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Chapter 3
FINANCIAL STATEMENTS, TAXES,AND CASH FLOW
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OUTLINE
Balance Sheet
Profit and Loss Account
Finance Topics
Statement of Cash Flows
Manipulation of Bottom Line
Taxes
Free Cash Flow
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IMPORTANT QUESTIONS
Managers, shareholders, creditors and other interested groups
seek answers to the following important questions about a firm: What is the financial position of the firm at a given point of
time?
How has the firm performed financially over a given period of
time?
What have been the sources and uses of cash over a period of
time?
The accountant prepares the balance sheet, the profit and lossaccount, and the statement of cash flows to answer the above
questions
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BALANCE SHEETHorizontal Form
Liabilities + Equity AssetsShare capital Fixed assets Reserves and surplus Investments Secured loans Current assets, loans and Unsecured loans advances Current liabilities and provisions Current assets
Current liabilities Loans and advances Provisions Miscellaneous expendituresand
losses
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BALANCE SHEETVertical (or Report) Form
I. Sources of Funds
(1) Shareholders funds:(a) Capital
(b) Reserves and Surplus
(2) Loan funds:
(a) Secured loans
(b) Unsecured loans
II. Application of funds
(1) Fixed assets
(2) Investments
(3) Current assets, loans and advances
Less: Current liabilities and provisions:
Net current assets
(4) Miscellaneous expenditures and losses
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BALANCE SHEET OF HORIZON LIMITED AS ONMARCH 31, 20 X 1
A. Account Form Rs.in crore
Liabilities 20 x 1 20 x 0 Assets 20 x 1 20 x 0
Share capital 15.00 15.00 Fixed assets 33.00 32.20
Equity 15.00 15.00 Investments 1.00 1.00
Preference Current assets, loans
Reserve & surplus 11.20 10.60 and advances 23.40 15.60
Secured loans 14.30 13.10 Miscellaneous
Unsecured loans 6.90 2.50 expenditures and losses 0.50 0.50
Current liabilities
and provisions 10.50 8.10
57.90 49.30 57.90 49.30
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BALANCE SHEET OF HORIZON LIMITED AS ONMARCH 31, 20 X 1
Rs.in million
20 x 1 20 x 0
I. Sources of Funds(1) Shareholders funds: 26.20 25.60
(a) Share capital 15.00
(b) Reserves and surplus 11.20
(2) Loan funds: 21.20 15.60
(a) Secured loans 14.30(b) Unsecured loans 6.90
47.40 41.20
II. Application of Funds
(1) Fixed assets 33.00 32.20
(2) Investments 1.00 1.00
(3) Current assets, loans and advances 23.40 15.60
57.40 48.80
Less: Current liabilities and provisions: 10.50 8.10
Net current assets 12.90 40.70
(4) Miscellaneous expenditures and losses 0.50 0.50
47.40 41.20
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LIABILITIES
Share Capital
Reserves & Surplus
Secured Loans
Unsecured Loans
Current Liabilities and Provisions
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ASSETS
Fixed Assets
Investments
Current Assets, Loans, & Advances
Miscellaneous Expenditure & Losses
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PROFIT & LOSS ACCOUNT OF HORIZON LTD, FORTHE YEAR ENDING ON MARCH 31, 20 X 1
(Rs.in crore)
IncomeSales 70.1
Other income (loss)
70.1
Expenditure
Material and other expenditure 58.2
Interest 2.1
Depreciation 3.0
Profit before tax 6.8
Provision for tax 3.4
Profit after tax 3.4
Prior period adjustments 0.8
Profit available for appropriations 4.2
Appropriations 3.5
Balance carried forward 0.7
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PROFIT & LOSS ACCOUNT OF HORIZON LTD FOR
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PROFIT & LOSS ACCOUNT OF HORIZON LTD, FORTHE YEAR ENDING ON MARCH 31, 20 X 1
(Rs. in crore)
20 x 1 20 x 0Net sales 70.1 62.3
Cost of goods sold 55.2 47.5Stocks 42.1Wages and salaries 6.8Other manufacturing expenses 6.3
Gross profit 14.9 14.8Operating expenses 6.0 4.9
Depreciation 3.0
General administration 1.2Selling 1.8
Operating profit 8.9 9.9Non-operating surplus/deficit 0.6Profit before interest and tax 8.9 10.5Interest 2.1 2.2Profit before tax 6.8 8.3
Provision for tax 3.4 4.1Current tax 2.1 2.9Deferred tax 1.3 1.2
Profit after tax 3.4 4.2Prior period adjustments 0.8 0.7Amount available for appropriation 4.2 4.9Appropriations 3.5 4.0Balance carried forward 0.7 0.9
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PROFIT AND LOSS ACCOUNT ITEMS
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses
Operating Profit
Non-operating Gains and Losses
Profit Before Interest and Taxes
Interest
Profit before Tax
Income Tax Provision
