FINANCIAL REPORTING, STATEMENTS AND ANALYSIS

UNIT IV

Liquidity and solvency analysis using cash flow statement–the dilemma of cause and effect–
Prerequisites of an effective financial statements–case studies

Meaning of Liquidity and Solvency:

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 analysed 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.

Liquidity ratios are used to determine a company’s ability to meet its short-term debt obligations.
Investors often take a close look at liquidity ratios when performing fundamental analysis on a
firm. Since a company that is consistently having trouble meeting its short-term debt is at a
higher risk of bankruptcy, liquidity ratios are a good measure of whether a company will be able
to comfortably continue as a going concern. Any type of ratio analysis should be looked at
within the correct context. For instance, investors should always look at a company’s ratios
against those of its competitors, its sector and its industry and over a period of several years. In
this issue’s Fundamental Focus, we investigate liquidity ratios using time-series analysis,
competitive analysis and sector and industry analysis.

Liquidity Ratio:
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 analysed 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.

Solvency Ratio:
The persons who have advanced money to the business on long-term basis are interested in
safety of their periodic payment of interest as well as there payment of principal amount at the
end of the loan period. Solvency ratios are calculated to determine the ability of the business to

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service its debt in the long run. The following ratios are normally computed for evaluating
solvency of the business

For Example:

Cash flow from activities:

Operating

Financing
Investing

+ + + Concerns a company with high liquidity, which has a surplus of

money from operating activity and gets more money from other
activities than it pays out. It confirms most often the preparation for
new investments or acquisitions.
+ – – Surplus from operating segment is used to pay for undertaken
investments or pay to owners and creditors. If the net increase in
cash and cash equivalents is negative, then it can suggest that the
firms is in financial troubles, but if the total cash increases during
the time, the situation is not bad and the firm saved money for the
future.
+ + – Company cannot pay the financial liabilities with cash flow from
operating activities and has to sell off its fixed assets. But it can
mean a sound firm which owns shares in other companies paying
dividends or it suggests that the company is restructuring its core
business as well.
Positive surplus of cash from operating activity is not enough to
meet capital expenditures (investing activity), therefore the firm has
to gain additional external capital. This is typical of growing and
developing corporations with such credibility to have access to
+ - + capital.

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 Cases

Operating

Financing
Investing
Shortage of cash flow from operating activity is covered by cash
from disposal of long term assets, by credits and loans and by issued
- + + capital. Although the company generates negative cash flow from
operating activity, its financial condition is sufficiently good to be
able to get external capital.
Such situation is typical of young growing companies which have
– – + access to external capital, though their operating activity generates
negative cash flows.
Company is trying to cover negative net cash flow from operating
activity and pay its financial liabilities. Cash comes from selling of
long-term assets and financial investments.
- + -
Such case could indicate serious financial troubles, because of
shortage of cash flow from core business. The liabilities are paid
thanks to selling off assets.
It could be a transition state and takes place in companies that
accumulated cash surplus in previous periods. Only then the
- - - company is able to pay its liabilities and to invest in fixed assets.
But maintaining this situation can lead to exhausting the money
surplus and loss of liquidity and could end in bankruptcy.

What is 'Solvency'?
Solvency is the ability of a company to meet its long-term financial obligations. Solvency is
essential to staying in business as it demonstrates a company’s ability to continue operations into
the foreseeable future. While a company also needs liquidity to thrive, liquidity should not be
confused with solvency. A company that is insolvent must often enter bankruptcy.

Solvency Ratios
Investors can use ratios to analyze a company's solvency. The interest coverage ratio divides
operating income by interest expense to show a company's ability to pay the interest on its debt,
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with a higher result indicating a greater solvency. The debt-to-assets ratio divides a company's
debt by the value of its assets to show whether a company has taken on too much debt, with a
lower result indicating a greater solvency. Equity ratios demonstrate the amount of funds that
remain after the value of the assets, offset by the outstanding debt, is divided among eligible
investors.
Solvency ratios vary by industry, so it is important to understand what constitutes a good ratio
for the company before drawing conclusions from the ratio calculations. Ratios that suggest a
lower solvency than the industry average may suggest financial problems are on the horizon.

