Statement of Cash Flows

 Usefulness of the Statement of Cash Flows

The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from
operating, investing, and fi nancing activities during a period. The information in a statement of cash fl ows should help
investors, creditors, and others assess:

1. The entity’s ability to generate future cash flows.

2. The entity’s ability to pay dividends and meet obligations.
3. The reasons for the difference between net income and net cash provided (used) by operating activities.
4. The cash investing and fi nancing transactions during the period.

 Classification of Cash Flows

1. Operating activities include the
cash effects of transactions that
create revenues and expenses. They
thus enter into the determination
of net income.
2. Investing activities include
(a) acquiring and disposing of
investments and property, plant,
and equipment, and (b) lending
money and collecting the loans.
3. Financing activities include
(a) obtaining cash from issuing debt
and repaying the amounts
borrowed, and (b) obtaining cash
from stockholders, repurchasing
shares, and paying dividends.
  Format of the Statement of Cash Flows
 Preparing the Statement of Cash Flows
The information to prepare this statement usually
comes from three sources:
*Comparative balance sheets. Information in the
comparative balance sheets indicates the amount of
the changes in assets, liabilities, and stockholders’
equities from the beginning to the end of the
period.
*Current income statement. Information in this
statement helps determine the amount of cash
provided or used by operations during the period.
*Additional information. Such information includes
transaction data that are needed to determine how
cash was provided or used during the period.

 Indirect and Direct Methods

A company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of
two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for “Net
cash provided by operating activities.” They differ in how they arrive at the amount.

1. The indirect method adjusts net income for items that do not affect cash. A great majority of companies (99%)
use this method, as shown in the chart on the left.1 Companies favor the indirect method for two reasons: (1) It
is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow
from operating activities.
2. The direct method shows operating cash receipts and payments, making it more consistent with the objective of
a statement of cash flows. The FASB has expressed a preference for the direct method but allows the use of
either method.

 Preparing the Statement of Cash Flows—Indirect Method

  Using Cash Flows to Evaluate a Company
Free Cash Flow - describes the cash remaining from operations after adjustment for capital expenditures and
dividends. The measurement of free cash flow provides additional insight regarding a company’s cash-
generating ability.

Gross Profit Variance Analysis

One technique in the analysis of Financial Statement, Gross Profit Variance Analysis is used to compare actual
data (represented here by 200B) with budgeted data, standard data, previous year's data, or base year data
(represented here by 200A).
Normally, these involves the Sales Variance and the Cost variance in consideration of the price and volume or
quantity factors.

Four types:
1.) 4-WAY ANALYSIS
Sales Variance:
Price factor = difference in selling prices x 200B units
Volume or quantity factor = difference in units x 200A selling price
Cost Variance:
Price factor = difference in cost prices x 200B units
Volume or quantity factor = difference in units x 200A cost price

2.) 6-WAY ANALYSIS

Sales Variance:
Price factor = difference in selling prices x 200A units
Volume or quantity factor = difference in units x 200A selling price
Price-Volume factor = difference in selling prices x difference in units
Cost Variance:
Price factor = difference in cost prices x 200A units
Volume or quantity factor = difference in units x 200A cost price
Price-Volume factor = difference in cost prices x difference in units

3.) 3-WAY ANALYSIS

Price factor = difference in selling prices x 200B units
Cost factor = difference in cost prices x 200B units
Volume or quantity factor = difference in units x 200A gross profit per unit
4.) 4-WAY ANALYSIS, PLUS - for two or more products

Sales Mix Variance:

200B units @ 200A sales price xx
Less 200B units @ 200A cost price xx
Difference xx
Less 200B units @ 200A average
xx
gross profit per unit
Sales Mix Variance xx

Final Sales Volume Variance:

200B units @ 200A average
xx
gross profit per unit
Less 200A gross profit xx
Final Sales Volume Variance xx

Gross profit analysis is designed to pick apart the reasons why the gross profit margin changes from period to period, so
that management can take steps to bring the gross margin in line with expectations. A decline in gross profits can be an
indicator of serious problems, so the figure is closely watched. Gross profit is calculated as:

Gross profit = Sales - direct materials - direct labor - manufacturing overhead

A change in gross profit can be caused by any of the following events:

 Sales prices have changed
 The unit volume of items sold have changed
 The mix of products sold has changed (which alters the gross profit if different products have different gross
margins)
 The purchase price of direct materials have changed
 The amount of direct materials required has changed, which in turn can be due to:
o Altered scrap levels
o Altered spoilage levels
o Altered amounts of rework
o Changes in the design of the product
 The amount of direct labor has changed, due to altered efficiency levels
 The cost of direct labor has changed, which in turn can be due to:
o Altered overtime levels
o Changes in the mix of employees having different pay rates
o Changes in the amount of shift differentials paid
o Changes in the equipment used
o Changes in the design of the product
 The amount of fixed overhead incurred has changed
 the amount of variable overhead incurred has changed
 The preceding list is not comprehensive, since gross profit analysis may also uncover problems in such as areas as
late or double-counted inventory, incorrect units of measure, and theft. Also, the broad scope of this list of events
should make it clear that controlling gross margin requires the input of many parts of a business, including the
engineering, materials management, sales, and production departments.

