MBA608 2_Review of _Corporate Finance-converted-converted

8. Capital budgeting is a. A long term investment b. Anirreversible decision c. A strategic investment decisions d. All of these 9. Dividend is income for the a. Shareholders b. SEBI c. Company d. Goods Suppliers 10. Which is the method of Capital budgeting? a. Net Present Value Method b. Rate of Return Method c. Payback period Method d. All of these Answers 1. a 2. b 3. d 4. a 5. A 6.c 7.b 8.d 9.a 10.d REFERENCES • Joseph Ogden; Frank C. Jen; Philip F. O'Connor (2002). Advanced Corporate Finance. Prentice Hall. ISBN 978-0130915689. • Pascal Quiry; Yann Le Fur; Antonio Salvi; Maurizio Dallochio; Pierre Vernimmen (2011). Corporate Finance: Theory and Practice (3rd ed.). Wiley. ISBN 978- 1119975588. • Stephen Ross, Randolph Westerfield, Jeffrey Jaffe (2012). Corporate Finance (10th ed.). McGraw-Hill. ISBN 978-0078034770 • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. 50 CU IDOL SELF LEARNING MATERIAL (SLM)

• M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 51 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 3 FINANCIAL ANALYSIS, PROFIT PLANNING AND CONTROL Structure Learning objectives Introduction Meaning and Concept of Financial Analysis Elements of a Company Assessed by the financial analysts: Objectives The Financial Analysis Process Distinguishing between Computations and Analysis Financial statement Horizontal and vertical analysis: Ratio Analysis Tools of Analysis of Financial Statements Comparative Statements Common size statement Trend Analysis Procedure for Calculating Trend Percentage Limitations of Financial Analysis Ratio analysis Types of Ratios Liquidity Ratios Cash flow statement Illustrations I.L1 Comparative statement I.L 2 Common size income statement I.L 3 Trend analysis I.L 4 Ratio Analysis Cash Flow statement 52 CU IDOL SELF LEARNING MATERIAL (SLM)

Summary Keywords Learning activity Unit end questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • explain the nature and significance of financial analysis; • identify the objectives of financial analysis; • describe the various tools of financial analysis; • state the limitations of financial analysis; • prepare comparative and common size statements and interpret the data giventherein; and • Calculate the trend percentages and interpret them. • About ratio analysis, about cash flow statement as well INTRODUCTION Financial analysis tools can be useful in assessing a company’s performance and trends in that performance. In essence, an analyst converts data into financial metrics that assist in decision making. Analysts seek to answer such questions as: How successfully has the company performed, relative to its own past performance and relative to its competitors? How is the company likely to perform in the future? Based on expectations about future performance, what is the value of this company or the securities it issues? A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary (operating and financial review or management’s discussion and analysis). This reading focuses on data presented in financial reports prepared under International Financial Reporting Standards (IFRS) and United States generally accepted accounting principles (US GAAP). However, financial reports do not contain all the information needed to perform effective financial analysis. Although financial statements do contain data about the past performance of a company (its income and cash flows) as well as its current financial condition (assets, liabilities, and owners’ equity), such statements do not necessarily provide all the information useful for analysis nor do they forecast future results. The financial analyst must be capable 53 CU IDOL SELF LEARNING MATERIAL (SLM)

of using financial statements in conjunction with other information to make projections and reach valid conclusions. Accordingly, an analyst typically needs to supplement the information found in a company’s financial reports with other information, including information on the economy, industry, comparable companies, and the company itself. This reading describes various techniques used to analyze a company’s financial statements. Financial analysis of a company may be performed for a variety of reasons, such as valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, or assessing a subsidiary’s performance. This reading will describe techniques common to any financial analysis and then discuss more specific aspects for the two most common categories: equity analysis and credit analysis. MEANING AND CONCEPT OF FINANCIAL ANALYSIS Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project. It can also be defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. It is the examination of a business from a variety of perspectives in order to fully understand the greater financial situation and determine how best to strengthen the business and it also looks at many aspects of a business from its profitability and stability to its solvency and liquidity. It is a process of scanning the Financial Statements for evaluating the relationship between the items as disclosed in them. In other words it can be defined as an analysis which critically examines the relationship between various elements of the Financial Statements with a view to obtain the necessary and effective information from them. According to John N. Myer, ‘Financial Statement Analysis is largely a study of relationships among the various financial factors in a business, as disclosed by a single set of statements, and study of these factors as shown in a series of statements.’ Financial Statement Analysis involves a systematic and critical examination of the information contained in the Financial Statements with a view to provide effective and more meaningful information to its different users. It is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity. 54 CU IDOL SELF LEARNING MATERIAL (SLM)

Financial analysis is an aspect of the overall business finance function that involves examining historical data to gain information about the current and future financial health of a company. According to Alan S. Donnahoe - \"The inability to understand and deal with financial data is a severe handicap in the corporate world\" Financial analysis can be applied in a wide variety of situations to give business managers the information they need to make critical decisions. “In a very real sense, finance is the language of business. Goals are set and performance is measured in financial terms. Plants are built, equipment ordered, and new projects undertaken based on clear investment return criteria. Financial analysis is required in every such case.\" Financial statement analysis is an analysis that highlights the important relationship in the financial statements. Financial statement analysis focuses on the evaluation of past performance of the business firm in terms of liquidity, profitability, operational efficiency and growth potentiality. Financial statements analysis includes the method use in assessing and interpreting the result of past performance and current financial position as they relate to particular factors of interest in investment decisions. Therefore financial statement analysis is an important means of assessing past performance and in forecasting and planning future performance. It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions, such as: 1. Continuing or discontinuing the business 2. Making or purchasing certain materials in the manufacture product 3. Acquire or rent/lease certain machineries and equipment in the production of its goods 4. Negotiating for a bank loan to increase its working capital and to issue the stocks 5. Making decisions regarding investing or lending capital 6. Allowing management to make an informed selection on various alternatives in the conduct of its business 3.2.1 Elements of a Company Assessed by the financial analysts: Generally financial analysts assess the following elements: 55 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Profitability – It is the ability to earn income and sustain growth in both the short- and long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results ofoperations. 2. Solvency – It is the ability to pay its obligation to creditors and other third parties in the long-term. It is also based on the company's balance sheet, which indicates the financial condition of a business at a given point of time. 3. Liquidity – It is the ability to maintain positive cash flow, while satisfying immediate obligations and it is also based on the company's balance sheet, which indicates the financial condition of a business at a given point of time. 4. Stability - The firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of the income statement and the balance sheet, as well as other financial and non-financial indicators. OBJECTIVES Assessment of Past Performance Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales; cost of goods sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management's past performance and are possible indicators of future performance. Assessment of current position Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities due against the enterprise. Prediction of profitability and growth prospects Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in earning which are used by investors while comparing investment alternatives and other users in judging earning potential of business enterprise. Prediction of bankruptcy and failure Financial statement analysis is an important tool in assessing and predicting bankruptcy and probability of business failure. 56 CU IDOL SELF LEARNING MATERIAL (SLM)