Risks to Solvency
Certain events can create a risk to an entity’s solvency. In the case of business, the pending
expiration of a patent may pose risks to solvency as it will allow competitors to produce the
product in question, and it results in a loss of associated royalty payments. Further, changes in
certain regulations that directly impact a company’s ability to continue business operations can
pose an additional risk. Both businesses and individuals may experience solvency issues should a
large judgment be ordered against them after a lawsuit.

Solvency vs. Liquidity

While solvency represents a company’s ability to meet long-term obligations, liquidity represents
a company's ability to meet its short-term obligations. In order for funds to be considered liquid,
they must be either immediately accessible or easily converted into usable funds. Cash is
considered the most liquid payment vehicle. A company that lacks liquidity can be forced to
enter bankruptcy even if solvent, if it cannot convert its assets into funds that can be used to meet
financial obligations.

Meaning of Financial Statements

Financial statements are the basic and formal annual reports through which the corporate
management communicates financial information to its owners and various other external parties
which include investors, tax authorities, government, employees, etc. These normally refer to: (a)
the balance sheet (position statement) as at the end of accounting period, and (b) the statement of
profit and loss of a company. Now-a-days, the cash flow statement is also taken as an integral
component of the financial statements of a company.

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Financial statements are prepared on certain basic assumptions (pre-requisites) known as
postulates such as going concern postulate, money measurement postulate, realisation postulate,
etc. Going concern postulate assumes that the enterprise is treated as a going concern and exists
for a longer period of time. So the assets are shown on historical cost basis. Money measurement
postulate assumes that the value of money will remain the same in different periods.

Objectives of Financial Statements

Financial statements are the basic sources of information to the shareholders and other external
parties for understanding the profitability and financial position of any business concern. They
provide information about the results of the business concern during a specified period of time in
terms of assets and liabilities, which provide the basis for taking decisions. Thus, the primary
objective of financial statements is to assist the users in their decision-making. The specific
objectives include the following:
(a) To provide information about economic resources and obligations of a business:
They are prepared to provide adequate, reliable and periodical information about
economic resources and obligations of a business firm to investors and other external
parties who have limited authority, ability or resources to obtain information.
(b) To provide information about the earning capacity of the business: They are to
provide useful financial information which can gainfully be utilised to predict,
compare and evaluate the business firm’s earning capacity.
(c) To provide information about cash flows: They are to provide information useful to
investors and creditors for predicting, comparing and evaluating, potential cash flows
in terms of amount, timing and related uncertainties.
(d) To judge effectiveness of management: They supply information useful for judging
management’s ability to utilise the resources of a business effectively.
(e) Information about activities of business affecting the society: They have to report
the activities of the business organisation affecting the society, which can be
determined and described or measured and which are important in its social
environment.
(f) Disclosing accounting policies: These reports have to provide the significant policies,
concepts followed in the process of accounting and changes taken up in them during
the year to understand these statements in a better way.

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Types of Financial Statements
The financial statements generally include two statements: balance sheet and statement of profit
and loss which are required for external reporting and also for internal needs of the management
like planning, decision-making and control. Apart from these, there is also a need to know about
movements of funds and changes in the financial position of the company. For this purpose, a
statement of changes in financial position of the company or a cash flow statement is prepared.

Every company registered under The Companies Act 2013 shall prepare its balance sheet,
statement of profit and loss and notes to account thereto in accordance with the manner
prescribed in the revised Schedule III to the Companies Act, 2013 to harmonise the disclosure
requirement with the accounting standards and to converge with new reforms. With regard to
this, the Ministry of Corporate Affairs (MCA) had prescribed a (Revised) Schedule VI to the
Companies Act, 1956 (vide Notification dated 28.02.2011). It is applied to the financial
statements prepared for all financial periods beginning on or after April 01, 2011 by the Indian
Companies.
Financial Statements of a Company

Balance Sheet as at 31st March, 20.....

