilities or stockholders’ equity
– Decreases in non cash assets
• Decreases in cash (cash outflows) stem from
– Decreases in liabilities or stockholders’ equity
– Increases in noncash assets

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Activities
Changes in fixed assets can usually be explained
by:
• Assets acquired
• Asset dispositions
• Depreciation
Increase in
net plant
assets
= Acquisitions - Disposals - Depreciation

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Activities
Changes in stockholders’ equity can be explained
by:
• New issuances of stock
• Net income
• Dividends
Increase in
stockholders’
equity
= New issuance + Net income - Dividends

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Approaches to Calculating the
Cash Flow from Operating Activities
Two approaches may be used to compute cash
flow from operating activities.
• Direct method - the method that calculates net cash
provided by operating activities as collections minus
operating distributions
• Indirect method - the method that adjusts the accrual
net income to reflect only cash receipts and outlays
Under either method, the final cash flow from
operating activities will be the same.

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Under the direct method, income statement
amounts are adjusted for changes in related asset
and liability accounts.
• Each revenue and expense account calculated under
the accrual method is adjusted to reflect the actual
cash paid or received.
Under the indirect method, accrual net income is
adjusted to reflect only cash transactions.

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The FASB prefers the direct method because it
shows operating cash receipts and payments in a
way that is easy for investors to understand.
The indirect method is more common because
many people are used to thinking in terms of net
income.

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Transactions Affecting Cash
Flows from All Sources
Effects of operating transactions on cash:
Sales of goods and services for cash +
Sales of goods and services on credit 0
Receive dividends or interest +
Collection of accounts receivable +
Recognize cost of goods sold 0
Purchase inventory for cash -
Purchase inventory on credit 0
Pay trade accounts payable -
“0” denotes that the transaction has no effect on cash.

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Effects of operating transactions on cash:
Accrue operating expenses 0
Pay operating expenses -
Accrue taxes 0
Pay taxes -
Accrue interest 0
Pay interest -
Prepay expenses for cash -
Write off prepaid expenses 0
Charge depreciation or amortization 0

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Effects of investing activities on cash:
Purchase fixed assets for cash -
Purchase fixed assets by issuing debt 0
Sell fixed assets +
Purchase securities that are not cash equivalents -
Sell securities that are not cash equivalents +
Make a loan -

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Effects of financing transactions on cash:
Increase long-term or short-term debt +
Reduce long-term or short-term debt -
Sell common or preferred shares +
Repurchase or retire common or preferred shares -
Purchase treasury stock -
Pay dividends -
Convert debt to common stock 0
Reclassify long-term debt to short-term debt 0

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A Detailed Example
of the Direct Method
ECO-BAG COMPANY
Balance Sheet (in thousands)
December 31, 20X3 and 20X2
Current assets: Current liabilities:
Cash Rs 16 Rs 25 Accounts payable Rs 74 Rs
6
Accounts receivable 45 25 Wages and salaries payable 25 4
Inventory 100 60
Total current assets Rs161 Rs110 Total current liabilities 99 10
Fixed assets, gross 581 330 Long-term debt 125 5
Accum. depreciation (101) (110) Stockholders’ equity 417 315
Net 480 220
Total liabilities and
Total assets Rs641 Rs330 stockholders’ equity Rs641
Rs330
======== ======== ======== ========

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A Detailed Example
ECO-BAG COMPANY
Statement of Income (in thousands)
for the Year Ended December 31, 20X3
Sales Rs200
Costs and expenses:
Cost of goods sold Rs100
Wages and salaries 36
Depreciation 17
Interest 4
Total costs and expenses 157
Income before income taxes 43
Income taxes 20
Net income Rs 23
========

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A Detailed Example
ECO-BAG COMPANY
Statement of Cash Flows (in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Cash collections from customers Rs 180
Cash payments:
To suppliers Rs 72
To employees 15
For interest 4
For taxes 20
Total cash payments (111)
Net cash provided by operating activities Rs 69

