CU-SEM-VI-Financial Analysis and Business Valuation

days pass between the time a company placed a purchase order and the time it receives payment from a sale before it receives its money back. The average collection period provides a true view of the business's collection process by measuring the turnover of the accounts receivables as a whole rather than how long it takes to collect each individual invoice. In most businesses, it is the Billing Department's responsibility to ensure that past-due payments are paid. Eventually, if a business fails to collect most of its sales on time it will experience cash shortages, which will force it to take debt to pay for its commitments. The Average Collection Period formula is calculated below: ACP = 365 / Accounts Receivable Turnover The turnover rate for accounts receivable shows how frequently net credit sales are converted into cash over the course of a year or other specified time period. The formula for the turnover rate of accounts receivable is as follows: ART = Net Credit Sales / Avg. Accounts Receivables Net Credit Sales: The total sales made through commercial credit as the mean of payment. Avg. Accounts Receivable: The sum of the beginning and ending balance of the accounts receivables divided by 2, for the time period under evaluation. Bro Repairs is a small business that offers maintenance of air conditioning units to commercial establishments, offices and households. They usually give their commercial clients at least 15 days of credit and these sales constitute at least 60% of their annual 2,340,000 in revenues. At the beginning of this year, Bro Repairs accounts receivables were 124,300 and by the end of the year the receivables were 121,213. The first thing that the owners need to do to figure out the Average Collection Period is to calculate the Accounts Receivable Turnover. Here’s how the calculation will look like: ART = (2,340,000 * 0.60) / ((124,300 + 121,213) / 2) = 11.4 times With this information we can calculate the Average Collection Period, as follows: ACP = 365 / 11.4 = 32 days. 151 CU IDOL SELF LEARNING MATERIAL (SLM)

This indicates that customers of Bro Repairs are utilizing at least two times the company's maximum credit period. Their cash cycle is negatively impacted, and they frequently have to take on debt to make up for the cash shortages caused by these late payments. The business is putting into effect a stricter credit policy, which includes cutting off credit lines for customers who make just one late payment and giving those who pay their bills on time a 2% discount. Average Collection Period Analysis The management team can assess the effectiveness of their billing teams and processes by calculating the average collection period for the company. As demonstrated in the case above, if the ACP is more than the typical credit term granted to clients, the billing process is not operating as it should. Most frequently, this can be the result of a lack of follow-up or poor credit lines that shouldn't have been opened in the first place. Before issuing credit lines to customers, businesses should carefully evaluate them in order to avoid this. A customer should not be given goods or services on credit if they have a history of paying suppliers late, as it will be challenging to recover such purchases. The Billing Team should also receive alerts from administrative systems when invoices are past due, encouraging them to follow up and lowering the percentage. A business that consistently misses the deadline for payment collection would eventually have cash flow problems as a result of a prolonged cash cycle. This is a costly scenario for the company to be in since it will have to take on debt to meet its obligations, and this debt has interest charges that will lower profits. Because of this, any business collection procedure' effectiveness is a key component to its success. Average payment period The average number of days it takes a company to pay its vendors for purchases made on credit is measured by the average payment period (APP), which is a solvency ratio. The average time it takes a business to settle its credit accounts payable is known as the average payment period. Credit agreements are frequently utilized to pay for wholesale or basic material purchases made by businesses. These straightforward payment plans provide the purchaser a predetermined number of days to pay for the item. 152 CU IDOL SELF LEARNING MATERIAL (SLM)

Oftentimes, discounts for paying in a shorter period of time are given. For example, a 10 / 30 credit term gives a 10% discount if the balance is paid within 30 days, whereas the standard credit term is 0 / 90, offering no discount but allowing payment in 90 days. The average payment period calculation can reveal insight about a company’s cash flow and creditworthiness, exposing potential concerns. For example, is the company meeting current obligations or just skimming by? Or, is the company using its cash flows effectively, taking advantage of any credit discounts? Therefore, investors, analysts, creditors and the business management team should all find this information useful. Find the accounts payable data on the balance sheet's current liabilities column before making the calculation. The average payment period is often determined using data from a full year, although it may also be helpful to evaluate over a quarterly or longer time frame. Therefore, the required time frame may determine whether financial statements are required. Here is a formula for figuring out the average payment period. To calculate, first determine the average accounts payable by dividing the sum of beginning and ending accounts payable balances by two, as in this equation: Average Accounts Payable = (Beginning + Ending AP Balance) / 2 Now, use the answer to solve for average payment period: Average Payment Period = (Beginning + Ending AP Balance) / 2 / (Total Credit Purchases / Days) The three inputs necessary to calculate the average payment period are explained in more detail below: Accounts Payable → The accounts payable line item appears on the balance sheet as a current liability and represents the accumulated balance of unpaid invoices. Number of Days in Period → The number of days in the chosen accounting period, e.g. an annual calculation would use 365 days. 153 CU IDOL SELF LEARNING MATERIAL (SLM)

Credit Purchases → The total value of orders placed by the company that was made on credit, as opposed to cash. In general, the buyer has more negotiation power when it comes to payment terms the more a provider depends on a customer. A buyer's bargaining power, or the capacity of a company to apply pressure when negotiating terms with its suppliers in order to receive favorable terms like price reductions and extensions of payment due dates, is frequently represented by the interval between the date of the initial purchase and the date of the actual cash payment (and receipt by the supplier).  Short Average Payment Period ➝Low Bargaining Leverage (and Less Free Cash Flow)  Long Average Payment Period ➝High Bargaining Leverage (and More Free Cash Flow) Companies with more buying power and negotiating leverage typically have the following characteristics:  Significant Order Size (or Volume)  High Frequency of Orders  Long-Term Relationship with Supplier  Customer Concentration Risk  Niche Technical Materials (i.e. Limited Number of Potential Customers) 8.6 SUMMARY  The stock turnover ratio, sometimes referred to as the inventory turnover ratio, is a productivity ratio that assesses the effectiveness of inventory management. To determine how frequently inventory is \"turned\" or sold over the course of a period, the inventory turnover ratio formula is equal to the cost of products sold divided by total or average inventory. The ratio can be used to assess whether inventory levels are out of proportion to sales. 154 CU IDOL SELF LEARNING MATERIAL (SLM)