Assessment of the operational efficiency Financial statement analysis helps to assess the operational efficiency of the management of a company. The actual performance of the firm which are revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of efficiency of the management. Some other objectives are: • Provide reliable financial information. • Provide other needed information about changes in economic resources and obligation. • Provide reliable information about changes in net resources. • Provide financial information that assess in estimating the earnings of a business. • Disclosing other information according to the needs of the users. THE FINANCIAL ANALYSIS PROCESS In financial analysis, it is essential to clearly identify and understand the final objective and the steps required to reach that objective. In addition, the analyst needs to know where to find relevant data, how to process and analyze the data (in other words, know the typical questions to address when interpreting data), and how to communicate the analysis and conclusions. The Objectives of the Financial Analysis Process Because of the variety of reasons for performing financial analysis, the numerous available techniques, and the often substantial amount of data, it is important that the analytical approach be tailored to the specific situation. Prior to beginning any financial analysis, the analyst should clarifythe purpose and context, and clearly understand the following: • What is the purpose of the analysis? What questions will this analysis answer? • What level of detail will be needed to accomplish this purpose? • What data are available for the analysis? • What are the factors or relationships that will influence the analysis? • What are the analytical limitations, and will these limitations potentially impair the analysis? Having clarified the purpose and context of the analysis, the analyst can select the set of techniques (e.g., ratios) that will best assist in making a decision. Although there is no single approach to structuring the analysis process, a general framework is set forth in Exhibit 1.2 The steps in this process were discussed in more detail in an earlier reading; the primary focus of this reading is on Phases 3 and 4, processing and analyzing data. 57 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.1 DISTINGUISHING BETWEEN COMPUTATIONS AND ANALYSIS An effective analysis encompasses both computations and interpretations. A well-reasoned analysis differs from a mere compilation of various pieces of information, computations, tables, and graphs by integrating the data collected into a cohesive whole. Analysis of past performance, for example, should address not only what happened but also why it happened and whether it advanced the company’s strategy. Some of the key questions to address include: • How well did the company’s performance meet these critical aspects? (Established through computation and comparison with appropriate benchmarks, such as the company’s own historical performance or competitors’ performance.) • What were the key causes of this performance, and how does this performance reflect the company’s strategy? (Established through analysis.) If the analysis is forward 58 CU IDOL SELF LEARNING MATERIAL (SLM)

looking, additional questions include: • What is the likely impact of an event or trend? (Established through interpretation of analysis.) • What is the likely response of management to this trend? (Established through evaluation of quality of management and corporate governance.) • What is the likely impact of trends in the company, industry, and economy on future cash flows? (Established through assessment of corporate strategy and through forecasts.) • What are the recommendations of the analyst? (Established through interpretationand forecasting of results of analysis.) • What risks should be highlighted? (Established by an evaluation of major uncertainties in the forecast and in the environment within which the company operates.) Example 1 demonstrates how a company’s financial data can be analyzed in the context of its business strategy and changes in that strategy. An analyst must be able to understand the “why” behind the numbers and ratios, not just what the numbers and ratios are Analysts often need to communicate the findings of their analysis in a written report. Their reports should communicate how conclusions were reached and why recommendations were made. FINANCIAL STATEMENT Types of Financial Statement Analysis Financial statement analysis can be performed by employing a number of methods or techniques. There are two key methods for analyzing financial statements: Horizontal and vertical analysis: Horizontal analysis is the comparison of financial information over a series of reporting periods, Horizontal analysis looks at amounts on the financial statements over the past years. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis. Vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. 59 CU IDOL SELF LEARNING MATERIAL (SLM)

Thus, horizontal analysis is the review of the results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each other within a single period. Ratio Analysis The second method for analyzing financial statements is the use of many kinds of ratios. You use ratios to calculate the relative size of one number in relation to another. After you calculate a ratio, you can then compare it to the same ratio calculated for a prior period, or that is based on an industry average, to see if the company is performing in accordance with expectations. In a typical financial statement analysis, most ratios will be within expectations, while a small number will flag potential problems that will attract the attention of the reviewer. The methods to be selected for the analysis depend upon the circumstances and the users' need. The user or the analyst should use appropriate methods to derive required information to fulfill their needs. Financial Statements are divided into three parts named • Income Statement/Profit & loss account • Balance Sheet and • Notes to Financial Statements TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS • The most commonly used techniques of financial analysis are as follows: • Comparative Statements: These are the statements showing the profitability and financial position of a firm for different periods of time in a comparative form to give an idea about the position of two or more periods. It usually applies to the two important financial statements, namely, balance sheet and statement of profit and loss prepared in a comparative form. The financial data will be comparative only when same accounting principles are used in preparing these statements. If this is not the case, the deviation in the use of accounting principles should be mentioned as a footnote. Comparative figures indicate the trend and direction of financial position and operating results. This analysis is also known as ‘horizontal analyses. • Common Size Statements: These are the statements which indicate the relationship of different items of a financial statement with a common item by expressing each item as a percentage of that common item. The percentage thus calculated can be easily compared with the results of corresponding percentages of the previous year or of some other firms, as the numbers are brought to common base. Such statements also allow an analyst to compare the operating and financing characteristics of two companies of different sizes in the same 60 CU IDOL SELF LEARNING MATERIAL (SLM)

industry. Thus, common size statements are useful, both, in intra-firm comparisons over different years and also in making inter-firm comparisons for the same year or for several years. This analysis is also known as ‘Vertical analysis’. • Trend Analysis: It is a technique of studying the operational results and financial position over a series of years. Using the previous years’ data of a business enterprise, trend analysis can be done to observe the percentage changes over time in the selected data. The trend percentage is the percentage relationship, in which each item of different years bear to the same item in the base year. Trend analysis is important because, with its long run view, it may point to basic changes in the nature of the business. By looking at a trend in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively constant. From this observation, a problem is detected or the sign of good or poor management is detected. • Ratio Analysis: It describes the significant relationship which exists between various items of a balance sheet and a statement of profit and loss of a firm. As a technique of financial analysis, accounting ratios measure the comparative significance of the individual items of the income and position statements. It is possible to assess the profitability, solvency and efficiency of an enterprise through the technique of ratioanalysis. • Cash Flow Analysis: It refers to the analysis of actual movement of cash into and out of an organization. The flow of cash into the business is called as cash inflow or positive cash flow and the flow of cash out of the firm is called as cash outflow or a negative cash flow. The difference between the inflow and outflow of cash is the net cash flow. Cash flow statement is prepared to project the manner in which the cash has been received and has been utilized during an accounting year as it shows the sources of cash receipts and also the purposes for which payments are made. Thus, it summarizes the causes for the changes in cash position of a business enterprise between dates of two balance sheets. Comparative Statements As stated earlier, these statements refer to the statement of profit and loss and the balance sheet prepared by providing columns for the figures for both the current year as well as for the previous year and for the changes during the year, both in absolute and relative terms. As a result, it is possible to find out not only the balances of accounts as on different dates and summaries of different operational activities of different periods, but also the extent of their increase or decrease between these dates. The figures in the comparative statements can be used for identifying the direction of changes and also the trends in different indicators of performance of an organization. The following steps may be followed to prepare the comparative statements: Step 1: List out absolute figures in rupees relating to two points of time (as shown in columns 2 and 3 of Exhibit 4.1). 61 CU IDOL SELF LEARNING MATERIAL (SLM)

Step 2: Find out change in absolute figures by subtracting the first year (Col.2) from the second year (Col.3) and indicate the change as increase (+) or decrease (–) and put it in column 4. Step 3: Preferably, also calculate the percentage change as follows and put it in column 5. Particulars First Year Second Absolute Percentage Year Increase Increase (+) (+) or or Decrease 12 3 Decrease (–) Rs. Rs. (–) 5 Figure 3.2 4 %. Common size statement Rs. Figure 3.3 Common Size Statement, also known as component percentage statement, is a financial tool for studying the key changes and trends in the financial position and operational result of a 62 CU IDOL SELF LEARNING MATERIAL (SLM)