Particulars Figure as at the Figure as at the end
end of Current of Previous reporting
reporting period period
I. EQUITY AND LIABILITIES
(a) Shareholder’s Funds
(b) Share Capital
(c) Reserves and Surplus
(d) Money received against share warrants
(e) Share Application money pending allotment
(f) Non-current Liabilities
(g) Long term borrowings
(h) Deferred tax liabilities (net)
(i) Other long term liabilities
(j) Long term provisions

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 (k) Current Liabilities
(l) Short-term borrowings
(m) Trade payables
(n) Other current liabilities
(o) Short-term provisions
Total
II. ASSETS
Non-Current Assets
Fixed assets
Tangible assets
Intangible assets
Capital work-in-progress
Intangible assets under development
Non-current investments
Deferred tax assets (net)
Long-term loans and advances
Other non-current assets
Current Assets
Current investments
Inventories
Trade receivables
Cash and cash equivalents
Short term loans and advances
Other current assets
Total
See accompanying notes to the financial statements
NOTES:
Important Features of Presentation
• It applies to all Indian companies preparing financial statement commencing on or after
April 01, 2011.

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 • It does not apply to (i) Insurance or Banking Company, (ii) Company for which a form of
balance sheet or income statement is specified under any other Act.
• Accounting standards shall prevail over Schedule III of the Companies Act, 2013.
• Disclosure on the face of the financial statements or in the notes are essential and
mandatory.
• Terms in the revised Schedule III will carry the meaning as defined by the applicable
accounting standards.
• Balance to be maintained between excessive details that may not assist users of financial
statements and not providing important information.
• Current and non-current bifurcation of assets and liabilities is applicable.

Uses and Importance of Financial Statements

The users of financial statements include management, investors, shareholders, creditors,
government, bankers, employees and public at large. Financial statements provide the necessary
information about the performance of the management to these parties interested in the
organisation and help in taking appropriate economic decisions. It may be noted that the
financial statements constitute an integral part of the annual report of the company in addition to
the directors report, auditors report, corporate governance report, and management discussion
and analysis.
The various uses and importance of financial statements are as follows:
a) Report on stewardship function: Financial statements report the performance of the
management to the shareholders. The gaps between the management performance and
ownership expectations can be understood with the help of financial statements.
b) Basis for fiscal policies: The fiscal policies, particularly taxation policies of the
government, are related with the financial performance of corporate undertakings. The
financial statements provide basic input for industrial, taxation and other economic
policies of the government.
c) Basis for granting of credit: Corporate undertakings have to borrow funds from banks
and other financial institutions for different purposes. Credit granting institutions take
decisions based on the financial performance of the undertakings. Thus, financial
statements form the basis for granting of credit.

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 d) Basis for prospective investors: The investors include both short-term and long-term
investors. Their prime considerations in their investment decisions are security and
liquidity of their investment with reasonable profitability. Financial statements help the
investors to assess long-term and short-term solvency as well as the profitability of the
concern.
e) Guide to the value of the investment already made: Shareholders of companies are
interested in knowing the status, safety and return on their investment. They may also
need information to take decision about continuation or discontinuation of their
investment in the business. Financial statements provide information to the shareholders
in taking such important decisions.
f) Aids trade associations in helping their members: Trade associations may analyse the
financial statements for the purpose of providing service and protection to their members.
They may develop standard ratios and design uniform system of accounts.
g) Helps stock exchanges: Financial statements help the stock exchanges to understand the
extent of transparency in reporting on financial performance and enables them to call for
required information to protect the interest of investors. The financial statements enable
the Stock brokers to judge the financial position of different concerns and take decisions
about the prices to be quoted.

