MBA604_Financial Reporting and Analysis

Financial Statement Analysis III 295 11. Following information has been extracted from financial statements of Nia Manufacturing: Balance Sheet as at 31 March, 2017 Particulars Amount (`) Equity and Liabilities 3,00,000 Shareholders’ Funds 1,00,000 (a) Share Capital Non-current Liabilities — (a) Long-term Borrowings 80,000 Current Liabilities 20,000 (a) Short-term Borrowings 5,00,000 (b) Trade Payables (c) Other Current Liabilities 3,50,000 65,000 Assets 60,000 Non-current Assets 25,000 (a) Fixed Assets 5,00,000 (i) Tangible Assets Current Assets (a) Inventories (b) Trade Receivables (c) Cash and Cash Equivalents Extract from Income Statement: 9,00,000 Revenue from Operations Expenses 4,00,000 Cost of Goods Sold 1,00,000 Selling and Administration Expenses 2,50,000 Other Expenses (including tax) 1,50,000 Profit/(Loss) from Continuing Operations (after tax) CU IDOL SELF LEARNING MATERIAL (SLM)

296 Financial Reporting and Analysis You are required to determine the following: o Current Ratio o Working Capital o Current Assets to Total Assets Ratio o Current Liabilities to Total Assets Ratio o Cash Conversion Cycle o Market price of share if P/E ratio is 8. Amount (`) 12. Calculate absolute liquid ratio from the following information: 1,00,000 2,00,000 Share capital 25,000 12% Debentures 20,000 Bank overdraft 30,000 Trade payables 2,00,000 Bills payable 2,00,000 Goodwill 50,000 Plant and machinery 50,000 Inventories 30,000 Trade receivables 75,000 Cash in hand 10,000 Bills receivable 20,000 Marketable securities Cash at bank 13. Calculate current ratio, liquid ratio and absolute liquid ratio from the following information: Amount (`) Inventories 1,80,000 Trade receivables 2,25,000 Cash in hand 30,000 Bills receivable 90,000 Cash at bank 45,000 Bills payable 75,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 297 Trade payables 1,20,000 Outstanding expenses 1,05,000 Prepaid expenses Land and building 30,000 Goodwill 6,00,000 1,50,000 14. Find out Operating Ratio: Cost of goods sold ` 6,00,000 Office and administrative expenses ` 45,000 Selling and distribution expenses ` 30,000 Sales Sales return ` 9,00,000 ` 30,000 15. You are required to find out: (a) Dividend Yield Ratio ` (b) Dividend Payout Ratio and 15,00,000 (c) Earning Per Share Ratio with below details: 18,00,000 10% Preference Shares of `10 each 4,50,000 1,80,000 Equity Shares of ` 10 each 50% Additional Information: 30% Profit after Tax ` 40 Tax Rate Equity Dividend Rate Market Price of Equity Share 16. What is a cash flow statement? List the classifications of cash flow. 17. Explain the meaning of ‘cash and cash equivalents’ as per AS-3 (Revised). 18. Explain operating activities. 19. What are the items of operating activities? 20. Prepare a format of ‘Cash Flow Statement’ under Indirect Method. 21. What are the advantages of preparing Cash Flow Statement? CU IDOL SELF LEARNING MATERIAL (SLM)