 A corporation may run out of money for ongoing operations and short-term debts if it does not keep an eye on its working capital turnover ratio. You may keep track of the state of your company's debt and stock management, as well as accounts payable and accounts receivable, by include working capital management in your business plan. This guarantees that you are aware of where your money is going and how to allocate it effectively for the best management and efficiency.  Average collection time is a measurement of the number of days it typically takes a business to collect its receivables. It measures the effectiveness of the collecting process; the lower it is, the shorter the business's cash cycle is, which benefits its profitability.  The length of a business's cash cycle must be determined by how long it takes it to recover the money it spends on inventory and raw materials. The cash cycle keeps track of how many days pass between the time a company placed a purchase order and the time it receives payment from a sale before it receives its money back.  To evaluate a company's overall operations and gauge its financial success, a working capital turnover ratio is frequently utilized. It can also be used to determine whether a business will be able to pay off debt within a predetermined time frame and prevent running out of money due to higher production demands.  The formula for calculating working capital turnover ratio is:  Working capital turnover = Net annual sales / Working capital. 8.7 KEYWORDS  The working capital turnover ratio It is derived by dividing the company's net sales during the period by the average working capital during the same period, aids in assessing how effectively the company uses its working capital (current assets minus current liabilities) in the business.  The stock turnover ratio The stock turnover ratio, sometimes referred to as the inventory turnover ratio, is a productivity ratio that assesses the effectiveness of inventory management. To determine how frequently inventory is \"turned\" or sold over the course of a period, the inventory turnover ratio formula is equal to the cost of products sold divided by total or average inventory. The ratio can be used to assess whether inventory levels are out of proportion to sales.  Net Credit Sales Net credit sales, or the amount of revenue made by a business paid on credit, is the numerator of the accounts receivable turnover ratio. Cash sales are included 155 CU IDOL SELF LEARNING MATERIAL (SLM)

in this number because they do not result in accounts receivable activity. Net credit sales are computed as gross credit sales less any remaining reductions from customer returns or sales discounts. 8.8 LEARNING ACTIVITY 1. Define turnover ratio ___________________________________________________________________________ ___________________________________________________________________________ 2. State the list of various turnover ratio ___________________________________________________________________________ ___________________________________________________________________________ 3. What is Inventory turnover ratio? ___________________________________________________________________________ ___________________________________________________________________________ 4. What is Average Collection period? ___________________________________________________________________________ ___________________________________________________________________________ 8.9 UNIT END QUESTIONS 156 A. Descriptive Questions Short Questions: 1. Define Turnover ratio 2. Explain what is Inventory turnover ratio? 3. Describe briefly about Receivables turnover ratio? 4. What do you understand by Average payment ratio? Long Questions: 1. What is a turnover ratio? Explain the various types of turnover ratios? 2. Describe the receivables and payables turnover ratio. 3. What are the Average Collection Period and Average Payment period? B. Multiple Choice Questions CU IDOL SELF LEARNING MATERIAL (SLM)

1. The stock turnover ratio is sometimes referred to as the ________ a. inventory turnover ratio b. Receivable ratio c. Payable ratio d. None of the above 2. ________ ratios show how effectively a business is able to collect accounts receivable a. Accounts receivable b. Accounts Payable c. Average collection period d. Average payment period 3. _______ is a measurement of the number of days it typically takes a business to collect its receivables. a. Average collection period b. Average Payable period c. Receivables turnover ratio d. payables turnover ratio 4. _______ is a gauge of how effectively a business can manage its stock a. Inventory turnover b. Average Payable period c. Receivables turnover ratio 157 CU IDOL SELF LEARNING MATERIAL (SLM)

d. payables turnover ratio Answers 1-a, 2-a, 3-a, 4-a 8.10 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. Website  https://www.investopedia.com/terms/t/turnoverratio.asp  https://www.accountingtools.com/articles/what-is-a-turnover-ratio.html  https://www.elearnmarkets.com/blog/turnover-ratios-analyzing-efficiency/ 158 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 9 CASH FLOW STATEMENTS STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 Cash flow from operating activities 9.3 Cash flow from investing activities 9.4 Cash flow from Financing Activities 9.5 Illustrations 9.6 Summary 9.7 Keywords 9.8 Learning Activity 9.9 Unit End Questions 9.10 References 9.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Describe Cash flow statements  Identify cash flow from operating activities  Understand cash flow from investing activities  Understand cashflow from financing activities 9.1 INTRODUCTION One of the three important financial statements that shows how much money was made and spent over a certain period of time is the Statement of Cash Flows (also known as the cash flow statement) (e.g., a month, quarter, or year). By displaying how money entered and exited the company, the statement of cash flows serves as a link between the income statement and balance sheet. Three Sections of the Statement of Cash Flows: 159 CU IDOL SELF LEARNING MATERIAL (SLM)

Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends) Definitions of Cash Flow Cash Flow: Inflows and Outflows of Cash and Cash Equivalents (CFI's Ultimate Cash Flow Guide has more information). Cash Balance: Balance of available cash and demand deposits (cash balance on the balance sheet) Cash Equivalents: Overdrafts and cash equivalents with short-term maturities are examples of cash equivalents. Funds equivalents also include cash maintained in bank accounts, short- term investments, and any other assets that can be converted to cash fairly easily (less than three months). 9.2 CASH FLOW FROM OPERATING ACTIVITIES The amount of money a business earns from ongoing, routine business operations, such as producing and selling products or offering clients a service, is known as cash flow from operating activities (CFO). It is shown as the first portion of the cash flow statement for a corporation. Investment income and expense are not included in cash flow from operational activities or long-term capital expenditures. CFO, also known as operating cash flow (OCF) or net cash from operating activities, focuses exclusively on the core business. An essential metric for assessing the financial performance of a company's fundamental business operations is cash flow from operating activities. On a cash flow statement, which also includes cash from investing and financing operations, the cash flow from operating activities is shown as the first part. The indirect technique and the direct approach are both ways to show cash from operating activities on a cash flow statement. 160 CU IDOL SELF LEARNING MATERIAL (SLM)

The cash basis figure is obtained using the indirect technique by starting with net income from the income statement and then adding back noncash items. The direct method uses actual cash inflows and outflows on the cash flow statement and tracks all transactions in a period on a cash basis. The entire quantity of money coming into and going out of an organization is represented by cash flow, which is one of the most crucial aspects of corporate operations. It is significant for a number of reasons because it affects the company's liquidity. It enables business owners and operators to determine where the money is coming from and going, assists them in taking actions to generate and retain the necessary cash for operational effectiveness and other requirements, and aids in the formulation of important and effective financial decisions. A company's cash flow statement, which is included in its quarterly and yearly reports, contains information regarding a company's cash flow in detail. The ability of a company's primary business activities to generate cash is shown by the cash flow from operating activities. It typically contains the income statement's net income as well as adjustments to change the basis of the income statement's net income from accrual to cash. If a company has cash on hand, it can choose to grow, develop, and introduce new goods, buy back shares to demonstrate their solid financial condition, distribute dividends to reward and boost shareholder trust, or reduce debt to avoid paying interest. Investors try to find companies whose stock prices are lower and whose cash flow from operations has been increasing over the past few quarters. The discrepancy suggests that the company's cash flow is expanding, which, if better employed, could result in higher share prices in the near future. Positive (and growing) cash flow from operating activities shows that the company's fundamental business operations are flourishing. In addition to the conventional metrics like net income or EBITDA, it offers an alternative measure or indicator of a company's potential for profitability. Types of Cash Flow from Operating Activities The cash flow from operating activities section can be displayed on the cash flow statement in one of two ways. Indirect Method The indirect technique is the first choice, in which the business starts with accrual accounting-based net income and works backwards to arrive at a cash basis figure for the 161 CU IDOL SELF LEARNING MATERIAL (SLM)

period. Revenue is recognized when earned, not necessarily when cash is received, according to the accrual method of accounting. For instance, a sale has been made but no money has yet been received if a buyer purchases a 500 widget on credit. The company continues to record the revenue in the month of the sale, and its income statement will show it as net income. As a result, on a cash basis, net income was inflated by this sum. The balance sheet's accounts receivable line item would reflect the offset to the 500 in revenue. The 500 rise in accounts receivable as a result of this sale would need to be deducted from net income on the cash flow statement. The cash flow statement would show it as \"Increase in Accounts Receivable -500.\" Fig 9.1 cash flow Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital Direct Method The second alternative is the direct technique, in which a business keeps a cash record of all transactions and populates the cash flow statement with actual cash inflows and outflows from the accounting period. Examples of the direct method of cash flows from operating activities include: 162 CU IDOL SELF LEARNING MATERIAL (SLM)

 Salaries paid out to employees  Cash paid to vendors and suppliers  Cash collected from customers  Interest income and dividends received  Income tax paid and interest paid Cash Flow from Operations Formula While the exact formula will be different for every company (depending on the items they have on their income statement and balance sheet), there is a generic cash flow from operations formula that can be used: Table 9.1 Cash Flow 9.3 CASH FLOW FROM INVESTING ACTIVITIES The portion of a company's cash flow statement titled Cash Flow from Investing Activities shows how much money was spent on (or profit was made from) making investments during a specific period of time. Purchases of long-term assets (including real estate, machinery, and equipment), the purchase of other companies, and investments in marketable securities are all examples of investing activities (stocks and bonds). Let's see an illustration of what investment activities entail. It's critical to understand how investing activities are treated in accounting because a wide range of items may be listed and included in this section of the cash flow statement. Investing activities can include: Purchase of property plant, and equipment (PP&E), also known as capital expenditures 163 CU IDOL SELF LEARNING MATERIAL (SLM)

 Proceeds from the sale of PP&E  Acquisitions of other businesses or companies  Proceeds from the sale of other businesses (divestitures)  Purchases of marketable securities (i.e., stocks, bonds, etc.)  Proceeds from the sale of marketable securities Every organization differs, and more goods beyond those mentioned above may be included. Looking at the balance sheet and comparing any differences between non-current assets across the two periods is the only surefire approach to determine what is included. There will be investing items to show on the cash flow statement if the valuations of these long-term assets change in any way (apart from the impact of depreciation). Now that you have a solid understanding of what’s included, let’s look at what’s not included. Not included items are:  Interest payments or dividends  Debt, equity, or other forms of financing  Depreciation of capital assets (even though the purchase of these assets is part of investing)  All income and expenses related to normal business operations A cash flow from investment activities can be used to account for the money spent on long- term or non-current assets that will provide value in the future. Growth and capital are crucial components of investing activity. A modification to the balance sheet's major line item, property, plant, and equipment (PPE), is seen as an investment activity. Investors and analysts can find the sources and uses of funds in the investment section of the cash flow statement when they want to see how much a company spends on PPE. This section also includes capital expenditures (CapEx), a common indicator of capital investment used in stock valuation. The corporation is investing in future operations as capital expenditures rise. Capital expenses, however, cause a decrease in cash flow. Usually, businesses that incur big capital expenditures are expanding. Several instances of cash flows from investment activities are shown below, along with information about whether they provide positive or negative cash flow. 164 CU IDOL SELF LEARNING MATERIAL (SLM)