Profit After Tax
Prior Period Adjustments
Amount Available for Appropriation
Appropriations
Balance Carried Forward
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BALANCE SHEET AND FINANCE TOPICS
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BALANCE SHEET AND FINANCE TOPICS Share capital
Equity
Preference
Reserves and surplus
Secured loans
Debentures
Loans and advances
Unsecured loans
Current liabilities and provisions
Trade creditors
Provisions
Fixed assets (net)
Gross block
Less: depreciation
Investments
Current assets, loans and advances
Cash and bank
Receivables
Inventories
Miscellaneous expenditure and losses
Capital structure
and cost of capital
Working capital
financing policy
Capital budgeting
Portfolio management
Cash management
Credit management
Inventory management
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PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS
Net sales
Cost of goods sold
Stocks
Wages and salaries
Other manufacturing expenses
Gross profit
Operating expenses
Selling and administration expenses
Depreciation
Operating profit
Non-operating surplus/deficit
Earnings before income and tax
Interest Profit before tax
Tax
Profit after tax
Dividends
Retained earnings
Revenue risk
Gross profit margin
Depreciation policy
Business risk
Financial risk
Tax planning
Return on equity
Dividend policy
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STATEMENT OF CASH FLOWS
Cash inflows
from operations
Cash inflows
from investing
activities
Cash inflows
from financing
activities
Cash outflows
from investing
activities
Cash flow
from investing
activities
Cash outflows
from financing
activities
Cash flow
from financing
activities
Operating
Investing
Financing
=
=
=
+
+
=
Cash outflows
from operations
Cash flow
from operations
Net cash flow
for the period
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CASH FLOW STATEMENT
LIABILITIES ASSETS
CAPITAL FIXED ASSETS
RESERVES & SURPLUS
INVESTMENTS
LOANS
INVENTORIES
CURRENT LIABILITIES DEBTORS
AND PROVISIONS
CASH
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SOURCES USES
FINANCING CAPITAL CAPITAL
OPERATING RES. & SURPLUS RES. & SURPLUS
FINANCING LOANS LOANS
OPERATING CURRENT LIABILITIES CURRENT LIABILITIES
& PROVISIONS & PROVISIONS
INVESTMENT FIXED ASSETS FIXED ASSETS
INVESTMENT INVESTMENTS INVESTMENTS
OPERATING INVENTORIES INVENTORIES
OPERATING DEBTORS DEBTORS
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CASH FLOW STATEMENT FOR HORIZON LTD, FORTHE PERIOD 1.4.20X0 TO 31.3.20X1
(Rs. in crore)
(A) Cash Flow from Operating Activities
Net profit before tax and extraordinary items 6.8
Adjustments for
Interest paid 2.1
Depreciation 3.0
Operating profit before working capital changes 11.9
Adjustments
Debtors (4.6)Inventories (3.3)
Advances 0.5
Trade credit 1.5
Advances 0.7
Provisions 0.2
Cash generated from operations 6.9
Income tax paid (3.4)
Cash flow before extraordinary items 3.5
Extraordinary item
Net cash flow from operating activities 3.5
(Contd.)
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(C td )
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(Contd.)(Rs.in crore)
(B) Cash Flow from Investing Activities
Purchase of fixed assets (3.8)
Net cash flow from investing activities (3.8)
(C) Cash Flow from Financing Activities
Proceeds from term loans 1.2
Proceeds from inter-corporate deposits 4.4
Interest paid (2.1)
Dividend paid (2.8)
Net cash flow from financing activities 0.7
(D) Net Increase in Cash and Cash Equivalents 0.4
Cash and cash equivalents as on 1.04.20x0 0.6Cash and cash equivalents as on 31.03.20x1 1.0
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A A O O O O
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MANIPULATION OF THE BOTTOM LINE1. INFLATE THE SALES FOR THE CURRENT YEAR BY ADVANCING THE SALES FROM THE
FOLLOWING YEAR
2. ALTER THE OTHER INCOME FIGURE BY PLAYING WITH NON-OPERATIONAL IETMS
3. FIDDLE WITH THE METHOD & RATE OF DEPRN
4. DEFER CERTAIN DISCRETIONARY EXPENSES TO THE FOLLOWING YEAR.
5. MAKE INADEQUATE PROVISIONS . . LIABILITIES
6. MAKE EXTRA PROVISIONS . . PROSPEROUS PERIODS . . WRITE THEM BACK . . LEAN PERIODS
7. USE TOTALLY UNACCEPTABLE ACCOUNTING PRACTICES.
8. REVALUE ASSETS . . CREATE . . IMPRN . . RESERVES
9. LENGTHEN ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.
WHY ? PROJECT IMAGE OF LOW RISK
PROMOTE PERCEPN . . COMPETENT MGT
INCREASE MGRL COMPENN
QUALITY PROMPTNESS
OF CANDOUR IN ANALYSING PAST PERFORMANCE
REPORTING MEANINGFUL DISCUSSION . . PROSPECTS
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TAXES
Taxes may be divided into two broad categories : direct
taxes and indirect taxes.