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A Detailed Example
ECO-BAG COMPANY
(continued)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of fixed assets Rs(287)
Proceeds from sale of fixed assets 10
Net cash used by investing activities (277)

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A Detailed Example
ECO-BAG COMPANY
(continued)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issue of long-term debt Rs120
Proceeds from issue of common stock 98
Dividends paid (19)
Net cash provided by financing activities 199
Net decrease in cash (9)
Cash, December 31, 20X2 25
Cash, December 31, 20X3 Rs 16
========

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A Detailed Example
The first step in developing the statement of cash
flows is to compute the amount of the change in
cash from the beginning to the end of the period.
• This calculation is often included at the bottom of the
statement.
• The net change is added to the beginning
balance to compute the ending balance.

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A Detailed Example
In this example, cash decreases by Rs9,000.
• Operating activities contribute Rs69,000 cash during
the period.
• Investing activities use Rs277,000 cash during the
period.
• Financing activities contribute Rs199,000 cash during
the period.
This example shows how a firm may have net
income but still have a decline in cash.

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Computing Cash Flows from
Operating Activities
Collections from sales to customers are usually
the largest source of operating cash inflows.
Disbursements for purchases of goods to be sold
and operating expenses are usually the largest
sources of operating cash outflows.
Operating cash inflows minus operating cash
outflows equals the net cash provided by (or used
by) operating activities.

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Working from Income Statement
Amounts to Cash Amounts
Accountants often compute collections and other
operating cash flow items from figures in the
income statement.
• Many accountants use the balance sheet along with
additional information and familiarity with the causes
of certain changes in balance sheet amounts to
compute the cash flow items.
• However, many accounting systems are not capable of
providing detailed information needed for that
method.

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In our example, Rs180,000 was collected from
customers. That amount is determined as follows:
Sales Rs200,000
+ Beginning accounts receivable 25,000
Potential collections Rs225,000
– Ending accounts receivable 45,000
Cash collections from customers Rs180,000
===============
or
Sales Rs200,000
Decrease (increase) in accounts receivable (20,000)
Cash collections from customers Rs180,000
===============
 Note that the increase in A/R means that sales > collections.

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The difference between cost of goods sold and
cash payments to suppliers can be determined by
looking at inventory and accounts payable.
Ending inventory Rs100,000
+ Cost of goods sold 100,000
Inventory to account for Rs200,000
– Beginning inventory (60,000)
Purchases of inventory Rs140,000
===============
Beginning trade accounts payable Rs 6,000
+ Purchases of inventory 140,000
Total amount to be paid in cash Rs146,000
– Ending trade accounts payable (74,000)
Accounts paid in cash Rs 72,000
===============

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The effects of inventory and accounts payable on
the previous slide can be combined into one
calculation as follows:
Cost of goods sold Rs1,00,000
Increase (decrease) in inventory 40,000
Decrease (increase) in trade accounts payable (68,000)
Payments to suppliers Rs 72 ,000
===============

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 Cash payments to employees can be determined by
examining wages and salaries payable.
Beginning wages and salaries payable Rs 4,000
+ Wages and salaries expense 36,000
Total to be paid in cash Rs 40,000
– Ending wages and salaries payable (25,000)
Cash payments to employees Rs 15,000
==============
or
Wages and salaries expense Rs 36,000
Decrease (increase) in wages & sal. payable (21,000)
Cash payments to employees Rs 15,000
==============

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Notice in this example that both interest payable
and income taxes payable were zero at the
beginning and end of the period.
• This means that the entire amounts of interest expense
and income tax expense were incurred and paid
during the period, so the cash
flows are the amounts of the
expenses, Rs4,000 and Rs20,000,
respectively.

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Preparing a Statement of Cash
Flows - The Indirect Method
In calculating cash flows from operating
activities, the alternative to the direct method is
the indirect method.
• The indirect method is generally more convenient.
• The indirect method reconciles
accrual net income to cash flows
from operating activities.