Financial Statements: Financial statements are the end products of accounting process, which
reveal the financial results of a specified period and financial position as on a particular date.
Financial Statements are prepared and published by corporate undertakings for the benefit of
various stakeholders. These statements include Statement of profit and loss and balance sheet.
The basic objective of these statements is to provide information required for decision-making
by the management as well as other outsiders who are interested in the affairs of the undertaking.

From the given particulars of Shine and Bright Co. Ltd., as at March 31, 2017, prepare balance
sheet in accordance to the Schedule III:
Amount Amount
Particulars Rs. Particulars Rs.
Preliminary expenses 2,40,000 Goodwill 30,000
Discount on Issue of shares 20,000 Loose Tools 12,000

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 10% Debentures 2,00,000 Motor vehicles 4,75,000
Stock in trade 1,40,000 Provision for tax 16,000
Cash at bank 1,35,000
Bills receivables 1,20,000

Solution:
Balance Sheet of Shine and Bright Ltd. as at March 31, 2017

Figure as at the end Figure as at the

Particulars of current end of previous
Reporting period Reporting period

I. Equity and Liabilities

1. Non-current Liabilities
a) Long-term borrowings 2,00,000
2. Current liabilities
a) Short-term provisions 16,000
II. Assets
1. Non-current assets
a) Fixed assets
Tangible assets 4,75,000
Intangible assets 30,000
2. Other non-current assets* 2,60,000
Current assets
a) Inventories 1,52,000
b) Trade receivables 12,000
c) Cash and cash equivalents 1,35,000
Long-term borrowings:
10% debentures 2,00,000
Short-term provisions:

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 Provision for taxation 16,000
Fixed assets:
(i) Tangible assets
Motor vehicles 4,75,000
(ii) Intangible assets
Goodwill 30,000
Other non-current assets
Preliminary expenses 2,40,000
Discount on issue of debentures 20,000 2,60,000
Inventories
Stock in trade 1,40,000
Loose tools 12,000 1,52,000
Trade receivables
Bills receivables 12,000
Cash & cash equivalents
Cash at bank 1,35,000

Pre requisites of Financial Statements

The income statement, balance sheet and cash flow statement are all interrelated. The income
statement describes how the assets and liabilities were used in the stated accounting period. The
cash flow statement explains cash inflows and outflows, and it will ultimately reveal the amount
of cash the company has on hand, which is also reported in the balance sheet. By themselves,
each financial statement only provides a portion of the story of a company's financial condition;
together, they provide a more complete picture.

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 The Relationship Between the Financial Statements

Stockholders and potential creditors analyze a company's financial statements and calculate a
number of financial ratios with the data they contain to identify the company's financial strengths
and weaknesses and determine whether the company is a good investment/credit risk. Managers
use them to aid in decision making. (To learn more, check out Reading The Balance
Sheet, Understanding The Income Statement and The Essentials Of Cash Flow.)
One important way the financial statements are used together is in the calculation of free cash
flow (FCF). Smart investors love companies that produce plenty of free cash flow. It signals a
company's ability to pay debt and dividends, buy back stock and facilitate the growth of business
- all important undertakings from an investor's perspective. However, while free cash flow is a
great gauge of corporate health, it does have its limits and is not immune to accounting trickery.

Cash Flow Statement:

Accounting Standard-3 (AS-3), issued by The Institute of Chartered Accountants of India
(ICAI) in June 1981, which dealt with a statement showing ‘Changes in Financial Position’,
(Fund Flow Statement), has been revised and now deals with the preparation and presentation of
Cash flow statement. The revised AS-3 has made it mandatory for all listed companies to prepare
and present a cash flow statement along with other financial statements on annual basis. Hence,
it may be noted, that Fund Flow statement is no more considered relevant in accounting and so
not discussed here.