 Purchase of fixed assets–cash flow negative  Purchase of investments such as stocks or securities–cash flow negative  Lending money–cash flow negative  Sale of fixed assets–cash flow positive  Sale of investment securities–cash flow positive  Collection of loans and insurance proceeds–cash flow positive Table 9.2 Cash Flow 9.4 CASH FLOW FROM FINANCING ACTIVITIES Cash Flow from Financing Activities tracks the net change in cash related to raising capital (e.g. equity, debt), share repurchases, dividends, and repayment of debt. The statement of cash flows includes a line item for cash flows from financing operations. One of the documents that make up a company's financial statements is this statement. The line item includes the total of the changes that an organization went through over a specified reporting period as a result of dealings with owners or lenders to either give the company long-term money or to return those funds to the owners or lenders. If the business is a not-for- profit, all donations from supporters that are only intended for long-term uses should also be included in this line item. Items that may be included in the financing activities line item are:  Sale of stock (positive cash flow)  Repurchase of company stock (negative cash flow)  Issuance of debt, such as bonds (positive cash flow)  Repayment of debt (negative cash flow)  Payment of dividends (negative cash flow)  Donor contributions restricted to long-term use (positive cash flow) 165 CU IDOL SELF LEARNING MATERIAL (SLM)

One of the more crucial lines on the cash flow statement is the cash flows from financing activities line item because it has the potential to be a sizable source or consumer of cash that greatly outweighs any positive or negative cash flow from operations. A smaller company, on the other hand, might discover that it had no financing operations during a reporting period if it had no debt and paid no dividends. As a result, it did not need to include this line item in its statement of cash flows. Table 9.3 Cash Flow 166 Financing activities include cash inflows from: • Issuing stock • Issuing debt Financing activities include cash outflows from: • Purchasing treasury stock • Retiring stock by purchase • Debt payments • Dividend payments CU IDOL SELF LEARNING MATERIAL (SLM)

9.5 ILLUSTRATIONS Illustration 1: The net Income reported in the Income Statement for the year was Rs. 110,000 and depreciation of fixed assets for the year was Rs. 44000. The balances of the current assets and current liabilities at the beginning and end of the year are as follows. Calculate cash from operating activities Table 9.3 currant item Solution: 167 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 9.4 operating activities Illustration 2: Table 9.5 Illustration 168 CU IDOL SELF LEARNING MATERIAL (SLM)

Additional Information : (i) During the year a machine costing Rs 40,000 with this accumulated depreciation Rs 24000 was sold for Rs 20,000 (ii) Patents were written off to the extent of Rs 40,000 and some patents were sold at a profit of Rs 20,000 Solution: Table 9.6 Machinery And Patent Account 169 CU IDOL SELF LEARNING MATERIAL (SLM)

Illustration 3: Table 9.7 Financing Activities Additional Information : Interest paid on debentures Rs10000. Solution. Calculation of Cash from financing activities Table 9.8 Calculation of Cash from financing activities Illustration 4: From the summarised cash account of ABC Limited (Ltd.) prepare cash flow statement for the year ended 31st December 2006 in accordance with AS-3 (Revised) using the direct method and indirect method. The company does not have any cash equivalents : 170 CU IDOL SELF LEARNING MATERIAL (SLM)

Solution: Table 9.9 Summarised Cash flow statement of ABC Ltd for the year ended 31st December 2006 (Indirect method) 171 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 9.10 Indirect method Cash Flow Statement (Direct Method) of ABC Ltd. for the year ended 31st December 2006 172 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 9.11 Cash Flow Statement 9.6 SUMMARY  Cash Flow from Financing Activities tracks the net change in cash related to raising capital (e.g. equity, debt), share repurchases, dividends, and repayment of debt.  The portion of a company's cash flow statement titled Cash Flow from Investing Activities shows how much money was spent on (or profit was made from) making investments during a specific period of time.  The amount of money a business earns from ongoing, routine business operations, such as producing and selling products or offering clients a service, is known as cash flow from operating activities (CFO). It is shown as the first portion of the cash flow statement for a corporation. 173 CU IDOL SELF LEARNING MATERIAL (SLM)

 Investment income and expense are not included in cash flow from operational activities or long-term capital expenditures. CFO, also known as operating cash flow (OCF) or net cash from operating activities, focuses exclusively on the core business.  Overdrafts and cash equivalents with short-term maturities are examples of cash equivalents. Funds equivalents also include cash maintained in bank accounts, short- term investments, and any other assets that can be converted to cash fairly easily (less than three months).  Growth and capital are crucial components of investing activity. A modification to the balance sheet's major line item, property, plant, and equipment (PPE), is seen as an investment activity 9.7 KEYWORDS  Indirect Method : The indirect technique is the first choice, in which the business starts with accrual accounting-based net income and works backwards to arrive at a cash basis figure for the period.  Direct Method : The direct technique, in which a business keeps a cash record of all transactions and populates the cash flow statement with actual cash inflows and outflows from the accounting period.  Cash flow from operating activities (CFO) : The amount of money a business earns from ongoing, routine business operations, such as producing and selling products or offering clients a service, is known as cash flow from operating activities (CFO).  Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital  Capital expenditures : Purchase of property plant, and equipment (PP&E), also known as capital expenditures  Cash flow from operational activities: Investment income and expense are not included in cash flow from operational activities or long-term capital expenditures. CFO, also known as operating cash flow (OCF) or net cash from operating activities, 174 CU IDOL SELF LEARNING MATERIAL (SLM)