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Reconciliation of Net Income to
Net Cash Provided by Operations
The indirect method begins with net income.
• Additions or deductions are made for changes in
related asset or liability accounts (items that affect net
income and net cash flow differently).
If a company uses the direct method, the FASB
requires such a reconciliation using the indirect
method.

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Items included in the reconciliation:
• Depreciation is added back to net income because it
was deducted in arriving at net income, but it does not
represent a use of cash.
• Increases in noncash current assets result in less cash
flow from operations, so such increases are deducted
from net income.
• Decreases in noncash current assets result in more
cash flow from operations, so such decreases are
added back to net income.

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Items included in the reconciliation (continued):
• Increases in current liabilities result in more cash flow
from operations, so such increases are added back to
net income.
• Decreases in current liabilities result in less cash flow
from operations, so such decreases are deducted from
net income.

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The general rules for additions and deductions to
adjust net income using the indirect method are
the same as those for adjusting line items on the
income statement under the direct method.

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The cash flows from operating activities for Eco-
Bag Company:
Net income Rs23
Adjustments to reconcile net income to net
cash provided by operating activities
Depreciation Rs 17
Net increase in accounts receivable (20)
Net increase in inventory (40)
Net increase in accounts payable 68
Net increase in wages and salaries payable 21
Total additions and deductions 46
Net cash provided by operating activities Rs 69
=======

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As stated earlier, depreciation is an allocation of
historical cost to expense over a period of time.
Depreciation does not entail a current outflow of
cash, therefore, it is a noncash expense.
Depreciation is added back to net income to
compute cash flows from operating activities
simply to cancel its deduction in calculating net
income.

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Reconciling Items
Add charges (expenses) not requiring cash
Depreciation
Depletion
Amortization of intangible assets
Nonoperating losses
Amortization of bond discount
Deduct credits to income (revenue) not providing cash
Nonoperating gains
Amortization of bond premium
Adjust for changes in current assets and liabilities relating to
operating activities
Changes in noncash Current Assets Changes in noncash Current Liabilities
deduct increases add increases
add decreases deduct decreases

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Reconciling Items
Non operating gains and losses are gains and
losses that are not part of the normal ongoing
activities of the business but are included in net
income.
Gains (losses) must be deducted (added back)
from net income because they arise from
activities other than operations.
• The transaction that created the gain or loss must be
included elsewhere on the statement of cash flows,
including the gain or loss; removing it from net
income keeps the gain or loss from being included
twice.

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Reconciling Items
Boyd Corporation sells a piece of land for
Rs50,000 in cash. The land originally cost
Rs75,000. The loss on the sale is Rs25,000.
How does this transaction affect the operating
activities section of the statement of cash flows?

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Reconciling Items
Net income includes the loss of Rs25,000. The
cash flow from the sale is Rs50,000, but this is
not cash from operations.
The Rs50,000 cash flow from the sale is included
in the investing activities section (sale of long-
lived asset).
The Rs25,000 is added back to net income in the
reconciliation to avoid including elements of the
sale in two places on the statement of cash flows.

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Cash Flow and Earnings
 The income statement and the statement of cash flows
fill different critical information needs.
• The income statement shows how a
company’s owners’ equity changes
as a result of operations.
• It matches revenues and expenses
using the accrual concept and provides
a measure of economic activity.
• The statement of cash flows focuses on the net cash
flow from operating activities.

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CASH FLOW STATEMENT
 PRINCIPAL USES
• ASSESS THE ABILITY TO GENERATE POSITIVE
NET CASH
• DETERMINE THE ABILITY TO MEET
OBLIGATIONS, TO PAY DIVIDENDS, TO USE
EXTERNAL FINANCING
• ASSESS THE DIFFERENCES BETWEEN NET
INCOME AND CASH FLOWS
• ASSESS THE EFFECTS ON FINANCIAL
POSITION (BALANCE SHEET)

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Ratio Analysis
The key concept of ratio analysis is
establishing the
relationship of one number to another
number.