company. Here, each item in the statement is stated as a percentage of the aggregate, of which that item is a part. For example, a common size balance sheet shows the percentage of each asset to the total assets, and that of each liability to the total liabilities. Similarly, in the common size statement of profit and loss, the items of expenditure are shown as a percentage of the net revenue from operations. If such a statement is prepared for successive periods, it shows the changes of the respective percentages over a period of time. Common size analysis is of immense use for comparing enterprises which differ substantially in size as it provides an insight into the structure of financial statements. Inter-firm comparison or comparison of the company’s position with the related industry as a whole is possible with the help of common size statement analysis. The following procedure may be adopted for preparing the common size statements. • List out absolute figures in rupees at two points of time, say year 1, and year 2 (Column 2 & 4 of Exhibit 4.2). • Choose a common base (as 100). For example, revenue from operations may be taken as base (100) in case of statement of profit and loss and total assets or totalliabilities (100) in case of balance sheet. • For all items of Col. 2 and 3 work out the percentage of that total. Column 4 and 5 shows these percentages. Trend Analysis The financial statements may be analyzed by computing trends of series of information. Trend analysis determines the direction upwards or downwards and involves the computation of the percentage relationship that each item bears to the same item in the base year. In case of comparative statement, an item is compared with itself in the previous year to know whether it has increased or decreased or remained constant. Common size analysis is to ascertain whether the proportion of an item (say cost of revenue from operations) is increasing or decreasing in the common base (say revenue from operations). But in case of trend analysis, we learn about the behavior of the same item over a given period, say, during the last 5 years. Take for example, administrative expenses, whether they are exhibiting increasing tendency or decreasing tendency or remaining constant over the period of comparison. Generally trend analysis is done for a reasonably long period. Many companies present their financial data for a period of 5 or 10 years in various forms in their annual reports. Procedure for Calculating Trend Percentage One year is taken as the base year. Generally, the first year is taken as the base year. The figure of base year is taken as 100. The trend percentages are calculated in relation to this base year. If a figure in other year is less than the figure in base year, the trend percentage 63 CU IDOL SELF LEARNING MATERIAL (SLM)

will be less than 100 and it will be more than 100 if figure is more than the base year figure. Each year’s figure is divided by the base year figure. The accounting procedures and conventions used for collecting data and preparation of financial statements should be similar; otherwise the figures will not be comparable Limitations of Financial Analysis Though financial analysis is quite helpful in determining financial strengths and weaknesses of a firm, it is based on the information available in financial statements. As such, the financial analysis also suffers from various limitations of financial statements. Hence, the analyst must be conscious of the impact of price level changes, window dressing of financial statements, changes in accounting policies of a firm, accounting concepts and conventions, personal judgement, etc. Some other limitations of financial analysis are: • Financial analysis does not consider price level changes. • Financial analysis may be misleading without the knowledge of the changes in accounting procedure followed by a firm. • Financial analysis is just a study of reports of the company. • Monetary information alone is considered in financial analysis while non-monetary aspects are ignored. • The financial statements are prepared on the basis of accounting concept, as such, it does not reflect the current position. RATIO ANALYSIS As stated earlier, accounting ratios are an important tool of financial statements analysis. A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio. For example, if the gross profit of the business is Rs. 10,000 and the ‘Revenue from Operations’ 10, 000 are Rs. 1,00,000, it can be said that the gross profit is 10% (10,000/1,00,000) 100 of the ‘Revenue from Operations’. This ratio is termed as gross profit ratio. Similarly, inventory turnover ratio may be 6 which implies that inventory turns into ‘Revenue from Operations’ six times in a year. It needs to be observed that accounting ratios exhibit relationship, if any, between accounting numbers extracted from financial statements. Ratios are essentially derived numbers and their 64 CU IDOL SELF LEARNING MATERIAL (SLM)

efficacy depends a great deal upon the basic numbers from which they are calculated. Hence, if the financial statements contain some errors, the derived numbers in terms of ratio analysis would also present an erroneous scenario. Further, a ratio must be calculated using numbers which are meaningfully correlated. A ratio calculated by using two unrelated numbers would hardly serve any purpose. For example, the furniture of the business is Rs. 1, 00,000 and Purchases are Rs. 3, 00,000. The ratio of purchases to furniture is 3 (3,00,000/1,00,000) but it hardly has any relevance. The reason is that there is no relationship between these two aspects. Types of Ratios There is a two way classification of ratios: Figure 3.4 (1) traditional classification, and (2) functional classification. The traditional classification has been on the basis of financial statements to which the determinants of ratios belong. On this basis the ratios are classified as follows: • ‘Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as gross profit ratio. It is calculated using both figures from the statement of profit and loss. 65 CU IDOL SELF LEARNING MATERIAL (SLM)

• Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. For example, ratio of current assets to current liabilities known as current ratio. It is calculated using both figures from balance sheet. • Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet. Although accounting ratios are calculated by taking data from financial statements but classification of ratios on the basis of financial statements is rarely used in practice. It must be recalled that basic purpose of accounting is to throw light on the financial performance (profitability) and financial position (its capacity to raise money and invest them wisely) as well as changes occurring in financial position (possible explanation of changes in the activity level). As such, the alternative classification (functional classification) based on the purpose for which a ratio is computed, is the most commonly used classification which is as follows: 1. Liquidity Ratios: To meet its commitments, business needs liquid funds. The ability of the business to pay the amount due to stakeholders as and when it is due is known as liquidity, and the ratios calculated to measure it are known as ‘Liquidity Ratios’. These are essentially short-term in nature. 2. Solvency Ratios: Solvency of business is determined by its ability to meet its contractual obligations towards stakeholders, particularly towards external stakeholders, and the ratios calculated to measure solvency position are known as ‘Solvency Ratios’. These are essentially long-term in nature. 3. Activity (or Turnover) Ratios: This refers to the ratios that are calculated for measuring the efficiency of operations of business based on effective utilization of resources. Hence, these are also known as ‘Efficiency Ratios’. 4. Profitability Ratios: It refers to the analysis of profits in relation to revenue from operations or funds (or assets) employed in the business and the ratios calculated to meet this objective are known as ‘Profitability Ratios’. Liquidity Ratios Liquidity ratios are calculated to measure the short-term solvency of the business, i.e. the firm’s ability to meet its current obligations. These are analyzed by looking at the amounts of current assets and current liabilities in the balance sheet. The two ratios included in this category are current ratio and liquidity ratio. 66 CU IDOL SELF LEARNING MATERIAL (SLM)

Current RATIO Current ratio is the proportion of current assets to current liabilities. It is expressed as follows: Current Ratio = Current Assets: Current Liabilities or Current Assets Current Liabilities Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc. Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions. Quick or Liquid RATIO It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as Quick ratio = Quick Assets: Current Liabilities or Quick Assets / Current Liabilities The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non- liquid current assets it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’. Debt-Equity RATIO Debt-Equity Ratio measures the relationship between long-term debt and equity. If debt component of the total long-term funds employed is small, outsiders feel more secure. From security point of view, capital structure with less debt and more equity is considered favorable as it reduces the chances of bankruptcy. Normally, it is considered to be safe if debt equity ratio is 2: 1. However, it may vary from industry to industry. It is computed as follows: 67 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.5 Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders. However, from the perspective of the owners, greater use of debt (trading on equity) may help in ensuring higher returns for them if the rate of earnings on capital employed is higher than the rate of interest payable. CASH FLOW STATEMENT Till now you have learnt about the financial statements being primarily inclusive of Position Statement (showing the financial position of an enterprise as on a particular date) and Income Statement (showing the result of the operational activities of an enterprise over a particular period). There is also a third important financial statement known as Cash flow statement, which shows inflows and outflows of the cash and cash equivalents. This statement is usually prepared by companies which comes as a tool in the hands of users of financial information to know about the sources and uses of cash and cash equivalents of an enterprise over a period of time from various activities of an enterprise. It has gained substantial importance in the last decade because of its practical utility to the users of financial information. 68 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.6 Cash flow statement format Financial Statement of companies are prepared following the accounting standards prescribed in the companies Act, 2013. Accounting Standards are notified under section 133 of the Companies Act, 2013 vide Accounting Standards Rules, 2006 and are mandatory in nature. Companies Act, 2013 also specifies that if the accounting standards are not followed, financial statements will not be true and fair, which is a quality of financial statement. Financial Statements are defined in Companies Act, 2013 (Section 2 (40)] and includes Cash Flow Statement prepared in accordance with Accounting Standard- 3 (AS-3)- Cash Flow Statement. A cash flow statement provides information about the historical changes in cash and cash equivalents of an enterprise by classifying cash flows into operating, investing and financing activities. It requires that an enterprise should prepare a cash flow statement and should present it for each accounting period for which financial statements are presented. This 69 CU IDOL SELF LEARNING MATERIAL (SLM)