298 Financial Reporting and Analysis 22. From the following Profit and Loss Account of ABC Ltd. for the year ended 31st March 2017 calculate Cash generated from “Operating Activities” by Direct Method. Profit and Loss Account for the Year Ended 31st March, 2017 Particulars ` ` Particulars ` To Opening Stock 1,60,000 By Sale (Cash) 42,50,000 31,00,000 By Commission accrued 40,000 To Purchases (Cash) By Dividend received 60,000 5,00,000 By Profit on sale of Plant To Wages 4,40,000 (Sale proceeds ` 22,40,000 2,40,000 2,30,000 — Book value ` 20,00,000) 2,20,000 Add: Outstanding 60,000 80,000 By Closing Stock 48,10,000 To Salaries 2,20,000 1,20,000 1,10,000 Add: Outstanding 20,000 20,000 2,40,000 44,000 20,000 Less: Prepaid 10,000 4,26,000 48,10,000 To Office Expenses To Selling Expenses To Depreciation To Income Tax paid To Goodwill written off To Preliminary Expenses written off To Net profit 23. From the following details relating to the accounts of Grow More Ltd., prepare Cash Flow Statement: Particulars 31.03.2016 31.03.2015 `` Liabilities 10,00,000 8,00,000 Share Capital 2,00,000 1,50,000 Reserve 1,00,000 Profit and Loss Account 2,00,000 60,000 Debentures 1,00,000 — Provision for Taxation 2,00,000 Proposed Dividend 7,00,000 70,000 Sundry Creditors 1,00,000 8,20,000 25,00,000 20,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 299 Assets 7,00,000 5,00,000 Plant and Machinery 6,00,000 4,00,000 Land and Building 1,00,000 Investments 5,00,000 — Sundry Debtors 4,00,000 7,00,000 Stock 2,00,000 2,00,000 Cash on Hand/Bank 2,00,000 25,00,000 20,00,000 Additional Information: (i) Depreciation @ 25% was charged on the opening value of Plant and Machinery. (ii) During the year one, old machine costing ` 50,000 (WDV ` 20,000) was sold for ` 35,000. (iii) ` 50,000 was paid towards income tax during the year. (iv) Building under construction was not subject to any depreciation. Prepare Cash flow Statement. 24. Following are the Balance Sheets of Suhani Ltd. as on 31st March, 2015 and 2016. Particulars 31.03.2016 31.03.2015 `` Liabilities 4,00,000 3,00,000 Share Capital 1,00,000 3,00,000 General Reserve Profit & Loss A/c 50,000 30,000 Debentures 1,00,000 1,50,000 Provision for Taxation Proposed Dividend 40,000 50,000 Trade Creditors 40,000 30,000 70,000 90,000 Assets Goodwill 8,00,000 7,30,000 Plant and Machinery Investment 90,000 1,00,000 Sundry Debtors 4,29,250 2,98,000 Stock 1,00,000 Prepaid Expenses 60,000 1,60,000 1,10,000 50,000 80,000 4,000 5,750 CU IDOL SELF LEARNING MATERIAL (SLM)

300 Financial Reporting and Analysis Cash and Bank Balance 20,000 10,000 Discount on Debentures 5,000 8,000 8,00,000 7,30,000 Additional Information: (i) Depreciation on Plant and Machinery has been charged @ 15%. (ii) A machine costing ` 10,000 (W.D.V. ` 3,000) has been discarded. An old machine costing ` 50,000 (W.D.V. ` 20,000) has been sold for ` 35,000. (iii) A profit of ` 10,000 has been earned by sale of investments. (iv) Debentures have been redeemed at 5% premium. (v) ` 45,000 income tax has been paid and adjusted against provision for taxation. Prepare Statement of Changes in Financial Position on cash basis. 25. From the following, prepare a cash flow statement for XYZ Ltd. for the year 2016. XYZ Ltd. Balance Sheet as at March 31, 2015 (` ’000) Liabilities & Equity ` Assets ` Paid-up Capital 50 Gross Fixed Assets 1,000 Retained Earnings Long-term Debt 350 Less: Accumulated Depreciation 100 900 Notes Payable 100 Accounts Payable 500 Inventory 50 10 80 Account Receivables 80 Cash 1,060 1,060 Balance Sheet as at March 31, 2016 (` ’000) Liabilities & Equity ` Assets ` Paid up Capital 50 Gross Fixed Assets 1,125 950 Retained Earnings 415 Less: Accumulated Depreciation 175 110 Long-term Debt 550 Inventory 60 Notes Payable 100 Account Receivables 85 Accounts Payable 1,205 90 Cash 1,205 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 301 Income Statement, March 31, 2016 Particulars ` (‘000) Sales 1,200 Less: Cost of goods sold – 800 Gross Profit Less: Selling, general, administration, expenses 400 EBIT – 150 Less: Interest expenses EBT 250 Less: Taxes (50%) – 50 Net Income 200 – 100 100 Additional information: : 35 (i) Dividend paid : 65 (ii) Additions to retained earnings : 75 (iii) Depreciation 26. Financial information of ABC Ltd. for the year ended 31st March, 2015 and 2016 are as follows: Summarised Balance Sheet as on 31st March, 2016 and 2015 Particulars 2016 2015 ` ` Assets 4,500 1,500 Cash and cash equivalents 7,500 3,750 Trade receivables 3,000 2,250 Inventory 1,500 2,250 Intangible asset (net) 28,500 28,500 Due from associates 18,000 33,750 Property, plant and equipment at cost (7,500) (9,000) Accumulated depreciation 10,500 24,750 Property, plant and equipment (net) Liabilities Total assets 55,500 63,000 Accounts payable Total liabilities Provision for taxation 7,500 18,750 7,500 4,500 15,000 23,250 CU IDOL SELF LEARNING MATERIAL (SLM)