9.8 LEARNING ACTIVITY 1. Define Cash Flow From Financing Activities 2.State the types of Cash Flow from Operating Activities ________________________________________________________________________ ________________________________________________________________________ _______________________________________________________________________ 9.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Define Direct method of Cash Flow from Operating Activities. 2. Define Indirect method of Cash Flow from Operating Activities. 3. Explain Cash Flow From Financing Activities. 4. Explain with definition three sections of statement of cash flow statement. Long Questions: 1. Explain cash flow from investment activities. 2. Explain cash flow from operating activities. B. Multiple Choice Questions 175 CU IDOL SELF LEARNING MATERIAL (SLM)

1. The financial statements that shows how much money was made and spent over a certain period of time is the ____________________ a. Statement of cash flows b. Statement of operating activities c. Statement of investment activities d. All of the above 1. The portion of a company's cash flow statement titled __________________shows how much money was spent on (or profit was made from) making investments during a specific period of time. a. Cash Flow from Investing Activities b. Cash Flow from operating activities c. Cash flow statement d. None of the above 2. ____________are crucial components of investing activity. a. Money and Goodwill b. Growth and capital c. Both a and b d. All of the above 3. The amount of money a business earns from ongoing, routine business operations, such as producing and selling products or offering clients a service, is known as ________ a. cash flow from operating activities (CFO). b. Cash flow from investing activities c. Cash flow statement d. None of the above 176 CU IDOL SELF LEARNING MATERIAL (SLM)

4. __________can find the sources and uses of funds in the investment section of the cash flow statement when they want to see how much a company spends on PPE. a. Investors and analysts b. Investors and shareholders c. Debenture holders and equity shareholders d. Preference shareholders and Bonds Answers 1-a, 2-a, 3-b, 4-a, 5-a 9.10 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. Website  https://www.investopedia.com/investing/what-is-a-cash-flow-statement/  https://corporatefinanceinstitute.com/resources/knowledge/accounting/statement-of- cash-flows/  https://www.accountingcoach.com/cash-flow-statement/explanation 177 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 10 BUSINESS VALUATION I STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 valuation of Goodwill 10.3 Average profit method 10.4 Illustrations 10.5 Summary 10.6 Keywords 10.7 Learning Activity 10.8 Unit End Questions 10.9 References 10.0 LEARNING OBJECTIVES After studying this unit, you will be able to: ● Describe in detail valuation of goodwill. ● State the Average profit Method. ● List the methods for Valuation of Goodwill. 10.1 INTRODUCTION The process of estimating the economic value of a whole firm or company unit is known as a business valuation. The fair worth of a business can be established through business valuation for a number of purposes, such as sale value, determining partner ownership, taxation, and even divorce processes. For an unbiased assessment of the value of the business, owners frequently resort to qualified professional business assessors. Corporate finance discussions regularly touch on the subject of firm valuation. A company often does a business appraisal when it wants to sell all or part of its operations, combine with another business, or buy another business. The process of estimating a company's present value while considering all of its facets involves doing a business valuation. 178 CU IDOL SELF LEARNING MATERIAL (SLM)

An review of a company's management, financial structure, potential for future earnings, or market worth of its assets may be included in a business valuation. Depending on the evaluator, the company, and the industry, many tools may be employed for appraisal. Examining financial records, discounting cash flow models, and similar company comparisons are common methods for valuing businesses. In addition, valuation is crucial for tax reporting. The Internal Revenue Service (IRS) mandates that a company's fair market value be used to determine its valuation. Depending on valuation, certain tax-related actions, such as the sale, purchase, or donation of company shares, will be taxed. 10.2 VALUATION OF GOODWILL The main intangible asset associated with the acquisition of one company by another is goodwill. This percentage of the purchase price, which is greater than the whole net fair value of the acquired assets, is covered by the concept. The significance of goodwill can be appreciated by considering how important it is for boosting the worth of the company. Additionally, it helps businesses attract more clients. In everyday speech, a company's goodwill is generally regarded to be its established track record. Many different things can affect a company's positive reputation. These variables tend to include, among others, the business's need for financing, the state of the market, the owners' reputation, and profit trends. An illustration of goodwill is when business X purchases firm Y for more than the fair market value of company X's liabilities and assets; the difference is recorded as goodwill in company X's balance sheet. Let's move on to the techniques for valuing goodwill now that we have updated our knowledge of it. Valuation of Goodwill In essence, goodwill valuation refers to the process of calculating these intangible assets to evaluate how much a firm would still be worth if it were to be acquired. The value of a company is determined by a number of factors, including the owners' reputation, management effectiveness, the state of the market, and any unique advantages. 179 CU IDOL SELF LEARNING MATERIAL (SLM)

Several different scenarios need the assessment of goodwill. In Partnership - If partners retire, expire, or are newly admitted, there is a need for goodwill valuation. It also becomes important in case of alterations in profit-sharing ratio or amalgamation In Company - In the instance of amalgamation of a company or acquiring controlling interest, another would require goodwill valuation. In Sole Proprietorship - Purchase considerations of selling off business are some of the situations where the valuation of goodwill is needed. Methods for Valuation of Goodwill A business chooses a valuation strategy that is compatible with its position in the market and the trade's customs. The various goodwill appraisal techniques are described here. 1. Average Profits Method The average profits method primarily takes the following two forms - e. Simple Average Here, the goodwill is evaluated by the calculation of average profit against the number of years purchased. f. Weighted Average This approach, which also emphasizes the profit for the current year, is typically employed when there are changes in profit. In order to determine the valuation, it figures out the earnings from the prior year. (Super profit = Average / Actual profit – Normal profit 180 Normal profit = (Capital employed X Normal rate of return) / 100) The super-profits method can be undertaken by either of the two following methods. CU IDOL SELF LEARNING MATERIAL (SLM)