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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 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
utilise 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:
1. 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.
2. 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 and compare
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

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 because it eliminates the effects of using different accounting treatments for the same
transactions and events.
3. 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 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 liquidable 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.

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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:
(i) 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.

Cash from Investing Activities

As per AS-3, investing activities are the acquisition and disposal of long-term assets and other
investments not included in cash equivalents. Investing activities relate to purchase and sale of
long-term assets or fixed assets such as machinery, furniture, land and building, etc. Transactions
related to long-term investment are also investing activities.
Separate disclosure of cash flows from investing activities is important because they
represent the extent to which expenditures have been made for resources intended to generate
future income and cash flows. Examples of cash flows arising from investing activities are:

Cash Outflows from investing activities

(a) Cash payments to acquire fixed assets including intangibles and capitalised research and
development.

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 (b) Cash payments to acquire shares, warrants or debt instruments of other enterprises other
than the instruments those held for trading purposes.
(c) Cash advances and loans made to third party (other than advances and loans made by a
financial enterprise wherein it is operating activities).

Cash Inflows from Investing Activities

a. Cash receipt from disposal of fixed assets including intangibles.
b. Cash receipt from the repayment of advances or loans made to third parties (except in
case of financial enterprise).
c. Cash receipt from disposal of shares, warrants or debt instruments of other enterprises
except those held for trading purposes.
d. Interest received in cash from loans and advances.
e. Dividend received from investments in other enterprises.
Cash from Financing Activities
As the name suggests, financing activities relate to long-term funds or capital of an enterprise,
e.g., cash proceeds from issue of equity shares, debentures, raising long-term bank loans,
repayment of bank loan, etc. As per AS-3, financing activities are activities that result in changes
in the size and composition of the owners’ capital (including preference share capital in case of a
company) and borrowings of the enterprise. Separate disclosure of cash flows arising from
financing activities is important because it is useful in predicting claims on future cash flows by
providers of funds ( both capital and borrowings ) to the enterprise. Examples of financing
activities are:

Cash Inflows from financing activities

a. Cash proceeds from issuing shares (equity or/and preference).
b. Cash proceeds from issuing debentures, loans, bonds and other short/ long-term
borrowings.

Cash Outflows from financing activities

a. Cash repayments of amounts borrowed.
b. Interest paid on debentures and long-term loans and advances.
c. Dividends paid on equity and preference capital.

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Cash Flow Statement: Liquidity Vs Solvency
Analysis of Operational Activity Cash flows
Cash Inflows Cash Outflows

Proceeds from sale of

goods Payment of employee
and services to customers benefit expenses

Receipt from royalties, Operating Purchase of inventory

Activitie
fees, commission and s from suppliers

other revenues

Pay operating expenses

Non-cash Transactions

As per AS-3, investing and financing transactions that do not require the use of cash or cash
equivalents should be excluded from a cash flow statement. Examples of such transactions are –
acquisition of machinery by issue of equity shares or redemption of debentures by issue of equity
shares. Such transactions should be disclosed elsewhere in the financial statements in a way that
provide all the relevant information about these investing and financing activities. Hence, assets
acquired by issue of shares are not disclosed in cash flow statement due to non-cash nature of the
transaction.

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Ascertaining Cash Flow from Operating Activities
Operating activities are the main source of revenue and expenditure in an enterprise. Therefore,
the ascertainment of cash flows from operating activities need special attention.
As per AS-3, an enterprise should report cash flows from operating activities either by using:
l Direct method whereby major classes of gross cash receipts and gross cash payments
are disclosed; or
1 Indirect method whereby net profit or loss is duly adjusted for the effects of (1)
transactions of a non-cash nature, (2) any deferrals or accruals of past/future operating
cash receipts, and (3) items of income or expenses associated with investing or financing
cash flows. It is important to mention here that under indirect method, the starting point is
net profit/ loss before taxation and extra ordinary items as per Statement of Profit and
Loss of the enterprise. Then this amount is for non-cash items, etc., adjusted for
ascertaining cash flows from operating activities. Accordingly, cash flow from operating
activities can be determined using either the Direct method or the Indirect method. These
methods are discussed in detail as follows.