302 Financial Reporting and Analysis Shareholders’ equity 9,750 9,750 Share capital 30,750 30,000 Retained earnings 40,500 39,750 Total shareholders’ equity 55,500 63,000 Total liabilities and shareholders’ equity Summarised Statement of Profit and Loss for the year ended 31st March, 2016 Particulars ` Sales 45,000 Cost of sales (15,000) Gross operating profit Administrative and selling expenses 30,000 Interest expenses (3,000) Depreciation of property, plant and equipment (3,000) Amortisation of intangible asset (3,000) Investment income Net profit before taxation (750) Taxes on profit 4,500 24,750 Net profit (6,000) 18,750 Additional information: 1. All sales made are credit sales. All purchases are also credit purchases. 2. Interest expense for the year 2015-2016 was ` 3,000 which was fully paid during the year. 3. The company pays salaries and other employee dues before the end of each month. All administration and selling expenses incurred were paid before 31st March, 2016. 4. Investment income comprised dividend income from investments in shares of blue chip companies. This was received before 31st March, 2016. 5. Equipment with a net book value of ` 11,250 and original cost of ` 15,750 was sold for ` 11,250. 6. The company declared and paid dividends of ` 18,000 to its shareholders during 2015- 2016. 7. Income tax expense for the year 2015-2016 was ` 6,000, against which the company paid ` 3,000 during 2015-2016 as an estimate. Using all the given financial information of ABC Ltd., prepare the cash flows statement as per AS-3 under indirect method. CU IDOL SELF LEARNING MATERIAL (SLM)

Financial Statement Analysis III 303 B. Multiple Choice/Objective Type Questions 1. Net working capital is defined as: (a) Total assets minus current assets (b) The excess of current assets over current liabilities (c) Current liabilities less current assets (d) Marketable securities and cash 2. The __________ is a measure of liquidity which excludes __________ generally the least liquid asset. (a) Current ratio, account receivable (b) Liquid ratio, inventory (c) Gross profit margin and operating ratio (d) Current ratio and average collection period 3. The __________ indicates the percentage of each sales rupee remaining after the firm has paid for its goods. (a) Net profit margin (b) Operating profit margin (c) Gross profit margin (d) Earnings available to equity shareholders 4. Higher gearing means __________ (a) Capital structure is high geared (b) Capital structure is optimum (c) Capital structure is low geared (d) None of the above 5. Return on Proprietor’s fund indicates __________ (a) Utilisation of capital employed (b) Utilisation of assets (c) Utilisation of proprietor’s fund (d) Utilisation of total resources 6. Which among the following is useful in evaluating credit and collection policies: (a) Average payment period (b) Average collection period (c) current ratio (d) Inventory turnover ratio CU IDOL SELF LEARNING MATERIAL (SLM)

