Chapter 3 Financial Statement Taxes and Cashflow

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

• Free Cash Flow


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


BALANCE SHEET

Horizontal Form

Liabilities + Equity Assets

Share capital Fixed assets

Reserves and surplus Investments

Secured loans Current assets, loans and

Unsecured loans advances

Current liabilities and provisions Current assets

Current liabilities Loans and advances Provisions Miscellaneous expenditures

and losses


BALANCE SHEET

Vertical (or Report) FormI. Sources of Funds

(1) Shareholders’ funds:

(a) Capital

(b) Reserves and Surplus

(2) Loan funds:

(a) Secured loans

(b) Unsecured loans

II. 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


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

A. Account Form Rs.in crore

Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0

Share capital 15.00 15.00 Fixed assets 33.00 32.20

Equity 15.00 15.00 Investments 1.00 1.00

Preference – – Current assets, loans

Reserve & surplus 11.20 10.60 and advances 23.40 15.60

Secured loans 14.30 13.10 Miscellaneous

Unsecured loans 6.90 2.50 expenditures and losses 0.50

0.50

Current liabilities

and provisions 10.50 8.10

57.90 49.30 57.90 49.30


BALANCE SHEET OF HORIZON LIMITED AS ON MARCH 31, 20 X 1 Rs.in crores

20 x 1 20 x 0 I. 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

II. Application of Funds (1) Fixed assets 33.00 32.20(2) Investments 1.00 1.00(3) Current assets, loans and advances 23.40 15.60

Less: Current liabilities and provisions: 10.50 8.10

Net current assets 12.90 7.50(4) Miscellaneous expenditures and losses 0.50 0.50

47.40 41.20

LIABILITIES

• Share Capital

• Reserves & Surplus

• Secured Loans

• Unsecured Loans

• Current Liabilities and Provisions


ASSETS

• Fixed Assets

• Investments

• Current Assets, Loans, & Advances

• Miscellaneous Expenditure & Losses


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) –

70.1Expenditure Material and other expenditure 58.2 Interest 2.1 Depreciation 3.0 Profit before tax 6.8 Provision for tax 3.4Profit after tax 3.4

Prior period adjustments 0.8Profit available for appropriations 4.2Appropriations 3.5Balance carried forward 0.7


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 sales 70.1 62.3Cost of goods sold 55.2 47.5 Stocks 42.1 Wages and salaries 6.8 Other manufacturing expenses 6.3Gross profit 14.9 14.8Operating expenses 6.0 4.9 Depreciation 3.0 General administration 1.2 Selling 1.8Operating profit 8.9 9.9Non-operating surplus/deficit – 0.6 Profit before interest and tax 8.9 10.5Interest 2.1 2.2Profit before tax 6.8 8.3Provision for tax 3.4 4.1 Current tax 2.1 2.9 Deferred tax 1.3 1.2Profit after tax 3.4 4.2Prior period adjustments 0.8 0.7Amount available for appropriation 4.2 4.9Appropriations 3.5 4.0Balance carried forward 0.7 0.9


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


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

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

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


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

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

COMPONENTS OF CASH FLOWS

Cash inflows from operations

Cash inflows from investing

activities

Cash inflows from financing

activities

Cash outflows from investing

activities

Cash flow from investing

activities

Cash outflows from financing

activities

Cash flow from financing

activities

Operating

Investing

Financing

–

–

=

=

=

+ –

+ –

=

–

Cash outflows from operations

Cash flow from operations

Net cash flow for the period


CASH FLOW STATEMENT

LIABILITIES ASSETS

CAPITAL FIXED ASSETS

RESERVES & SURPLUSINVESTMENTS

LOANS

INVENTORIES

CURRENT LIABILITIES DEBTORS

AND PROVISIONS CASH


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


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 2.1Depreciation 3.0

Operating profit before working capital changes 11.9 Adjustments

Debtors (4.6)Inventories (3.3)Advances 0.5Trade credit 1.5Advances 0.7Provisions 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.)


(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 Equivalents 0.4

Cash and cash equivalents as on 1.04.20x0 0.6

Cash and cash equivalents as on 31.03.20x1 1.0


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


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


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.



• 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.



1. 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.

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

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


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.


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.


CASH FLOW SUMMARY

A. The cash flow identity

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

B. Cash flow from assetsCash flow from assets = Operating cash flow – Net capital spending –

Change in net working capital

whereOperating cash flow = PBIT – Taxes + DepreciationCapital spending = Ending net fixed assets – Beginning net fixed assets + DepreciationChange in net working capital = Ending net working capital – Beginning net working capital

C. Cash flow to lendersCash flow to lenders = Interest paid – Net new borrowing

D. Cash flow to shareholdersCash flow to shareholders = Dividends paid – Net new share capital raised


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.


• 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.


• 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


Documents

Chapter 3 Financial Statement Taxes and Cashflow