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RATIOS
Ratios are tools that enable management to:
 Measure and compare information within a
business over several periods
 Compare similar businesses in the same
industry

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Sources of information
Information used in ratios comes from:
 Statement of Financial Position
– Current ratio
– Liquid or quick asset ratio
– Debt to equity ratio
 Statement of Financial Performance
– Gross profit ratio
– Net profit ratio
 Both Statement of Financial Position and Performance
– Accounts receivable turnover

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KEY RATIO
Current ratio
Equity Ratio
Gross Profit Ratio
Inventory Turnover Ratio
Net Profit Ratio
Quick Asset Ratio
Accounts receivable turnover ratio

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KEY RATIO
Return on Equity Ratio
Return on Asset Ratio
Working capital ratio
Debt Ratio
Debt to Equity ratio

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TYPES OF RATIOS:
100%
sales
Net
profit
Gross
ratio
profit
Gross 

100%
sales
Net
profit
Net
ratio
profit
Net 

PROFITABILITY RATIOS

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TYPES OF RATIOS:
100%
equity
s
owner'
Average
profit
Net
equity
on
Return 

100%
assets
total
Average
profit
Net
assets
on
Return 


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TYPES OF RATIOS:
s
liabilitie
Current
assets
Current
ratio
capital
Working 
overdraft
bank
-
s
liabilitie
Current
s
prepayment
-
s
inventorie
-
assets
Current
ratio
asset
Quick 
100%
assets
Total
equity
s
owner'
Total
ratio
Equity 

FINANCIAL STABILITY

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TYPES OF RATIOS:
EFFICIENCY RATIOS
Inventory efficiency ratios
s
inventorie
Average
sold
goods
of
Cost
turnover
Inventory 
turnover
Inventory
365
days
in
Inventory 

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TYPES OF RATIOS:
Accounts receivable
receivable
Accounts
sales
credit
Annual
turnover
receivable
Accounts 
turnover
receivable
Accounts
365
period
collection
receivable
Accounts 

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Financial Ratios
• Debt Ratio
• Earnings per Share (EPS)
• Price-Earnings (P-E) Ratio
• Dividend-Yield Ratio
• Dividend-Payout Ratio

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Debt Ratio
The debt ratio measures the proportion
of company’s assets financed by debt.
Total liabilities ÷ Total assets

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Debt ratio = Total liabilities ÷ Total assets
Debt Ratio
The debt ratio indicates the proportion
of assets that is financed with debt.
This ratio measures a business’s
ability to pay total liabilities
A low debt ratio is safer than a high debt ratio.

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Debt-to-Equity Ratio
This ratio expresses the relationship
between liabilities and equity.
Total liabilities ÷ Total equity

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Earnings per Share (EPS)
EPS is shown on the face of the income
statement.
Earnings per share is the net income per common
share of stock outstanding during a period.
g
outstandin
shares
of
number
Average
income
Net
EPS 

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Price-Earnings (P-E) Ratio
The P-E ratio measures how much investors are
willing to pay for a chance to share the
company’s potential earnings.
share
per
Earnings
share
per
price
Market
Ratio
E
-
P 

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Price-Earnings (P-E) Ratio
A high P-E ratio indicates that investors predict
that the company’s net income will grow rapidly.
The ratio is determined by the marketplace
because the market price of the stock is used to
compute the ratio.

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Dividend-Yield Ratio
The dividend-yield ratio measures dividends paid
for a period compared to the market prices of the
stock on a given day.
share
per
price
Market
share
per
dividend
Common

Dividend-Yield
Ratio

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Dividend-Payout Ratio
The dividend-payout ratio measures the
percentage of earnings per share distributed in the
form of cash dividends.
share
per
Earnings
share
per
dividends
Common

Dividend-Payout
Ratio

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Current ratio
= Total current assets
÷ Total current liabilities
The current ratio measures
the company’s ability to pay
current liabilities with current assets.
Current Ratio
Rule of thumb: A strong current ratio is 2.00.