chapter discusses this technique and explains the method of preparing a cash flow statement for an accounting period. Objectives of Cash Flow Statement A Cash flow statement shows inflow and outflow of cash and cash equivalents from various activities of a company during a specific period. The primary objective of cash flow statement is to provide useful information about cash flows (inflows and outflows) of an enterprise during a particular period under various heads, i.e., operating activities, investing activities and financing activities. This information is useful in providing users of financial statements with a basis to assess the ability of the enterprise to generate cash and cash equivalents and the needs of the enterprise to utilize those cash flows. The economic decisions that are taken by users require an evaluation of the ability of an enterprise to generate cash and cash equivalents and the timing and certainty of their generation. Benefits of Cash Flow Statement Cash flow statement provides the following benefits: • A cash flow statement when used along with other financial statements provides information that enables users to evaluate changes in net assets of an enterprise, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timings of cash flows in order to adapt to changing circumstances and opportunities. • Cash flow information is useful in assessing the ability of the enterprise to generate cash and cash equivalents and enables users to develop models to assess andcompare the present value of the future cash flows of different enterprises. • It also enhances the comparability of the reporting of operating performance by different enterprises because it eliminates the effects of using different accounting treatments for the same transactions and events. • It also helps in balancing its cash inflow and cash outflow, keeping in response to changing condition. It is also helpful in checking the accuracy of past assessments of future cash flows and in examining the relationship between profitability and net cash flow and impact of changing prices. Cash and Cash Equivalents As stated earlier, cash flow statement shows inflows and outflows of cash and cash equivalents from various activities of an enterprise during a particular period. As per AS-3, ‘Cash’ comprises cash in hand and demand deposits with banks, and ‘Cash equivalents’ means short-term highly liquid investments that are readily convertible into known amounts 70 CU IDOL SELF LEARNING MATERIAL (SLM)

of cash and which are subject to an insignificant risk of changes in value. An investment normally qualifies as cash equivalents only when it has a short maturity, of say, three months or less from the date of acquisition. Investments in shares are excluded from cash equivalents unless they are in substantial cash equivalents. For example, preference shares of a company acquired shortly before their specific redemption date, provided there is only insignificant risk of failure of the company to repay the amount at maturity. Similarly, short-term marketable securities which can be readily converted into cash are treated as cash equivalents and is liquid able immediately without considerable change in value. Cash Flows ‘Cash Flows’ implies movement of cash in and out due to some non-cash items. Receipt of cash from a non-cash item is termed as cash inflow while cash payment in respect of such items as cash outflow. For example, purchase of machinery by paying cash is cash outflow while sale proceeds received from sale of machinery is cash inflow. Other examples of cash flows include collection of cash from trade receivables, payment to trade payables, payment to employees, receipt of dividend, interest payments, etc. Cash management includes the investment of excess cash in cash equivalents. Hence, purchase of marketable securities or short-term investment which constitutes cash equivalents is not considered while preparing cash flow statement. Classification of Activities for the Preparation of Cash Flow Statement You know that various activities of an enterprise result into cash flows (inflows or receipts and outflows or payments) which is the subject matter of a cash flow statement. As per AS-3, these activities are to be classified into three categories: (1) operating, (2) investing, and (3) financing activities so as to show separately the cash flows generated (or used) by (in) these activities. This helps the users of cash flow statement to assess the impact of these activities on the financial position of an enterprise and also on its cash and cash equivalents. CASH from OPERATING Activities Operating activities are the activities that constitute the primary or main activities of an enterprise. For example, for a company manufacturing garments, operating activities are procurement of raw material, incurrence of manufacturing expenses, sale of garments, etc. These are the principal revenue generating activities (or the main activities) of the enterprise and these activities are not investing or financing activities. The amount of cash from operations’ indicates the internal solvency level of the company, and is regarded as the key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, paying dividends, making of new investments and repaying of loans without recourse to external source of financing. 71 CU IDOL SELF LEARNING MATERIAL (SLM)

Cash flows from operating activities are primarily derived from the main activities of the enterprise. They generally result from the transactions and other events that enter into the determination of net profit or loss. Examples of cash flows from operating activities are: Cash Inflows from operating activities • cash receipts from sale of goods and the rendering of services. • cash receipts from royalties, fees, commissions and other revenues. Cash Outflows from operating activities • Cash payments to suppliers for goods and services. • Cash payments to and on behalf of the employees. • Cash payments to an insurance enterprise for premiums and claims, annuities, and other policy benefits. • Cash payments of income taxes unless they can be specifically identified with financing and investing activities. The net position is shown in case of operating cash flows. An enterprise may hold securities and loans for dealing or for trading purposes. In either case they represent Inventory specifically held for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made by financial enterprises are usually classified as operating activities since they relate to main activity of that enterprise. 72 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.7 Preparation of Cash Flow Statement As stated earlier cash flow statement provides information about change in the position of Cash and Cash Equivalents of an enterprise, over an accounting period. The activities contributing to this change are classified into operating, investing and financing. The methodology of working out the net cash flow (or use) from all the three activities for an accounting period has been explained in details and a brief format of Cash Flow Statement has also been given in Exhibit 6.2. However, while preparing a cash flow statement, full details of inflows and outflows are given under these heads including the net cash flow (or use). The aggregate of the net ‘cash flows (or use) is worked out and is shown as ‘Net Increase/Decrease in cash and Cash Equivalents’ to which the amount of ‘cash and cash equivalent at the beginning’ is added and thus the amount of ‘cash and cash equivalents at the end’ is arrived at as shown in Exhibit 6.2. This figure will be the same as the total amount of cash in hand, cash at bank and cash equivalents (if any) given in the balance sheet (see Illustrations 7 to 10). Another point that needs to be noted is that when cash flows from operating activities are worked out by an indirect method and shown as such in the cash flow statement, the statement itself is termed as ‘Indirect method cash flow statement’. Thus, the Cash flow statements prepared in Illustrations 7, 8 and 9 falls under this category as the cash flows from operating activities have been worked out by indirect method. Similarly, if the cash flows from operating activities are worked by direct method while preparing the cash 73 CU IDOL SELF LEARNING MATERIAL (SLM)

flow statement, it will be termed as ‘direct method Cash Flow Statement’. Illustration 10 shows both types of Cash Flow Statement. However, unless it is specified clearly as to which method is to be used, the cash flow statement may preferably be prepared by an indirect method as is done by most companies in practice. ILLUSTRATIONS I.L1 Comparative statement Convert the following statement of profit and loss into the comparative statement of profit and loss of BCR Co. Ltd.: Particulars Note 2013-14 2014-15 No. Rs. Rs. (i) Revenue from operations 60,00,000 75,00,000 (ii) Other incomes 1,50,000 1,20,000 (iii) Expenses 44,00,000 50,60,000 (iv) Income tax 35% 40% Solution: Comparative statement of profit and loss for the year ended March 31, 2014 and 2015: Particulars 2013-14 2014-15 Absolute Percentage Increase Increase I. Revenue from Rs. Rs. (+) or (+) operations 60,00,000 75,00,000 Decrease or II. Add: Other 1,50,000 1,20,000 (–) Decrease incomes 61,50,000 76,20,000 (–) III. Total Revenue 44,00,000 50,60,000 Rs. % I+II 17,50,000 25,60,000 15,00,000 25.00 IV Less: Expenses 6,12,500 10,24,000 Profit before tax 11,37,500 15,36,000 (30,000) (20.00) V Less: Tax Profit after tax 14,70,000 23.90 6,60,000 15.00 8,10,000 46.29 4,11,500 67.18 3,98,500 35.03 74 CU IDOL SELF LEARNING MATERIAL (SLM)