I. Annuity Method of Goodwill The annuity method in the valuation of goodwill uses the average super profit over a specific number of years. The current value of an annuity is found on the basis of a discounted amount of super profit at the established rate of interest. II. Purchase Method by Number-of-Years Super profits in a definite number of purchase years are evaluated for establishing goodwill. 1. Capitalisation Method In the goodwill capitalization method, there are two ways in which the calculation can be done. a. Average Profits Method The calculation covers the deduction of its actual capital that has been employed from the average profits of the capitalized value. It is undertaken based on the normal rate of return. (Capitalised average profits = Average profits X 100 / Normal rate of return Actual capital employed = Total assets (excluding goodwill) – Outside liabilities) b. Super Profits Method of Valuation of Goodwill In these methods, super profits are directly capitalized for the valuation of goodwill. 10.3 AVERAGE PROFIT METHOD One of the most popular and straightforward approaches for valuing goodwill is the average profit method. Using this method, the average expected profit or average prospective profit is multiplied by the number of years since the purchase to determine the goodwill value. There are two different methods of calculating average profit which are 1. Simple average 181 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Weighted average a. Simple Average: In the Simple Average Profit Method, the company generates regular earnings over a certain period of years. The total amount of profits is added up, and their average is calculated. Average profit is multiplied by the number of years' worth of purchases to determine goodwill. The number of years purchased indicates how long after a change in ownership the company will continue to make the same amount of profit as a result of its prior efforts. When an operating business is purchased, the buyer is required to pay a goodwill fee in exchange for the right to make a profit during the first few years of operation. Under this method, the goodwill is valued at the agreed number of years’ of purchase of the average profits of the past years. Steps of Average Profit Method of Calculating Goodwill: Step 1: Calculate the normal past business profit for each year by deducting abnormal gains and non-business expenses. Step 2: Add the profits calculated for the past given years. Step 3: Calculate the Average Profit (or Average Maintainable Profit) as: Goodwill = Average Profit x No. of years’ of purchase b. Weighted Average: To determine the value of goodwill, the Weight Average Profit Method multiplies each profit by the number of specified weights, i.e. 1, 2, 3, 4. The weighted average profit is determined by multiplying the weighted average profit by the agreed-upon number of years' purchase, and the goodwill is determined by dividing the total products of profits by the total weights. Steps of Weighted Average Profit Method of Calculating Goodwill Step 1: Assigning weights to the profits. The highest weight is assigned to the profit of the most recent year. Step 2: The product of profits is calculated by multiplying the weight with the respective profit of that particular year. 182 CU IDOL SELF LEARNING MATERIAL (SLM)

Step 3: Weighted Average Profit is then calculated by dividing the Total of products of profits by the Total Weights. Step 4: The value of Goodwill is calculated by multiplying the Weighted Average Profit by the Number of years of purchase. Under this method, the goodwill is valued at an agreed number of years’ of purchase of the weighted average profits of the past years. We use the weighted average when there exists an increasing or decreasing trend in the profits giving the highest weight to the current year’s profit. Goodwill = Weighted Average Profit x No. of years’ of purchase Weighted Average Profit = Sum of Profits multiplied by weights/ Sum of weights Illustration 1: Calculate the value of goodwill of the firm of three years’ purchase from the previous five- year profits earned: Illustration 2: Calculate the value of goods on two years’ purchase of average profit of the firm from the following: 183 CU IDOL SELF LEARNING MATERIAL (SLM)

2020: ₹94,000 (excluding ₹8,000 as insurance premium on the firm’s property-now to be insured) 2021: ₹1,25,000 (including the abnormal gain of ₹20,000) 2022: ₹78,600 (after charging an abnormal loss of ₹4,000) Solution: Table 10.1 Adjusted Profit Total Profits for the last 3 years = ₹86,000 + ₹1,05,000 + ₹82,600 = ₹2,73,600 Average Profit = 273600/3 = ₹91,200 Goodwill = Average profit x Number of years of purchase = ₹91,200 x 2 = ₹1,82,400 Illustration 3: Calculate the value of Goodwill based on four years’ purchase of the weighted average profit after assigning weights 1,2,3,4,5 and 6, respectively to the profits for 2016, 2017, 2018, 2019, 2020, and 2021. The profits of the firm for the year ended 31st March for the last six years were: 184 CU IDOL SELF LEARNING MATERIAL (SLM)

Solution: Table 10.2 Solution Illustration 4: X Ltd. agreed to purchase business of a sole trader. For that purpose, goodwill is to be valued at 3 years’ purchase of average profits of last 5 years. 185 CU IDOL SELF LEARNING MATERIAL (SLM)

Table 10.3 Illustration Illustration 5: A&B co. ltd. decided to the purchased business of C&D co. ltd. the profit of the last 4 years are shown as the following: – 2016 – 25,000 2017 – 35,000 2018 – 30,000 2019 – 50,000 Calculate the goodwill on the base of 3-year purchase of the average profit for the last 4 years. Solution: Total Profit of C&D for the last 4 years = 25,000 + 35,000 + 30,000 + 50,000 = 1,40,000/- 186 CU IDOL SELF LEARNING MATERIAL (SLM)