Direct Method
As the name suggests, under direct method, major heads of cash inflows and outflows (such as
cash received from trade receivables, employee benefits expenses paid, etc.) are considered.
It is important to note here that items are recorded on accrual basis in statement of profit and
loss. Hence, certain adjustments are made to convert them into cash basis such as the following:
1. Cash receipts from customers = Revenue from operations + Trade receivables in the
beginning – Trade receivables in the end.
2. Cash payments to suppliers = Purchases + Trade Payables in the beginning – Trade
Payables in the end.
3. Purchases = Cost of Revenue from Operations – Opening Inventory + Closing
Inventory.
4. Cash expenses = Expenses on accrual basis + Prepaid expenses in the beginning and
Outstanding expenses in the end – Prepaid expenses in the end and Outstanding
expenses in the beginning.
However, the following items are not to be considered:
1. Non-cash items such as depreciation, discount on shares, etc., be written-off.

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 2. Items which are classified as investing or financing activities such as interest received,
dividend paid, etc.

As per AS-3, under the direct method, information about major classes of gross cash receipts
and cash payments may be obtained either–
l from the accounting records of the enterprise, or
l by adjusting revenue from operation, cost of revenue from operations and other items in
the statement of profit or loss for the following:
l changes during the period in inventories and trade receivables and payables;
l other non-cash items; and
l other items for which cash effects are investing or financing cash flows.

Exhibit shows the proforma of cash flows from operating activities using direct method.
Cash Flows from Operating Activities (Direct Method)
Cash flows from operating activities:
Cash receipts from customers xxx
(–) Cash paid to suppliers and employees (xxx)

= Cash generated from operations xxx

(–) Income tax paid (xxx)

= Cash flow before extraordinary items xxx

+/– Extraordinary items xxx

= Net cash from operating activities xxxx

Illustration 1: From the following information, calculate cash flow from operating activities
using direct method.
Statement of Profit and Loss for the year ended on March 31, 2017
Figures for Current
Particulars Note reporting period
i) Revenue from operations 2,20,000

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 ii) Other Income

iii) Total revenue (i+ii) 2,20,000

iv) Expenses
Cost of materials consumed 1,20,000
Employees benefits expenses 30,000
Depreciation 20,000
Other expenses
Insurance Premium 8,000
Total expenses 1,78,000
v) Profit before tax (iii-iv) 42,000
Less Income tax (10,000)
vi) Profit after tax 32,000

Additional information:
April 01, 2016 March 31, 2017
Particulars Rs Rs
Trade receivables 33,000 36,000
Trade payables 17,000 15,000
Inventory 22,000 27,000
Outstanding employees benefits
expenses 2,000 3,000
Prepaid insurance 5,000 5,500
Income tax outstanding 3,000 2,000

Solution:
Cash Flows from Operating Activities
Particulars (Rs)
Cash receipts from customers 2,17,000
Cash Paid to suppliers (1,27,000)
Cash Paid to employees (29,000)
Cash Paid for Insurance premium (8,500)

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 Cash generated from operations 52,500
Income Tax paid (11,000)
Net Cash Inflow from Operations 41,500

Working Notes:

1. Cash Receipts from Customers is calculated as under :

Cash Receipts from Customers = Revenue from Operations + Trade Receivables in the
beginning – Trade Receivables in the end
= Rs 2,20,000 + Rs 33,000 – Rs 36,000
= Rs 2,17,000
2. Purchases = Cost of Revenue from Operations – Opening Inventory + Closing Inventory
= Rs 1,20,000 – Rs 22,000 + Rs 27,000 = Rs 1,25,000
3. Cash payment to suppliers = Purchases + Trade Payables in the beginning – Trade
Payables in the end = Rs 1,25,000 + Rs 17,000 – Rs 15,000 = Rs 1,27,000
4. Cash Expenses = Expenses on Accrual basis – Prepaid Expenses in the beginning and
Outstanding Expenses in the end + Prepaid Expenses in the end and Outstanding
Expenses in the beginning
5. Cash Paid to Employees = Rs 30,000 + Rs 2,000 – Rs 3,000 = Rs 29,000
6. Cash Paid for Insurance Premium = Rs 8,000 – Rs 5,000 + Rs 5,500 = Rs 8,500
7. Income Tax Paid = Rs 10,000+Rs 3,000 – Rs 2,000 = Rs 11,000
8. It is important to note here that there are no extraordinary items.

Understand the Cash Flow from Operations and to understand the Solvency position of the
Organisation
From the following information, calculate cash flow from operating activities using direct
method.
Statement of Profit and Loss for the year ended on March 31, 2017
Figures for Current
Particulars Note reporting period
i) Revenue from operations 2,20,000
ii) Other Income

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 iii) Total revenue (i+ii) 2,20,000
iv) Expenses
Cost of materials consumed 1,20,000
Employees benefits expenses 30,000
Depreciation 20,000
Other expenses
Insurance Premium 8,000
Total expenses 1,78,000
v) Profit before tax (iii-iv) 42,000
Less Income tax (10,000)
vi) Profit after tax 32,000

Additional information:
April 01, 2016 March 31, 2017
Particulars Rs Rs
Trade receivables 33,000 36,000
Trade payables 17,000 15,000
Inventory 22,000 27,000
Outstanding employees benefits expenses 2,000 3,000
Prepaid insurance 5,000 5,500
Income tax outstanding 3,000 2,000

Solution
Indirect method of ascertaining cash flow from operating activities begins with the amount of net
profit/loss. This is so because statement of profit and loss incorporates the effects of all operating
activities of an enterprise. However, Statement of Profit and Loss is prepared on accrual basis
(and not on cash basis). Moreover, it also includes certain non-operating items such as interest
paid, profit/loss on sale of fixed assets, etc.) and non-cash items (such as depreciation, goodwill
to be written-off, etc.. Therefore, it becomes necessary to adjust the amount of net profit/loss as
shown by Statement of Profit and Loss for arriving at cash flows from operating activities.
Let us look at the example:

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Statement of Profit and Loss Account for the year ended March 31, 2017
Particulars Note Figures in
Rs

i) Revenue from Operations 1,00,000

ii) Other Income 1 2,000

iii) Total Revenues (i+ii) 1,02,000

iv) Expenses
Cost of Materials Consumed 30,000
Purchases of stock-in-trade 10,000
Employees Benefits Expenses 10,000
Finance Costs 5,000
Depreciation 5,000
Other Expenses 12,000
72,000
v) Profit before Tax (iii-iv) 30,000

The above Statement of Profit and Loss shows the amount of net profit of Rs 30,000. This
has to be adjusted for arriving cash flows from operating activities. Let us take various items one
by one.
1. Depreciation is a non-cash item and hence, Rs 5,000 charged as depreciation does not
result in any cash flow. Therefore, this amount must be added back to the net profit.
2. Finance costs of Rs 5,000 is a cash outflow on account of financing activity. Therefore,
this amount must also be added back to net profit while calculating cash flows from
operating activities. This amount of finance cost will be shown as an outflow under the
head of financing activities.
3. Other income includes profit on sale of land: It is cash inflow from investing
activity. Hence, this amount must be deducted from the amount of net profit while
calculating cash flows from operating activities.
The above example gives you an idea as to how various adjustments are made in the amount
of net profit/loss. Other important adjustments relate to changes in working capital which are
necessary (i.e., items of current assets and current liabilities) to convert net profit/loss which is

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based on accrual basis into cash flows from operating activities. Therefore, the increase in
current assets and decrease in current liabilities are deducted from the operating profit, and the
decrease in current assets and increase in current liabilities are added to the operating profit so
as to arrive at the exact amount of net cash flow from operating activities.