I.L 2 Common size income statement From the following information, prepare a Common size Income Statement for the year ended March 31, 2014 and 2015: Particulars 2014-15 2013-14 Rs. Rs. Net sales 18,00,000 25,00,000 Cost of goods sold 10,00,000 12,00,000 Operating expenses 80,000 1,20,000 Non-operating expenses 12,000 15,000 Depreciation 20,000 40,000 Wages 10,000 20,000 Solution: Common Size Income Statement for the year ended March 31, 2013 and March 31, 2014 Particulars Absolute Amounts Percentage of Net Sales Net Sales 2013-14 2014-15 2013-14 2014-15 (Less) Cost of goods Sold* Rs. Rs. (%) (%) 25,00,000 18,00,000 100 100 12,00,000 10,00,000 48 55.56 Gross Profit 13,00,000 8,00,000 52 44.44 (Less) Operating 1,20,000 80,000 4.80 4.44 Expenses** Operating Income 11,80,000 7,20,000 47.20 40 (Less) Non- 15,000 12,000 0.60 0.67 Operating Expenses 11,65,000 7,08,000 46.60 39.33 Profit * Wages is the part of cost of goods sold; ** Depreciation is the part of operating expenses. Example 2 From the following information, prepare Common size statement of profit and loss for the 75 CU IDOL SELF LEARNING MATERIAL (SLM)

year ended March 31, 2014 and March 31, 2015: Particulars 2013-14 2014-15 Rs. Rs. Revenue from operations 25,00,000 20,00,000 Other income 3,25,000 2,50,000 Employee benefit expenses 8,25,000 4,50,000 Other expenses 2,00,000 1,00,000 Income tax (% of the profit before tax) 30% 20% Solution: Common size statement of Profit and Loss for the year ended March 31, 2014 and March 31, 2015: Particulars Absolute Amounts Percentage of Net Revenue from Revenue from Operations (Add) Other income operations Total revenue (Less) expenses: 2013-14 2014-15 2013- 2014- a) Employee benefit Rs. Rs. 14 15 expenses 25,00,000 20,00,000 b) Other expenses 3,25,000 2,50,000 (%) (%) Profit before tax (Less) taxes 28,25,000 22,50,000 100 100 Profit after tax 8,25,000 4,50,000 2,00,000 1,00,000 13 12.5 113 112.5 33 22.5 85 18,00,000 17,00,000 72 85 5,40,000 3,40,000 21.6 17 12,60,000 13,60,000 50.4 68 I.L 3 Trend analysis Calculate the trend percentages from the following figures of sales, stock and profit of X Ltd., taking 2010 as the base year and interpret them. (Rs. in lakhs) Year Sales (Rs.) Stock (Rs.) Profit before tax 76 CU IDOL SELF LEARNING MATERIAL (SLM)

2010 1,881 709 (Rs.) 2011 2,340 781 2012 2,655 816 321 2013 3,021 944 435 2014 3,768 1,154 458 527 627 Solution: Trend Percentages (base year 2010 = 100) (Rs. in lakhs) Year Sales Trend Stock Trend Profit Trend Rs. % Rs. % Rs. % 2010 1881 100 709 100 321 100 2011 2340 124 781 110 435 136 2012 2655 141 816 115 458 143 2013 3021 161 944 133 527 164 2014 3768 200 1154 163 627 195 Interpretation: 1. The sales have continuously increased in all the years up to 2014, though in different proportions. The percentage in 2014 is 200 as compared to 100 in 2010. The increase in sales is quite satisfactory. 2. The figures of stock have also increased over a period of five years. The increase in stock is more in 2013 and 2014 as compared to earlier years. 3. Profit has substantially increased. The profits have increased in greater proportion than sales which implies that the company has been able to reduce their cost of goods sold and control the operating expenses. Example 2 From the following data relating to the assets of Balance Sheet of ABC Ltd., for the period ended March 31, 2011 to March 31, 2014, calculate trend percentages Particulars 2010- 2011-12 2012-13 2013- 11 14 Cash 100 120 80 140 Debtors 200 250 325 400 Stock 300 400 350 500 77 CU IDOL SELF LEARNING MATERIAL (SLM)

Other current assets 50 75 125 150 Land 400 500 500 500 Buildings 800 1000 1200 1500 Plant 1000 1000 1200 1500 Solution: Trend percentage Asset 20 Tr 20 Tre 20 Tre 20 Tre s 10 en 11 nd 12 nd 13 nd - d - %- %- % Curre 11 % 12 13 14 nt Asset 10 100 12 120 80 80 14 140 s 0 Cash 20 00 0 Debto 30 100 25 125 32 162 40 200 rs 0 Stock 50 0 5 .5 0 Other 65 100 40 133 35 116 50 166 Curre 0 nt 0 .33 0 .67 0 .67 Asset 40 s 0 100 75 150 12 250 15 300 80 Non- 0 50 curre nt 100 84 130 88 135 1,1 183 Asset 5 0 .38 90 .08 s Land 100 50 125 50 125 50 125 000 Buildi ngs 100 1,0 125 1,2 150 1,5 187 00 00 00 .5 78 CU IDOL SELF LEARNING MATERIAL (SLM)

Plant 10 100 1,0 100 1,2 120 1,5 150 00 00 00 00 Total 2,2 100 2,5 113 2,9 131 3,5 159 Asset 00 00 .64 00 .82 00 .00 s 2,8 100 3,3 117 3,7 132 4,6 164 50 45 .36 80 .63 90 .56 Interpretation: 1. The assets have exhibited a continuous increasing trend over the period. 2. The current assets increased much faster than the Non-current assets. 3. Sundry debtors and other current assets and buildings have shown higher growth I.L 4 Ratio Analysis Calculate current ratio from the following information’s: Particulars (Rs.) Inventories 50,000 Trade receivables 50,000 Advance tax 4,000 Cash and cash equivalents 30,000 Trade payables 1,00,000 Short-term borrowings (bank overdraft) 4,000 Solution: Example 2 79 CU IDOL SELF LEARNING MATERIAL (SLM)

The current ratio is 2: 1. State giving reasons which of the following transactions would improve, reduce and not change the current ratio: (a) Payment of current liability; (b) Purchased goods on credit; (c) Sale of a Computer (Book value: Rs. 4,000) for Rs. 3,000only; (d) Sale of merchandise (goods) costing Rs. 10,000 for Rs. 11,000; (e) Payment of unclaimed dividend. Solution The given current ratio is 2: 1. Let us assume that current assets are Rs. 50,000 and current liabilities are Rs. 25,000; Thus, the current ratio is 2: 1. Now we will analyses the effect of given transactions on current ratio. (a) Assume that Rs. 10,000 of creditors is paid by cheque. This will reduce the current assets to Rs. 40,000 and current liabilities to Rs. 15,000. The new ratio will be 2.67: 1 (Rs. 40,000/Rs.15,000). Hence, it has improved. (b) Assume that goods of Rs. 10,000 are purchased on credit. This will increase the current assets to Rs. 60,000 and current liabilities to Rs. 35,000. The new ratio will be 1.7:1 (Rs. 60,000/Rs. 35,000). Hence, it has reduced. (c) Due to sale of a computer (a fixed asset) the current assets will increase to Rs. 53,000 without any change in the current liabilities. The new ratio will be 2.12: 1 (Rs. 53,000/Rs. 25,000). Hence, it has improved. (d) This transaction will decrease the inventories by Rs. 10,000 and increase the cash by Rs. 11,000 thereby increasing the current assets by Rs. 1,000 without any change in the current liabilities. The new ratio will be 2.04: 1 (Rs. 51,000/Rs. 25,000). Hence, it has improved. (e) Assume that 5,000 is given by way of unclaimed dividend. It will reduce the current assets to 45,000 and unclaimed current liabilities by 5,000. The new ratio will be 2:25:1 (45,000/20,000). Hence, it has improved. Cash Flow statement From the following information, prepare Cash Flow Statement for Pioneer Ltd. Balance Sheet of Pioneer Ltd., as on March 31, 2017 Particulars Amount Amount (Rs.) (Rs.) 80 CU IDOL SELF LEARNING MATERIAL (SLM)