Simple Average profit = 35,000 Goodwill = Simple Average Profit X Number of the years of purchase Goodwill = 35,000 X 3 = 1,05,000 10.4 SUMMARY ● The process of estimating the economic value of a whole firm or company unit is known as a business valuation. ● The fair worth of a business can be established through business valuation for a number of purposes, such as sale value, determining partner ownership, taxation, and even divorce processes. ● The annuity method in the valuation of goodwill uses the average super profit over a specific number of years. The current value of an annuity is found on the basis of a discounted amount of super profit at the established rate of interest. ● In essence, goodwill valuation refers to the process of calculating these intangible assets to evaluate how much a firm would still be worth if it were to be acquired. The value of a company is determined by a number of factors, including the owners' reputation, management effectiveness, the state of the market, and any unique advantages. 10.5 KEYWORDS  Super Profits Method of Valuation of Goodwill In these methods, super profits are directly capitalized for the valuation of goodwill. 187 CU IDOL SELF LEARNING MATERIAL (SLM)

 Average Profit MethodIn the Simple Average Profit Method, the company generates regular earnings over a certain period of years. The total amount of profits is added up, and their average is calculated. Average profit is multiplied by the number of years' worth of purchases to determine goodwill.  Super Profits Method of Valuation of GoodwillIn these methods, super profits are directly capitalized for the valuation of goodwill. 10.6 LEARNING ACTIVITY 1. Define Average Profit Method. ___________________________________________________________________________ ___________________________________________________________________________ 1. Define Valuation of goodwill. ___________________________________________________________________________ ___________________________________________________________________________ 2. State the methods of Valuation of goodwill. ___________________________________________________________________________ _________________________________________________________________________ 10.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions: 1. Simple Average Method 2. Weighted Average Method 3. Capitalization Method Long Questions: 188 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Explain in detail about Average profit method. 2. Write in detail about Valuation of Goodwill. B. Multiple Choice Questions 1. The process of estimating the economic value of a whole firm or company unit is known as ______________ a. a Business valuation b. b .Business expansion c. Business growth d. Business development 2. We use the weighted average when there exists an increasing or decreasing trend in the profits giving the highest weight to _______ a. the current year’s profit. b. the last year’s profit c. the coming year’s profit d. none of the above 3. Under ____________method, the goodwill is valued at the agreed number of years’ of purchase of the average profits of the past years a. Simple average b. Weighted average c. Capitalization method d. Goodwill method 3. In the instance of ___________of a company or acquiring controlling interest, another would require goodwill valuation. a. Amalgamation 189 b. Merger CU IDOL SELF LEARNING MATERIAL (SLM)

c. Acquisition d. Division Answers 1-a, 2-a, 3-a, 4-a 10.8 REFERENCES References book  Financial Statement Analysis - Martin Fridson. ...  International Financial Statement Analysis - Thomas Robinson. ...  The Finance Book - Stuart Warner & Si Hussain. ...  Financial Statements: Step by Step - Thomas Ittelson. Website ● https://www.investopedia.com/terms/b/business-valuation.asp ● https://en.wikipedia.org/wiki/Business_valuation ● https://www.uschamber.com/co/run/finance/business-valuation-how-to-guide 190 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT - 11 BUSINESS VALUATION II STRUCTURE 11.0Learning Objectives 11.1Introduction 11.2Super Profit Method 11.3Capitalisation Method 11.4Summary 11.5Keywords 11.6Learning Activity 11.7Unit End Questions 11.8 References 11.0 LEARNING OBJECTIVES After studying this unit, you will be able to: ● Describe Super Profit Method. ● Describe Capitalisation Method. 11.0 INTRODUCTION The process of estimating the economic value of a whole firm or company unit is known as a business valuation. The fair worth of a business can be established through business valuation for a number of purposes, such as sale value, determining partner ownership, taxation, and even divorce processes. For an unbiased assessment of the value of the business, owners frequently resort to qualified professional business assessors. Corporate finance discussions regularly touch on the subject of firm valuation. A company often does a business appraisal when it wants to sell all or part of its operations, combine with another business, or buy another business. The process of estimating a company's present value while considering all of its facets involves doing a business valuation. An review of a company's management, financial structure, potential for future earnings, or market worth of its assets may be included in a business valuation. Depending on the evaluator, the company, and the industry, many tools may be employed for appraisal. 191 CU IDOL SELF LEARNING MATERIAL (SLM)

Examining financial records, discounting cash flow models, and similar company comparisons are common methods for valuing businesses. In addition, valuation is crucial for tax reporting. The Internal Revenue Service (IRS) mandates that a company's fair market value be used to determine its valuation. Depending on valuation, certain tax-related actions, such as the sale, purchase, or donation of company shares, will be taxed. 11.2 SUPER PROFIT METHOD Super profit is the excess of estimated future profit than the normal profit. It is a way of determining the extra profits that are earned by the business. The goodwill is determined by multiplying the value of super profits by a certain number (that number being the number of years of purchase). The excess of the average profit over the typical profit is known as the super profit. The super profit is multiplied by the predetermined number of years after purchase to determine goodwill. The capital used in the firm produces a profit. From the capital invested in the organization, certain organizations make more profit than other organizations. The normal return is the ratio of capital expended to profit realized by a business of a comparable nature. To determine super profit, the average capital utilized is taken into account. (i) The Number of Years Purchase Method: Under this method, the goodwill is valued at the agreed number of years’ of purchase of the super profits of the firm. Goodwill = Super Profit x No. of years’ of purchase # Super Profit = Actual or Average profit – Normal Profit # Normal Profit = Capital Employed x (Normal Rate of Return/100) (ii) Annuity Method: This method considers the time value of money. Here, we consider the discounted value of the super profit. Goodwill = Super Profit x Discounting Factor 192 CU IDOL SELF LEARNING MATERIAL (SLM)