304 Financial Reporting and Analysis 7. Which among the following ratio provide the information critical to the long-run operation of the firm: (a) Liquidity (b) Activity (c) Solvency (d) Profitability 8. Which among the following analysis involves the comparison of different firms financial ratio at the same point of time: (a) Time-series (b) Cross-sectional (c) Marginal (d) None of the above 9. Time-series analysis is often used to: (a) Assess developing trends (b) Standardize result (c) Correct errors of judgement (d) None of above 10. Which among the following is the name of ‘Return on Investment’: (a) Rate of return (b) Return on capital employed (c) Yield on capital (d) All the above Answers: 1. (b), 2. (b), 3. (c), 4. (a), 5. (c), 6. (b), 7. (c), 8. (b), 9. (a), 10. (d) 8.12 References 1. Williams, Jan R., Susan F. Haka, Mark S. Bettner and Joseph V. Carcello (2008), Financial and Managerial Accounting. McGraw-Hill Irwin, p. 266, ISBN 978-0-07-299650-0. 2. W.H. Beaver, “Financial Ratios as Predictors of Failure”, Empirical Research in Accounting Selected Studies, 1996, p. 71. 3. Helfert, Erich A., “The Nature of Financial Statements: The Cash Flow Statement”, Financial Analysis – Tools and Techniques: A Guide for Managers. 4. “Operating Activity on Dividends in GAAP”, chron.com, Retrieved 16th March, 2018. CU IDOL SELF LEARNING MATERIAL (SLM)

Window Dressing 305 UNIT 9 WINDOW DRESSING Structure: 9.0 Learning Objectives 9.1 Introduction 9.2 Limitations ofFinancial Statements 9.3 Window Dressing 9.4 Techniques ofWindow Dressing 9.5 Summary 9.6 Key Words/Abbreviations 9.7 LearningActivity 9.8 Unit End Questions (MCQ and Descriptive) 9.9 References 9.0 Learning Objectives After studying this unit, you will be able to:  Explain the limitations of Financial Statements  Understand the concept of window dressing 9.1 Introduction Financial statement helps the interested parties to make an assessment of the earning capacity and financial soundness of a firm. But such statement has its own limitations also. Such information must be kept in mind while using the information provided by the financial analysis. Some of the limitations are as follows: CU IDOL SELF LEARNING MATERIAL (SLM)

306 Financial Reporting and Analysis 9.2 Limitations of Financial Statements 1. Hinders the performance of financial analysis: As we know that financial analysis is based on financial statements, the limitations of financial statements also become the limitation of financial analysis. As the information given in financial statements may be incomplete and unauthentic, financial statements are alsobased on accounting concepts and conventions. 2. Affected by window dressing: Some firms resort to window dressing their financial statements to cover up the bad financial position on the eve of accounting date. For example, they may not record the purchases made at the end of the year or they may overvalue their closing stock. In such cases, the results obtained by analysis of financial statements will be misleading. 3. Do not reflect changes in price level: Figures given in financial statements do not show the effect of changes in price level. As such, the comparison of past year figures with current year figures may lead to misleading conclusions 4. Different accounting policies: If two firms adopt different accounting policies, the comparison between the two will be unreliable. For example, one firm may adopt the method of providing depreciation on original cost method and the other firm may adopt written down value method, hence, the results obtained from the comparison of the financial statements of such firms may give misleading picture. 5. Difficulty in forecasting: As we know that financial statements are a record of past events and historical facts. In the fast changing and developing business, the analysis of past information may not be of much use in future forecasting. 6. Lack of qualitative analysis: Financial statements record only those events and transactions which can be expressed in terms of money. Thus, the changes in management, reputation of the business, firm’s ability to develop new products, efficiency of management, etc. which have a vital bearing on the profitability of the company are all ignored and omitted from being recorded because of these are qualitative in nature: 7. Problem of comparison: Information conveyed by these statements may not be comparable on account of difference between dates of preparation of these statements. At the same time, the difference in methods of accounting followed by different firms and in nature of business of different firms may render the financial statements of two concerns difficult for the comparison. 8. Static picture: Balance sheet is considered to be a static document; and it reflects the position of the concern at a moment of time. The real position of the firm may be changing day to day. 9. Effects of personal ability and bias of the analyst: Figures given in the financial statements do not speak by themselves. Hence, any conclusion can be drawn from these figures. Conclusions CU IDOL SELF LEARNING MATERIAL (SLM)