As per AS-3, under indirect method, net cash flow from operating activities is determined by
adjusting net profit or loss for the effect of:
l Non-cash items such as depreciation, goodwill written-off, provisions, deferred taxes, etc.,
which are to be added back. All other items for which the cash effects are investing or
financing cash flows. The treatment of such items depends upon their nature. All investing
and financing incomes are to be deducted from the amount of net profits while all such
expenses are to be added back. For example, finance cost which is a financing cash
outflow is to be added back while other income such as interest received which is
investing cash inflow is to be deducted from the amount of net profit.
l Changes in current assets and liabilities during the period. Increase in current assets and
decrease in current liabilities are to be deducted while increase in current liabilities and
decrease in current assets are to be added up.

Exhibit 6.4 shows the proforma of calculating cash flows from operating activities as per
indirect method.
The direct method provides information which is useful in estimating future cash flows. But
such information is not available under the indirect method. However, in practice, indirect
method is mostly used by the companies for arriving at the net cash flow from operating
activities.
Cash Flows from Operating Activities (Indirect Method)
Net Profit/Loss before Tax and Extraordinary Items
+ Deductions already made in Statement of Profit and Loss on account of Non-
cash items such as Depreciation, Goodwill to be Written-off. xxx
+ Deductions already made in Statement of Profit and Loss on Account of xxx
Non-operating items such as Interest.
– Additions (incomes) made in Statement of Profit and Loss on xxx
Account of Non-operating items such as Dividend received, xxx

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 Profit on sale of Fixed Assets.
Operating Profit before Working Capital changes
+ Increase in Current liabilities xxx
+ Decrease in Current assets xxx
– Increase in Current assets xxx
– Decrease in Current Liabilities xxx

Cash Flows from Operating Activities before Tax and Extraordinary Items xxx
– Income Tax Paid xxx
+/– Effects of Extraordinary Items xxx

Net Cash from Operating Activities xxx

As stated earlier, while working out the cash flow from operating activities, the starting
point is the ‘Net profit before tax and extraordinary items’ and not the ‘Net profit as per
Statement of Profit and Loss’. Income tax paid is deducted as the last item to arrive at the net
cash flow from operating activities.

Understand the Cash Flow from Investing Activities and to understand the Liquidity position
of the Organisation
Problem No 1: Welprint Ltd. has given you the following information:
(Rs)
Machinery as on April 01, 2016 50,000
Machinery as on March 31, 2017 60,000
Accumulated Depreciation on April 01, 2016 25,000
Accumulated Depreciation on March 31, 2017 15,000
During the year, a Machine costing Rs 25,000 with Accumulated Depreciation of Rs 15,000
was sold for Rs 13,000.
Calculate cash flow from Investing Activities on the basis of the above information.

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Solution:
Cash Flows from Investing Activities
Sale of Machinery Rs 13,000
Purchase of Machinery (Rs 35,000)
Net cash used in Investing Activities (Rs 22,000)
Working Notes:
Dr. Machinery Account Cr.
Amount Amount
Particulars J.F. Particulars J.F.
(Rs) (Rs)
Cash (proceeds from
Balance b/d 50,000 sale of machine) 13,000

Statement of Profit and Loss Accumulated

(profit on sale of machine) 3,000 Depreciation 15,000
Cash (balancing figure: new
machinery purchased) 35,000 Balance c/d 60,000
88,000 88,000

Accumulated Depreciation Account

Amount Amount
Particulars J.F. (Rs) Particulars J.F. (Rs)
Machinery 15,000 Balance b/d 25,000
Statement of Profit and
Balance c/d 15,000 Loss 5,000
(Depreciation provided
during the year)
30,000 30,000

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