A tax is a direct tax if the impact and incidence of the tax
is on the same person. Example : Income tax
A tax is an indirect tax if the impact is on one person but
through the process of shifting the incidence is on
another. Example : Excise duty
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CORPORATE INCOME TAX
A companys taxable income is determined by taking into
account its revenues, expenses, and deductions on accountof various incentives and reliefs. The taxable income is
subject to a tax rate of 35 percent for domestic companies
and 40 percent for foreign companies.
While computing the taxable income, among other things,
bear in mind the provisions relating to the following -
depreciation, interest expense, dividend payment, dividend
income, unabsorbed business loss and depreciation,exemptions and deductions, minimum alternate tax, and
advance tax.
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CORPORATE INCOME TAX
1. Depreciation is charged on blocks of assets which
represent a group of assets within the broad class ofassets such as buildings, plant, machinery, and
furniture, for which a common rate of depreciation is
applicable.
2. While interest on borrowings is a tax-deductible
expense, dividend on share capital is not.
3. Unabsorbed business loss of any year can be carried
forward and set off against income under the head ofbusiness of subsequent years.
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CASH FLOW SUMMARY
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CASH FLOW SUMMARY
A. The cash flow identity
Cash flow from assets = Cash flow to lenders + Cash flow toshareholders
B. Cash flow from assets
Cash flow from assets = Operating cash flowNet capital spending
Change in net working capitalwhere
Operating cash flow = PBITTaxes + DepreciationCapital spending = Ending net fixed assets Beginning
net fixed assets + Depreciation
Change in net working capital = Ending net working capital
Beginning net working capital
C. Cash flow to lenders
Cash flow to lenders = Interest paidNet new borrowing
D. Cash flow to shareholders
Cash flow to shareholders = Dividends paidNet new share capital
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SUMMING UP
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SUMMING UP
The balance sheet shows the financial position (or condition) of a firm at a given
point of time. It provides a snapshot and may be regarded as a static picture.
The income statement (referred to in India as the profit and loss account) reflects
the performance of a firm over a period of time. The cash flow statement
portrays the flow of cash through the business during a given accounting period.
Assets are classified into following categories : (i) fixed assets, (ii) investments,
(iii) current assets, loans and advances, and (iv) miscellaneous expenditures and
losses. Liabilities are classified into the following categories : (i) share capital,
(ii) reserves and surplus, (iii) secured loans, (iv) unsecured loans, and (v) current
liabilities and provisions.
The important items in the profit and loss account are: (i) net sales, (ii) cost of
goods sold, (iii) gross profit, (iv) operating expenses, (v) operating profit, (vi)non-operating surplus/deficit, (vii) profit before interest and tax, (viii) interest,
(ix) profit before tax, (x) tax and (xi) profit after tax.
The important topics in finance can be keyed to the balance sheet and the profit
and loss account.
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From a financial point of view, a firm basically generates cash and spends cash.
The activities that generate cash are called sources of cash and the activities that
absorb cash are called uses of cash. Increase in owners' equity and liabilities and
decrease in assets represent sources of cash. Decrease in owners equity and
liabilities and increase in assets, on the other hand represent uses of cash.
To understand how cash flows have been influenced by various decisions, it is
helpful to classify cash flows into three categories: cash flows from operating
activities, cash flows from investing activities, and cash flows from financing
activities.
Corporate managements have discretion in influencing the occurrence,
measurement and reporting of revenue, expenses, assets and liabilities. They
may use this latitude to manage the bottom line.
Taxes can be one of the major cash outflows for a firm. The magnitude of the tax
burden is determined by the tax code, which is subject to change.
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Taxes may be divided into two broad categories: direct taxes and indirect taxes
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Taxes may be divided into two broad categories: direct taxes and indirect taxes.
A tax is referred to as a direct tax if the impact and incidence of the tax is on the
same person. Income tax, wealth tax, and gift tax are examples of direct taxes.
A tax is regarded as an indirect tax if the impact and incidence of the tax is on
different persons. Excise duty, sales tax, and customs duty are the threeimportant indirect taxes.
We have a balance sheet identity which says that the value of a firm's assets is
equal to the value of its liabilities plus the value of its equity. In the same
manner we have a cash flow identity which says that :Cash flow from assets = Cash flow to lenders + Cash flow to shareholders
C t f Fi i l M t B l