Window Dressing 307 obtained from the analysis of these figures are affected to a great extent by the personal ability and knowledge of the analyst. For example the term ‘Capital’ may mean only the ‘Shareholder’s Fund’s’ for one analyst whereas the other analyst may tell that it as ‘Shareholders’ Funds and Long-term Debts’ as capital. 9.3 Window Dressing Meaning It is a technique used by companies and financial manager to manipulate financial statements and reports to show more favourable results for a period. It is actions taken to improve the appearance of a company’s financial statements. Window dressing is used mainly in two cases: firstly, when a business has a large number of shareholders, so that the management can give the appearance of a well-run company to investors who probably are not aware about the day-to-day activity of a company; secondly, it may also be used when a company wants to impress a lender in order to qualify for a loan. Example:  Company XYZ is in the process of generating its financial reports for the end of the reporting period. It wants to make the company look more attractive as possible in order to draw in new shareholders and investors. To this end, company XYZ window dresses by suddenly “acquiring” and holding substantial cash in order to make their company look more liquid easily able to make loan payments, hand out dividends, or use their substantial cash flow to invest in expanding the business. The company also try to show its sales projections significantly higher than they probably are in reality. The ultimate aim to change anything they possibly can to drive their stock price higher and make potential investors more interested. This concept is also used by fund managers, who replace poorly-performing securities with high-performing ones just before the end of a reporting period. 9.4 Techniques of Window Dressing  Collecting sales amount as early as possible by offering the customer a large amount of discount because the company wants to accelerate revenues from a future period into the current period.  Switch from accelerated depreciation to Straight-line depreciation in order to reduce the amount of depreciation charges as expenses in the current period. CU IDOL SELF LEARNING MATERIAL (SLM)

308 Financial Reporting and Analysis  A finance manager may postpone the payments of the supplier so that the period ended cash balances appears higher than it should be.  Understatement of assets can be done by charging more than the reasonable or allowable depreciation, creation of more provisions for bad debts or discounts on debtors than expected bad debts or discount on debtors, overstatement of liabilities along with understatement of owner claim, and treatment of contingent liabilities as actual liabilities on the liability side of balance sheet are the ways for the creation of secret reserve.  The convention of conservatism provides a safeguard against the overstatement of profits. By creating excess provisions, accountants can lower down profits to reduce tax burden and to lower down the rate of dividends.  The conventions and concepts of accounts are being abused by the accountants, e.g., convention of conservatism is being misused by the accountants for creating secret reserves by amortizing excess on intangible assets, etc.  By not showing debt financing on the face of the balance sheet, this is also termed as ‘Off- balance sheet financing’. The entire concept of window dressing is clearly unethical, since it is misleading. It is a short- term strategy to make financial statements and financial portfolios appear more consistent and desirable than they really are. Although this technique does not amount to fraud in most circumstances, it is usually done to mislead investors from the true company or fund performance. To verify window dressing an investor or a lender should have clear understanding about the comparison of financial statements and should be aware of the techniques of analyzing the financial statements. The financial statements comprises of Balance Sheet, Income Statement and Cash Flow Statement. Examples of Window Dressing in Indian Companies  Jet Airways changed its depreciation policy from Written Down Value to Straight-line Method, and thereby wrote back ` 920 crore into its profit and loss, which helped the company to report profits during the quarter. It also helped jet to report a higher net worth, which will help in keeping reported gearing low.  Dr. Reddy’s adjusted mark to market losses (Q1 FY08) on outstanding $250 million of hedges in the balance sheet, while P&L reflects forex gains realised. CU IDOL SELF LEARNING MATERIAL (SLM)

Window Dressing 309 Though there are some means to check Window Dressing:  Through verification and valuation of assets  Through verification and valuation of inventories  Through verification of provision  Through verification of capital and revenue items Need of Window Dressing  It is done for enhancing liquidity position of the corporate unit.  It is done to show the stable profitability of the company.  It is done for reducing tax liability of the firm.  It is done to attract more investors.  It is done to reassure moneylenders.  It is done to influence market price of shares of the company.  It is done to satisfy major investors as they want desired rate of return.  It is also done for achieving sales and profit target.  It is also done to ward off takeover bids 9.5 Summary Results obtained from the analysis of financial statements should not be taken as the true indicators of the strength and weaknesses of the concern. The results obtained from the analysis must be read carefully and cautiously. For example, the profit of a firm to sales is 15%, whether this is satisfactory or not will depend upon the figures of previous years. If the firm earned 12% of sales as profit in the previous year, it may be considered to have done better this year. However, the financial statements of two years may not be comparable due to the changes in accounting policies. The limitations of analysis must be kept in mind while take decisions based on the results obtained from such analysis. Limitations of Financial Statements are: (i) hinders the performance of financial analysis, (ii) affected by window dressing, (iii) do not reflect changes in price level, (iv) different accounting policies, (v) difficulty in forecasting, (vi) lack of qualitative analysis, (vii) problem of comparison, (vii) static picture and (ix) effects of personal ability and bias of the analyst. CU IDOL SELF LEARNING MATERIAL (SLM)