I. Equity and Liabilities 1. Shareholders’ Funds a) Share capital 1 7,00,000 5,00,000 b) Reserve and surplus 2 4,20,000 2,50,000 2. Non-current Liabilities Long-term borrowings: 10% Bank Load 50,000 1,00,000 3. Current Liabilities a) Trade Payables 45,000 50,000 b) Other current liabilities: outstanding rent 7,000 5,000 c) Short-term provisions 3 50,000 30,000 Total 12,72,000 9,35,000 II. Assets 1. Non-current assets a) Fixed assets 5,00,000 5,00,000 i) Tangible assets ii) Intangible assets b) Non-current investments 2. Current assets a) Inventories b) Trade receivables c) Cash and cash equivalents 95,000 1,00,000 1,00,000 - 1,30,000 50,000 1,20,000 80,000 3,27,000 2,05,000 Total 12,72,000 9,35,000 Notes to Accounts: 31st 31st Particulars March March 2017 2016 1. Equity share Capital (Rs.) (Rs.) 2. Reserve and Surplus 7,00,000 5,00,000 Surplus: i.e., Balance in Statement of Profit and Loss 4,20,000 2,50,000 81 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Short-term Provision Provision for Taxation 50,000 30,000 4. Fixed Assets Tangible assets 2,30,000 2,00,000 (i) Equipment’s 2,70,000 3,00,000 (ii) Furniture 5,00,000 5,00,000 5. Intangible Assets 95,000 1,00,000 Patents 6. Cash and Cash Equivalents (i) Cash 27,000 5,000 (ii) Bank Balance 3,00,000 2,00,000 3,27,000 2,05,000 Additional Information During the year, equipment costing Rs. 80,000 was purchased. Loss on sale of equipment amounted to Rs. 5,000. Depreciation ofRs. 15,000 and Rs. 3,000 charged on equipment’s and furniture. Loan Rs. 50,000 was repaid on 31.03.2017. Proposed dividend for the year 2015-16 was Rs. 50,000. Solution: Particulars (Rs.) 1. Cash flows from Operating Activities: 2,70,000 Net Profit before taxation & extraordinary items Provision for: 15,000 Depreciation on equipment 30,000 Depreciation on furniture 5,000 Patents written-off 5,000 Loss on sale of equipment’s 10,000 Interest on bank load Operating Profit before Working capital changes 3,35,000 - Decrease in trade payables (5,000) 82 CU IDOL SELF LEARNING MATERIAL (SLM)

+ Increase in outstanding rent 2,000 - Increase in trade receivables (40,000) - Increase in inventories (80,000) Cash generated from operating activities 2,12,000 (-) Tax paid (30,000) A. Cash Inflows from Operating Activities 1,82,000 II. Cash flows from Investing Activities Proceeds from sale of equipment’s 30,000 Purchase of new equipment (80,000) Purchase of investments (1,00,000) (1,50,000) B. Cash used in Investing Activities III. Cash flows from Financial Activities 2,00,000 Issues of equity share capital (50,000) Repayment of bank loan (50,000) Payment of dividend (10,000) Payment of Interest on bank load 90,000 C. Cash Inflows from Financing Activities 1,22,000 Net increase in cash & cash equipment’s (A+B+C) 2,05,000 + Cash and Cash Equivalents in the beginning 3,27,000 Cash and Cash Equivalents in the end Cr. Working Notes: J.F. Amount (1) Equipment Account (Rs.) 15,000 Dr. 30,000 Particulars J.F. Amount Particulars 5,000 (Rs.) Depreciation 2,30,000 (balance figure) 2,80,000 Balance 2,00,000 Bank Statement of b/d Cash 80,000 Profit & Loss (Loss on sale) 2,80,000 Balance c/d 83 CU IDOL SELF LEARNING MATERIAL (SLM)

(2) Patents of Rs. 5,000 (i.e., Rs. 1,00,000-Rs. 95,000) were written-off during the year, and depreciation on furniture was Rs. 30,000. (Rs. 3,00,000-Rs. 2,70,000) (3) It is assumed that dividend of Rs. 50,000 and tax of Rs. 30,000 provided in 2015-2016 has been paid during the year 2016-17. Hence, proposed dividend and provision for tax during the year amounts to Rs. 70,000 and Rs. 50,000 respectively. (1) Rs. Profit and Loss at the end 4,20,000 (-) Profit and Loss in the beginning (2,50,000) Net Profit during the year + Provision of tax during the year 1,70,000 + Proposed dividend 50,000 Net Profit before taxation & extraordinary items 50,000 2,70,000 SUMMARY Major Parts of an Annual Report An annual report contains basic financial statements, viz., Balance Sheet, Statement of Profit and Loss and Cash Flow Statement. It also carries management’s discussion of corporate performance of the year under review for futuristic prospects. Tools of Financial Analysis Commonly used tools of financial analysis are: Comparative statements, Common size statement, trend analysis, ratio analysis, and cash flow analysis. Comparative Statement Comparative statement shows changes in all items of financial statements in absolute and percentage terms over a period of time for a firm or between two firms. Common Size Statement Common size statement expresses all items of a financial statement as a percentage of some common base such as revenue from operations for statement of profit and loss and total assets for balance sheet. Ratio Analysis: An important tool of financial statement analysis is ratio analysis. Accounting ratios represent relationship between two accounting numbers. 84 CU IDOL SELF LEARNING MATERIAL (SLM)

Objective of Ratio Analysis: The objective of ratio analysis is to provide a deeper analysis of the profitability, liquidity, solvency and activity levels in the business. It is also to identify the problem areas as well as the strong areas of the business. Advantages of Ratio Analysis: Ratio analysis offers many advantages including enabling financial statement analysis, helping understand efficacy of decisions, simplifying complex figures and establish relationships, being helpful in comparative analysis, identification of problem areas, enables SWOT analysis, and allows various comparisons Cash Flow Statement: The Cash Flow Statement helps in ascertaining the liquidity of an enterprise. Cash Flow Statement is to be prepared and reported by Indian companies according to AS-3 notified as per Companies Act 2013. The cash flows are categorized into flows from operating, investing and financing activities. This statement helps the users to ascertain the amount and certainty of cash flows to be generated by company. KEYWORDS • Compensating Balance – excess balances left in a bank account to provide indirect compensation for loans or services. • Compound Interest – Interest paid on previously earned interest as well as on the principal. • Consolidation – the joining of two or more companies to form a new company. • Cash Flow Coverage Ratio – the ratio of financial obligations to earningsbefore interest, taxes, depreciation and amortization. • Cash Flow From Operations – a company’s net cash flow resulting directly from its regular operations. LEARNING ACTIVITY 1 Following are the balance sheets of Beta Ltd. at March 31, 2014 and 2015: Particulars March 31, March 31, 2015 (Rs.) 2014 (Rs.) I. Equity and Liabilities 85 CU IDOL SELF LEARNING MATERIAL (SLM)

Equity share capital 4,00,000 3,00,000 1,00,000 Reserves and surplus 1,50,000 1,00,000 50,000 Loan from IDBI 3,00,000 30,000 20,000 Short-term borrowings 70,000 1,00,000 7,00,000 Trade payables 60,000 2,20,000 Short-term provisions 10,000 1,00,000 60,000 Other current liabilities 1,10,000 90,000 60,000 Total 11,00,000 85,000 85,000 II. Assets 7,00,000 Fixed assets 4,00,000 Non-current investments 2,25,000 Current investments 80,000 Stock 1,05,000 Trade receivables 90,000 Short-term loans and advances 1,00,000 Cash and cash equivalents 1,00,000 Total 11,00,000 You are required to prepare a Comparative Balance Sheet. 2 Anand Ltd., arrived at a net income of Rs. 5,00,000 for the year ended March 31, 2017. Depreciation for the year was Rs. 2,00,000. There was a profit of Rs. 50,000 on assets sold which was transferred to Statement of Profit and Loss account. Trade Receivables increased during the year Rs. 40,000 and Trade Payables also increased by Rs. 60,000. Compute the cash flow from operating activities by the indirect approach. 86 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT END QUESTIONS A. Descriptive Question 1. Describe the different techniques of financial analysis and explain the limitations of financial analysis. 2. Explain the usefulness of trend percentages in interpretation of financialperformance of a company. 3. Explain, what is the importance of comparative statements? Illustrate your answer with particular reference to comparative income statement. 4. Discuss, what are liquidity ratios? Discuss the importance of current and liquid ratio. 5. Describe \"Indirect\" method of ascertaining Cash Flow from operating activities. Long descriptive Questions 6. Explain the major Cash Inflows and outflows from investing activities. 7. Explain the major Cash Inflows and outflows from financingactivities. 8. Following are the balance sheets of a Vijay & son: 9. .’Cash receipts from sale of goods by a trading company’ will come under which activity while preparing cash flow statement? 10. Prepare a cash flow statement on the basis of the information given in the balance sheet of Simco Ltd as at 31st March, 2013 and 2012 87 CU IDOL SELF LEARNING MATERIAL (SLM)