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CURRENT LIABILITIES
ACCOUNTS PAYABLE
PAYROLL LIABILITIES
SHORT-TERM NOTES & INTEREST
PAYABLE
INCOME TAXES PAYABLE
WARRANTIES
UNEARNED REVENUES
CURRENT PORTION L-T DEBT

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Current Liabilities
Current liabilities are obligations due within
one year or within the company’s normal
operating cycle if it is longer than one year.

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Current Liabilities
Accounts payable
Short-term notes payable
Sales tax payable
Current portion of long-term debt
Accrued expenses
Payroll liabilities
Unearned revenues

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Current Liabilities
Accounts payable are amounts owed to suppliers
for goods or services purchased on account.
Short-term notes payable are notes
payable due within one year.

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TYPES OF RATIOS:
100%
sales
Net
expenses
selling
Total
ratio
expense
Selling 

100%
sales
Net
expenses
tion
administra
Total
ratio
expense
tion
Administra 

100%
sales
Net
expense
operating
Total
ratio
expense
operating
Total 

100%
sales
Net
expenses
finance
Total
ratio
expense
Finance 

OTHER RATIOS

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INTERPRETATION OF RATIOS
Profitability ratios
Financial stability ratios
Ratios of efficiency

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Gross profit ratio
Shows the return on net sales prior to adding
revenue or deducting expenses
• Reasons gross profit ratio increases:
– selling prices increase and purchase price remains
unchanged
– opening inventory undervalued
– closing inventory overvalued
– purchase bought at lower price

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Gross profit ratio
• Reasons gross profit ratio decreases:
– discounts given on sales products
– closing inventory undervalued
– obsolete or damaged stock written off
– purchases bought at higher price but sales values not
adjusted

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Net profit ratio
Shows the amount earned by normal activities
after accounting for other revenue and expenses
• Measures operation efficiency
• Reasons net profit ratio increases:
– expenses decrease
– operating revenue increases
– fixed costs spread over higher sales revenue

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Net profit ratio
• Reasons net profit ratio decreases:
–expenses increase at higher rate than COGS
–other operating revenue sources decline
• To arrest declining net profit margins:
–investigate business selling plans and techniques
–increase effective promotion and advertising
–encourage areas of operating revenue
–review alternative and cheaper interest rates
–review all expenses

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Return on equity ratio
Shows the return on every dollar invested in the
business
Return on assets
Indicates the earning capacity of the business
• Measures efficiency of business asset usage

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FINANCIAL STABILITY RATIOS
Working capital ratio
Test of business solvency, to see if it can meet
short-term debts from its current assets
• Shows amount of dollars to cover every dollar of
liabilities
• The higher the ratio, the better the position of the
business

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Quick asset ratio
Only the liquid business items that easily convert
to cash are used
• Inventories and prepayments are excluded from
current assets and the bank overdraft from current
liabilities
• Ratio well above 1:1 is acceptable

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Equity ratio
Shows relationship of owner’s equity invested in
business to the total assets of the business
• It is the degree to which the business relies on owner
capital
• The higher the ratio, the lower the need for externally
borrowed funds
• High equity ratio = long-term financial stability

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RATIOS OF EFFICIENCY
Inventory turnover times
Means the number of times that inventories turn
over per year.
Inventory turnover in days
• Low turnover rate indicates inventory levels are too
high.
• Product demand may have slowed.

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Interpretation Of Ratios
Ratios Of Efficiency
Accounts receivable turnover
Measures the efficiency of management in
collecting the debts of the business
• The shorter the period of collection, the greater the
cash flow of the business.
• Long collection periods may lead to bad debt.

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LIMITATIONS OF RATIOS
Ratio analysis and interpretation can be
influenced by factors such as:
• poor or inadequate accounting methods
• incomplete financial reports
• changes in accounting methods
• existence of unusual items during a financial year e.g.
losses by fire
• management changes
• changes to the economy, such as an industry recession

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