310 Financial Reporting and Analysis Methods used for Window Dressing are: (i) sale and lease back, (ii) short-term borrowing, (iii) chasing debtor, (iv) bringing sales forward, (v) changing depreciation policy, (vi) including intangible assets and (vii) changing stock valuation policy Means to check Window Dressing: (i) through verification and valuation of assets, (ii) through verification and valuation of inventories, (iii) through verification of provision and (iv) through verification of capital and revenue items. Need of Window Dressing: (i) It is done for enhancing liquidity position of the corporate unit. (ii) It is done to show the stable profitability of the company. (iii) It is done for reducing tax liability of the firm. (iv) It is done to attract more investors. (v) It is done to reassure moneylenders. (vi) It is done to influence market price of shares of the company. (vii) It is done to satisfy major investors as they want desired rate of return. (viii) It is also done for achieving sales and profit target. (ix) It is done to ward off takeover bids. 9.6 Key Words/Abbreviations  Ward-off takeover bids: It allows existing shareholders to buy more shares at a discount, with the goal to dilute the shares held by the bidder and make the takeover bids more difficult and expensive.  Off-balance sheet financing: It is an accounting practice whereby companies records certain assets and liabilities in a way that prevents them from appearing on the balance sheet. 9.7 Learning Activity 1. Illustrate with help of some examples, how the financial statements can be ‘window dressed’? _________________________________________________________________ _________________________________________________________________ 2. As per your views, how can window dressing be stopped? _________________________________________________________________ _________________________________________________________________ CU IDOL SELF LEARNING MATERIAL (SLM)

Window Dressing 311 9.8 Unit End Questions (MCQ and Descriptive) A. Descriptive Type Questions 1. Give any one limitation of financial statement. 2. Explain how ‘subjectivity’ becomes the limitation of Financial Statement Analysis’? 3. How is ‘Window dressing’ a limitation of Financial Statement Analysis’? 4. Explain how Financial Statement Analysis ignores qualitative element? 5. “Financial Analysis is affected by window dressing and the personal ability and bias of the analyst.” Comment. B. Multiple Choice/Objective Type Questions 1. Which among the following is the limitation of financial statement? (a) Hinders the performance of financial analysis (b) Affected by window dressing (c) Lack of qualitative analysis (d) All the above 2. Balance sheet reflects the position of the concern at a moment of time is what type of limitation of financial statement? (a) Static picture (b) Lack of qualitative analysis (c) Do not reflect changes in price level (d) Different accounting policies 3. Which among the following is the ‘Technique of Window Dressing’? (a) Collecting sales amount as early as possible (b) Switch from accelerated depreciation to straight-line depreciation (c) By postponing the payments of the supplier (d) All the above CU IDOL SELF LEARNING MATERIAL (SLM)

312 Financial Reporting and Analysis 4. Which among the following is the ‘Need of Window Dressing’? (a) It is done for reducing tax liability of the firm (b) It is done to reassure moneylenders (c) To ward off takeover bids (d) All the above 5. Which among the following is the feature of ‘Window Dressing’? (a) The concept of window dressing is unethical (b) Off-balance sheet financing (c) It is usually done to mislead investors from the true company or fund performance (d) All the above Answers: 1. (d), 2. (a), 3. (d), 4. (d), 5. (d) 9.9 References 1. “A Guide to Window Dressing”, Book Overview, Google Books, Retrieved 13th February, 2010. CU IDOL SELF LEARNING MATERIAL (SLM)