A gross profit analysis involves comparing the gross profit for the period being reviewed to either the budgeted level
or the historical average. If you are using standard costing, then you can use any of the standard cost variance formulas
for gross profit analysis, which are:
 Purchase price variance. The actual price paid for materials used in the production process, minus the standard
cost, multiplied by the number of units used
 Labor rate variance. The actual price paid for the direct labor used in the production process, minus its standard
cost, multiplied by the number of units used.
 Variable overhead spending variance. Subtract the standard variable overhead cost per unit from the actual
cost incurred and multiply the remainder by the total unit quantity of output.
 Fixed overhead spending variance. The total amount by which fixed overhead costs exceed their total standard
cost for the reporting period.
 Selling price variance. The actual selling price, minus the standard selling price, multiplied by the number of
units sold.
 Sales volume variance. The actual unit quantity sold, minus the budgeted quantity to be sold, multiplied by the
standard selling price.
 Material yield variance. Subtract the total standard quantity of materials that are supposed to be used from the
actual level of use and multiply the remainder by the standard price per unit.
 Labor efficiency variance. Subtract the standard quantity of labor consumed from the actual amount and
multiply the remainder by the standard labor rate per hour.
 Variable overhead efficiency variance. Subtract the budgeted units of activity on which the variable overhead is
charged from the actual units of activity, multiplied by the standard variable overhead cost per unit.

If you are not using standard costs, you can still use the preceding variances, except that you use budgeted or
historical cost information as the baseline, rather than standard costs.

The gross profit analysis reported to management should describe the total variance from expectations, and then
itemize the exact reasons for the differences. The report should contain actionable items, so that management can
identify specifically what is wrong and proceed to fix it. An even better gross profit analysis is one that clusters identified
problems into categories and shows the frequency of occurrence of the categories over time. Doing so shows
management which problems are causing the most trouble on a repetitive basis, and which are therefore most worthy
of attention.

While gross profit analysis is important, it only covers product-related costs. Thus, if you want a comprehensive
review of all aspects of a company's financial results, you must also evaluate all costs of selling and administration, as
well as all financing and other non-operational expenses.

Gross profit analysis also ignores the amount of investment in working capital and fixed assets in proportion to sales.
That is, it does not account for the efficiency of asset usage in creating gross profits.
 Financial Ratios

Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful
information about a company. The numbers found on a company’s financial statements – balance sheet, income
statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity,
leverage, growth, margins, profitability, rates of return, valuation, and more.

Financial ratios are grouped into the following categories:

 Liquidity ratios
 Leverage ratios
 Efficiency ratios
 Profitability ratios
 Market value ratios
 Solvency Ratios

 Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations.
Common liquidity ratios include the following:

The current ratio measures a company’s ability to pay off short-term liabilities with current assets:

Current ratio = Current assets / Current liabilities

The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash
generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

 Leverage Financial Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used
to evaluate a company’s debt levels. Common leverage ratios include the following:

The debt ratio measures the relative amount of a company’s assets that are provided from debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

 Efficiency Ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets
and resources. Common efficiency ratios include:

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Total assets

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given
period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratio measures the average number of days that a company holds on to inventory before
selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

 Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating
costs, and equity. Common profitability financial ratios include the following:

The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company
makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratio compares the operating income of a company to its net sales to determine operating
efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratio measures how efficiently a company is using its assets to generate profit:

Return on assets ratio = Net income / Total assets

The return on equity ratio measures how efficiently a company is using its equity to generate profit:

Return on equity ratio = Net income / Shareholder’s equity

 Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the
following:

The book value per share ratio calculates the per-share value of a company based on equity available to shareholders:

Book value per share ratio = Shareholder’s equity / Total shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per
share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share

 Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time. Long-term creditors and
stockholders are particularly interested in a company’s ability to pay interest as it comes due and to repay the face value
of debt at maturity. Debt to total assets and times interest earned are two ratios that provide information about debt-
paying ability.

The debt to total assets ratio measures the percentage of the total assets that creditors provide.

Debt to Total Assets Ratio = Total Debt / Total Assets

Times interest earned provides an indication of the company’s ability to meet interest payments as they come due.

Times Interest Earned = Income before Income Taxes and Interest Expense / Interest Expense
DuPont Analysis
The Dupont analysis also called the Dupont model is a financial ratio based on the return on equity ratio that is used to
analyze a company’s ability to increase its return on equity. In other words, this model breaks down the return on equity
ratio to explain how companies can increase their return for investors.

The Dupont analysis looks at three main components of the ROE ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage
Based on these three performances measures the model concludes that a company can raise its ROE by maintaining a
high profit margin, increasing asset turnover, or leveraging assets more effectively.

FORMULA:
 Working Capital Finance
Basic definitions and concepts.

1. Working capital, sometimes called gross working capital, simply refers to current assets used in operations.

2. Net working capital is defined as current assets minus all current liabilities.

 Current Assets – reasonably expected to be realized in cash or consumed or sold during the normal operating
cycle of the business. These include cash, marketable securities, receivables and inventory.
 Temporary Current Assets – current assets that fluctuate with the firm’s operational needs.
 Permanent Current Assets – the portion of the company’s current assets required to maintain the firm’s
daily operations; the minimum level of current asset required if the firm is to continue its operations.
 Current Liabilities – their liquidation requires the use of current assets or incurrence of other current liabilities.
They include trade accounts payable, unearned revenues, accrued expenses, short-term debt, and the current
portion of long-term debts.