B. Multiple Choice Questions (MCQs) 1. The following groups of ratios are primarily measure risk: a. liquidity, activity, and profitability b. liquidity, activity, and inventory c. liquidity, activity, and debt d. liquidity, debt and profitability 2. The .................ratios are primarily measures of return: a. liquidity b. activity c. debt d. profitability 3. If the net profits earned during the year is Rs. 50,000 and the amount of debtors in the 88 CU IDOL SELF LEARNING MATERIAL (SLM)

beginning and the end of the year is Rs. 10,000 and Rs. 20,000 respectively, then the cash from operating activities will be equal to Rs. …………….. a. Rs. 40,000 b. Rs. 60,000 c. Rs. 35000 d. Rs. 65000 4. If the net profits made during the year are Rs. 50,000 and the bills receivables have decreased by Rs. 10,000 during the year then the cash flow from operating activities will be equal to Rs. a. Rs. 40,000 b. Rs. 60,000 c. Rs. 30,000 d. Rs.20000 5. Expenses paid in advance at the end of the year are......................... the profit made during the year a. added to b. deducted from c. Negative d. Debited 6.An increase in accrued income during the particular year is.......................the net profit a. added to b. deducted from c. Multiplied through d. Divided from 7.As per Accounting Standard-3, Cash Flow is classified into anOperating activity and investing activities 89 CU IDOL SELF LEARNING MATERIAL (SLM)

b Investing activities and financing activities c Operating activities and financing activities d Operating activities, financing activities and investing activities 8. Cash Flow Statement is also known as a Statement of Changes in Financial Position on Cash basis b Statement accounting for variation in cash c Both a and b d None of these 9. Cash Flow Statement is based upon a Cash basis of accounting b Accrual basis of accounting c Credit basis of accounting d None of the above 10. Cash flow statement is based upon while Funds Flow Statement recognizes . a Cash basis of accounting, accrual basis of accounting b Accrual basis of accounting, cash basis of accounting c Both are based on cash basis of accounting d None of these Answers 1. c 2. b 3. a 4. a 5. b 6. B 7.d 8.c 9.a 10. a REFERENCES • Higgins, Robert C. Analysis for Financial Management. McGraw-Hill, 2000. • Kristy, James E., and Susan Z. Diamond. Finance without Fear.American Management Association, 1984. • Management Accounting Chapter 2. Analysis and Interpretation of Financial 90 CU IDOL SELF LEARNING MATERIAL (SLM)

Statements 2.5 Concept of Financi.htm • Damodaran, A. (2007). Corporate Finance –Theory & Practice, Hoboken, New Jersey: John Wiley and Sons, Inc. • M Y Khan, P K Jain. (2018). Financial Management, New Delhi: Tata Mc Graw Hill. • Pandey, I.M. (2016). Financial Management. New Delhi: Vikas Publication House Pvt. Ltd. • Richard A Brealey, Stewart C myers, Franklin Allen, Pitabas Mohanty. (2018). Principles of Corporate Finance. New Delhi: Tata Mc Graw Hill. 91 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 4 CAPITAL BUDGETING 92 Structure Learning Objectives Introduction Nature of Capital Budgeting Utility of Capital Budgeting Investment Proposals and Administrative Aspects Choosing Among Alternative Proposals Estimating Cash Flows for Capital Budgeting Evaluating Investment Proposals General Principles Payback Method Return on Assets (ROA) Present value method Internal Rate of Return Method Tools/ Techniques of capital budgeting Concept of Cost of capital Importance of cost control Classification of Cost of Capital Measurement of Cost of Capital Cost of Long Term Debt Cost of Preference Capital Cost of Equity Capital Cost of Retained Earnings Weighted Cost of Capital Choice of Weights Some Misconceptions about Cost of Capital Summary Keywords CU IDOL SELF LEARNING MATERIAL (SLM)

Learning Activity Unit End Questions References LEARNING OBJECTIVES After studying this unit, you will be able to: • to explain nature and utility of Capital Budgeting, • to provide an understanding of the process of evaluation of Investment proposals, • to discuss various tools of ranking of Investment proposals • discuss the concept and importance of cost of capital • distinguish among various classes of cost of capital • illustrate the computation of cost of long term debt, preferences shares, equity shares and retained earnings • discuss and illustrate the various weighting approaches and the weighted average cost of capital (WACC). • Narrate misconceptions about cost of capital INTRODUCTION Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders. NATURE OF CAPITAL BUDGETING Capital budgeting is a managerial technique of planning capital expenditures whose benefits are expected to extend beyond one year, such as expenditure on acquisition of new buildings, improvement of existing buildings, replacement of plant and machinery, acquisition of new facilities, new machines, etc. Permanent addition to working capital, R&D expenditure are also regarded as capital expenditures. Capital budgeting technique involves matching of expected net cash inflows from the project 93 CU IDOL SELF LEARNING MATERIAL (SLM)

with anticipated cost of the project these two components of capital budgeting technique are determinant of investment outlay. UTILITY OF CAPITAL BUDGETING Capital budgeting is the most potent technique employed in assessing financial viability of projects and for that matter, allocating prudently the funds among the projects by providing useful guidelines in identifying useful projects and ranking them in terms of economic desirability to choose the most promising one. Thus, it helps a firm in strengthening its financial health and so its competitive position. Capital budgeting also acts as a planning and control device. As a planning tool, it helps the managements to determine long-term capital requirements and timings of such requirements. It also serves as a control device when it is employed to control expenditures. Capital budgeting as a technique of decision-making suffers from the problem involved in predicting future cash benefits, cost of capital. Further, it fails to take cognizance of total consequences of the decision. INVESTMENT PROPOSALS AND ADMINISTRATIVE ASPECTS Capital budgeting process involves several steps. The first step in the capital budgeting process is to assemble a list of proposed new investments, together with the data necessary to appraise them. Although practices vary from firm to firm, proposals dealing with asset acquisitions are frequently grouped according to the following four categories: 1. Replacements of existing/old projects. 2. Expansion: additional capacity in existing product lines. 3. Growth: new product lines. 4. Other (for example, pollution control equipment) Other important aspects of capital budgeting involve administrative matters. Approvals are typically required at higher levels within the organization as we move away from replacement decisions and as the sums involved increase. One of the most important functions of the board of directors is to approve the major outlays in a capital budgeting program as well as the total capital budget for each planning period. Such decisions are crucial for the future well-being of the firm. The planning horizon for capital budgeting programs varies with the nature of the industry. When sales can be forecast with a high degree of reliability for 10 to 20 years, the planning period is likely to be correspondingly long; electric utilities are an example of such 94 CU IDOL SELF LEARNING MATERIAL (SLM)