Steps to calculate Goodwill using Super Profit Method The following steps are involved in the calculation of goodwill using super profit method. 1. Calculate the total capital of the business. It will be the sum total of all the net current and fixed assets along with the shareholders equity. 2. Determine the normal profit by multiplying the total capital employed with the normal rate of return. 3. Calculate the average estimated profit or average manageable profit 4. Calculate super profit by subtracting the value of normal profit from the average estimated profit to determine the super profit. 5. Multiply the super profit by the number of years of purchase to determine the goodwill. It can be expressed in formula as follows: Normal Profit = Capital Employed x (Normal Rate of Return/100) Super Profit = Average estimated profit – Normal Profit Goodwill = Super Profit x No. of years of purchase Example of Super Profit Method The super profit method can be explained with the help of the following question. ABC Ltd has employed Rs.1000000 as the capital and the investors are not very happy when the income obtained from the investment is 30% while the actual profit obtained is Rs. 4,00,000. In this question, the normal profit is 30% of 1000000 which is 3,00,000 and the actual profit is 4,00,000. Therefore, the super profit is 193 Super Profit = Average estimated profit – Normal Profit = 4,00,000 – 3,00,000 CU IDOL SELF LEARNING MATERIAL (SLM)

= 1,00,000 Illustration 1: The net profit of a firm earned during the past four years is as follows: Table 11.1 Illustration The capital employed by the firm is ₹45,000 and the normal rate of return is 8%. Calculate the value of goodwill based on the past three years’ purchase of the average super profit for the last four years. Solution: 194 CU IDOL SELF LEARNING MATERIAL (SLM)

Illustration 2: M and N are partners sharing profit and losses in the ratio of 2:3. P is the new partner to be admitted in the firm of 2/3rd share. For this purpose, goodwill has to be valued at two years’ purchase of super profit. The average maintainable profit of the firm is ₹53,000. The normal rate of return is to take 10% and the capital investment of the firm is valued at ₹1,94,600. Calculate the value of Goodwill. Solution: 195 CU IDOL SELF LEARNING MATERIAL (SLM)

Illustration 3: A firm earned the net profits during the last three years as follows: Table 11.2 Illustration The capital employed in the firm is ₹3,40,000, and a fair return on capital is 17%. Calculate the value of goodwill of the firm based on three years’ purchase of average super profit. 196 CU IDOL SELF LEARNING MATERIAL (SLM)

11.3 CAPITALISATION METHOD One of the strategies used to value goodwill is the capitalization method. By subtracting the actual capital used from the capitalization value of average earnings based on the typical rate of return, the value of goodwill is determined using this method. There are several methods to calculate Goodwill. One such method of valuing Goodwill is a Capitalisation Profit Method. Under the Capitalisation Method, the capitalised value of the firm’s profit is determined to know the amount of capital required to earn the desired profit. The value of Goodwill can be calculated in two ways: There are two ways of calculating profits in capitalisation method and these methods are: 1. Capitalisation of Average Profit Method 2. Capitalisation of Super Profits Method g. Capitalisation of Average Profit Method Capitalization is the term used to describe the amount of capital needed to achieve a specific amount of profit at a typical rate of return. Using this method, a normal rate of return is used to compute the capitalised value of the average profit. Once the capitalised average profit value is established, the goodwill is calculated using the firm's net assets. This aids in determining how much capital is required to generate such an average profit. The following steps are to be followed to calculate the value of the goodwill under this Method: 197 CU IDOL SELF LEARNING MATERIAL (SLM)

Step 1: Calculation of Actual Average Profit. Step 2: Calculation of Capitalised Value of the Average Profit. Step 3: Calculation of Firm’s Goodwill. Goodwill = Capitalised Value of the Average Profit − Capital Employed here, Capital Employed/Net Assets (as on the date of Valuation of Goodwill) = Assets – Liabilities Illustration: Calculate goodwill according to the Capitalisation of Average Profit Method when a firm earned an Average Profit of ₹30,000. The Normal Rate of Return is 10% and the Capital Employed (as on the date of Valuation of Goodwill) is ₹2,40,000 Solution: Illustration: Ram and Mohan are partners in a business with a credit balance of ₹ 1,25,000 each in their Capital account and a credit balance of ₹15,000 and 10,000 in their current A/c, respectively. The Average Profit of the firm is ₹50,000, and the Normal Rate of Return is 10%. Calculate goodwill according to the Capitalisation of Average Profit Method. Solution: 198 CU IDOL SELF LEARNING MATERIAL (SLM)

h. Capitalisation of Super Profit Method: In this method, the capitalised value of the Super Profit is calculated on the basis of a normal rate of return for the assessment of the amount of capital needed for earning such a Super Profit. In this method, the following steps are to be followed to calculate the value of the goodwill: Step 1: Calculation of the Super Profit. Super Profit = Actual or Average Profit − Normal Profit Step 2: Calculation of the Firm’s Goodwill: Under the Capitalisation of Super Profit Method, the Value of Goodwill is equal to the capitalised value of the Super Profit. Therefore, Illustration From the following data, calculate goodwill according to the Capitalisation of Super Profit Method: Average Profit- ₹ 36,000 199 CU IDOL SELF LEARNING MATERIAL (SLM)

Capital Employed (as on the date of Valuation of Goodwill)- ₹ 2,85,000 Normal Rate of Return- 10% Calculating Super Profit: Super Profit = Average Profit – Normal Profit Super Profit = 36,000 – 28,500 Super Profit = ₹ 7,500 Illustration Calculate the value of Goodwill by Super Profit Method when the goodwill is valued at 3 years’ purchase of super profit. The average Profit during the last few years is ₹ 50,000, and the Normal Rate of Return is 10%. Assets of the business were ₹ 5,00,000 and external liabilities were ₹ 90,000. Solution: Calculation of Net Asset/Capital Employed: Capital Employed = Assets − Liabilities Capital Employed = 5,00,000 − 90,000 Capital Employed = ₹ 4,10,000. 200 CU IDOL SELF LEARNING MATERIAL (SLM)