an industry. Also, when the product-technology developments in the industry require an 8-to- 10-year cycle to develop a new major product, as in certain segments of the aerospace industry, a correspondingly long planning period is necessary. After a capital budget has been adopted, funding must be scheduled. Characteristically, the finance department is responsible for scheduling and acquiring funds to meet scheduled requirements. The finance department is also primarily responsible for cooperating with the operating divisions to compile systematic records on the uses of funds and the installation of equipment purchased. Effective capital budgeting programs require such information as the basis for periodic review and evaluation of capital expenditure decisions - the feedback and control phase of capital budgeting, often called the post-audit review. The foregoing represents a brief overview of the administrative aspects of capital budgeting; the analytical problems involved are considered in the following paragraphs. CHOOSING AMONG ALTERNATIVE PROPOSALS In most firms, there are more proposals for projects than the firm is able or willing to finance. Some proposals are good, others are poor, and methods must be developed for distinguishing between the good and the poor. Essentially, the end product is a ranking of the proposals and a cutoff point for determining how far down the ranked list to go In part, proposals are eliminated because some are mutually exclusive. Mutually exclusive proposals are alternative methods of doing the same job. If one piece of equipment is chosen, other will not be required. Thus, if there is a need to improve the materials handling system in a chemical plant, the job may be done either by conveyer belts or by forklift trucks. The selection of one method makes it unnecessary to use the others: They are mutually exclusive items. Independent projects are those that are being considered for different kinds of tasks that need to be accomplished. For example, in addition to the materials handling system, the chemical firm may need equipment to package the end product. The work would require a packaging machine, and the purchase of equipment for this purpose would be independent of the equipment purchased for materials handling. The firm may undertake any or all independent projects. 95 CU IDOL SELF LEARNING MATERIAL (SLM)

Finally, projects may be contingent. For example, there may be only one way to build a football stadium but two ways of housing it (in a metal structure or a geodesic dome). Because the stadium and its housing are contingent, the analysis requires that we consider them together. Hence, we would want to compare the stadium within a metal structure with the alternative of the stadium within a geodesic dome. To distinguish among the many proposals that compete for the allocation of the firm’s capital funds, a ranking procedure must be developed. This procedure requires calculating the estimated cash flows from the use of equipment and then translating them into a measure of their effect on shareholders’ wealth. First, we turn our attention to the problem of estimating cash flows for capital budgeting purposes. ESTIMATING CASH FLOWS FOR CAPITAL BUDGETING Cash flows for capital budgeting purposes are defined as the after-tax cash flows for an all- equity financed firm. Algebraically, this definition is equivalent to earnings before interest and taxes, EBIT, less the taxes the firm would pay if it had no debt, T (EBIT), plus noncash depreciation charges, W dep. W Cash flow = W EBIT - T (W EBIT) + W depreciation Note that this definition of cash flows is unaffected by the firm’s financing decision, for example the amount of debt which it uses. Consequently, the investment decision and the financing decision are kept separate when we use this definition of cash flows for capital budgeting purposes. We focus on how the firm’s cash flows will be changed. Table 5.1 provides an example of a pro-forma income statement which can be used to illustrate a cash flow calculation. To arrive at the change in after-tax cash flows created by the project, we start with increased revenues, WR, then subtract out all items which are expansible for tax purposes (WVC + WFCC + Wdep). The result is taxable income, assuming the firm has no debt. Next, we subtract the change in taxes and add back the change in depreciation because depreciation is not a cash outflow. The appropriate algebraic expression is: W Cash flow = (WR - WVC - WFCC - Weep) - T (W R - WVC - WFCC -W dep) + Wdep. 96 CU IDOL SELF LEARNING MATERIAL (SLM)

Description Symbol Amount Change in sales revenue WR Rs.145,000 Change in variable operating cost W VC -90,000 Change in fixed cash costs W FCC -10,000 Change in depreciation W dep -15,000 Change in earnings before interest and W 30,000 taxes EBIT Change in interest expense WrD -5,000 Change in earnings before tax W EBT 25,000 Change in taxes (@T=40%) W tax -10,000 Change in net income W NI 15,000 Pro-forma Income Statement This equation can be simplified as follows: WCash flow = (1–T) (WR – WVC – WFCC – WDep) + WDep Note that the term in brackets is the same as the change in earnings before interest and taxes, WEBIT; hence, the equation becomes: Wash flow = (1-T) WEBIT + Weep. Substituting in the numbers from Table 5.1, we have: Wash flow = (1 - .4) (Rs.145,000 - Rs.90,000 - Rs.10,000 - Rs.15,000) + Rs.15,000 = .6 (Rs.30,000) + Rs.15,000 = Rs.33,000 The procedure described above starts with revenues at the top of the income statement and then works down to obtain the definition of cash flows for capital budgeting purposes. Alternately, one can start at the bottom of the income statement, with changes in net income (WNI) and build upward to arrive at the same definition. Sometimes this approach is easier to use. The algebraic expression for the change in cash flows is W Cashflow – W NI + W dep + (1 – T) Wr D EVALUATING INVESTMENT PROPOSALS The point of capital budgeting - indeed, the point of all financial analysis - is to make decisions that will maximize the value of the firm. The capital budgeting process is designed to answer two questions: 97 CU IDOL SELF LEARNING MATERIAL (SLM)

(1) Which of several mutually exclusive investments should be selected? (2) How many projects, in total, should be accepted? Among the many methods used for evaluating investment proposals, five are discussed here. 1. Payback method (or payback period): Number of years required to return the original investment. 2. Return on assets (ROA) or return on investment (ROI): An average rate of return on assets employed. 3. Net present value (NPV) method: Present value of expected future cash flows discounted at the appropriate cost of capital, minus the cost of theinvestment. 4. Internal rate of return (IRR) method: Interest rate which equates the present value of future cash flows to the investment outlay. 5. Profitability Index (PI): It shows the relative profitability of any project, or the present value of benefits per rupee of costs. General Principles When comparing various capital budgeting criteria, it is useful to establish some guidelines. What are the properties of an ideal criterion? The optimal decision rule should have four characteristics: 1. It will select from a group of mutually exclusive projects the one which maximizes shareholders’ wealth. 2. It will appropriately consider all cash flows. 3. It will discount the cash flows at the appropriate market-determined opportunity cost of capital. 4. It will allow managers to consider each project independently from all others.This has come to be known as the value additivity principle. The value additivity principle implies that if we know the value of separate projects accepted by management, then simply adding their values, V’ will give us the value of the firm. If there are N projects, then the value of the firm will be: This is a particularly important point because it means that projects can be considered on their own merit without the necessity of looking at them in an infinite variety of combinations with other projects. 98 CU IDOL SELF LEARNING MATERIAL (SLM)

The cash flows for four mutually exclusive projects. They all same life, five years, and they all require the same investment outlay, Rs.1,500. Once accepted, no project can be abandoned without incurring the outflows indicated. For example, Project A has negative cash flows during its fourth and fifth years. Once the project is accepted these expected cash outflows must be incurred. An example of a project of this type is a nuclear power plant. Decommissioning costs at the end of the economic life of the facility can be as large as the initial construction costs and they must be taken into account. Cash flow Year A B C D PVIF@10% 0 - - - - 1.000 1,500 1,500 1,500 1,500 1 150 0 150 300 .909 2 1,350 0 300 450 .826 3 150 450 450 750 .751 4 -150 1,050 600 750 .683 5 -600 1,950 1,875 900 .621 Table 4.2: Cash Flows of Four Mutually Exclusive Projects The last column of Table 5.2 shows the appropriate discount factor for the present value of cash flows, assuming that the appropriate opportunity cost of capital is 10 percent. Since all four projects are assumed to have the same risk, they can be discounted at the same interest rate. Now we turn our attention to the actual implementation of the five above- mentioned capital budgeting techniques (1) the payback method, (2) the return on assets, (3) the net present value, (4) the internal rate of return, (5) Profitability Index. We shall see that only one technique - the net present value method - satisfies all four of the desirable properties for capital budgeting criteria. Payback Method The payback period is the number of years required to recover the initial capital outlay on a project. The payback periods for the four projects in Table 5.2 are given below. Project A, 2-year payback Project B, 4-year payback Project C, 4-year payback Project D, 3- year payback. If management were adhering strictly to the payback method, then Project A would bechosen as the best among the four mutually exclusive alternatives. Even a casual look at the numbers indicates that this would be a bad decision. The difficulty with the payback method 99 CU IDOL SELF LEARNING MATERIAL (SLM)