NMIMS

Subject: Financial Accounting and Analysis

Answer 1

Accounting period is the time period for which a company analyse and evaluate its financial position.
This period is the time range over which business transactions are accumulated into financial
statements and the result of which are compared by the investors over successive time period. This
concept is one of the fundamental accounting principle, applicable to both cash and accrual
accounting.

The concept of accounting period assumption is that all business can divide their financial activities
in a time period. This guideline generally allow the accountant to divide the complex, ongoing
activities of a business into a specific time period like yearly, half yearly, quarterly or monthly. The
length of time period to be considered for the financial statement generally depends on the nature
and requirement of the business. It also depends on the need of the company’s financial statement.

While explaining about the concept of the accounting period assumption to her junior, Ms.
Sandeepa should stress on the fact that accounting period assumption will help SS Enterprises to
evaluate the company’s performance in achieving the objectives during a specific period of time and
find out loop holes and scope of improvements. The users of the financial statement are in constant
need of current and reliable information to evaluate financial position of the company, which inturns
helps in making decisions and taking appropriate actions for the company. The time period even
makes it easier by dividing the activities into shorter time. For each time period, organisation
prepares and publishes set of financial statement to meet the needs of the user financial
statements.

The income statement tells the user that how profitably the company has performed during the
period and the balance sheet discloses the financial position of the business at the end of the period.
The statement of cash inflow and outflow gives the parties an idea about the portion of the
company’s profit that is distributed among owners and the portion of the profit kept for future
business growth and other purposes like meeting, debt, obligations, etc.

The accounting period assumption is very important for the management, investors, creditors,
government agencies and other users to decide on things to act on in near future. The information
facilitates the provision of latest and reliable financial information for the above mentioned parties
to make important decisions at the right time.

For example if SS Enterprise provides service of Rs. 50,000 to XYZ company for the first quarter of
the year. The XYZ company will pay for the goods in the next quarter however when SS Enterprise is
preparing the financial statements for the first quarter it has to include the revenue of Rs. 50,000
which is yet to come in its income statement of the first quarter. Another example is , if SS
Enterprise incurs an expenditure of Rs. 10,000 in the first quarter of the year however they need to
only pay it in the next quarter. On the basis of accounting period assumption SS Enterprise have to
show the expense on the income statement of the first quarter of the year.
Concept of Separate entity is an accounting concept which treats business separately from its owner.
The separate entity assumption states that the transactions which are conducted by the organisation
are absolutely separate from the ones conducted by the owner. If the owner is investing money into
some other business or buying an asset for the personal use, the investment or the asset is not
counted as the part of the organisation or the business. So in the above mentioned case, it is clear
that the business and the owner are two separate entities. In such cases, even the owner is
regarded as a creditor of the business.

To clarify it better Ms. Sandeepa can explain that when an owner makes an investment in the
business, it is assumed that the owner has given the money and the business has received the
money. And whenever the owner withdraws money from the business for personal use, the same is
considered as a different expense and not considered part of business expense. Therefore the
personal withdrawal of the cash will debited to the owner. Doing the same will require the use of
separate accounting records for the organisation that completely exclude the assets and liabilities of
any other entity or the owner. Without this concept, the records of multiple entities would be
intermingled, making it quite difficult to understand the financial or taxable results of a single
business.

For example, if Mr. Sharma is the owner of SS Enterprise and he has stared the organisation by
investing a total of Rs. 50,000. So while accounting the sum of Rs. 50,000 is treated as the capital and
it will be shown as a liability for the business to Mr. Singh. And if Mr. Singh withdraws Rs. 20,000 for
his personal use, so the amount will not be accounted as the company’s expense rather it will be
recorded as a loan to Mr. Singh.

The same can be concluded by stating that there are many advantages for the separate entity
concept. All the separate entities are taxed separately which is beneficial to the company. Separate
entity assumptions help to calculate the financial performance and financial entity of the company.
It is required to know the amount of payouts to the various owners. It is needed from a liability
perspective, to ascertain the assets available in the event of a legal judgment against a business
entity. Without the concept of separate entity assumption it would be very difficult to audit the
records of a business if the records have been combined with those of other entities or owners.

Answer 2

Market ratio states the economic status of an organisation in a marketplace. It is used to evaluate
the current share value of a publicly held company’s stock. These ratios are assessed by current and
future investors to find out if the company’s share rates are rightly priced. When an investor is
investing in a company’s share he/she must carefully analyse its financial data to find out the
company’s actual worth. The analysis can be done by generally examining the company’s profit and
loss account, balance sheet and cash flow statement. The market ratio of the company mostly is
available on the internet where customers may go and check the actual status.

There are many market ratios, however before investing Mary Kom should look into the following
types of market ratio:

1. Price Earnings Ratio (P/E Ratio): The price to earnings ratio states the number of stock that
the investors are ready to pay for each rupee of earnings. This shows that if the market is
 overvaluing or undervaluing a company. The ideal P/E ratio can be evaluated by comparing
the current P/E with the company’s previous P/E ratio, the average industry P/E ratio and
the market P/E ratio.
in short, the P/E ratio shows what the market is willing to pay today for a stock based on its
past or future earnings. Higher P/E usually indicates that the stock is overpriced. A stock that
has a lower P/E has more potential of attracting investors and rising. P/E ratios are usually
used in combination with other relevant financial ratios for informed decision making.
Price Earnings Ratio = Market Price Share/ Earnings price share
Importance of P/E ratio: It measures the amount investors are willing to pay for each rupee
earning.
2. Earnings per share: It is calculated as the reported earnings of the business, divided by the
total number of outstanding shares. It is very important for investors who are planning to
buy shares of a company. Higher earnings per share of a company indicate that the company
has a better profitability. This measurement does not reflect the market price of a
company’s shares in any way, however can be used by the investor to derive the price they
want to pay for the shares.
Though this is a very useful way to understand the company’s profile it should always be
considered in relation to other companies in order to make a more informed decisions.
Earnings per share = Net Income/ No of ordinary shares outstanding
Importance of Earnings per share: Growth in Earning per share is an important measure of
management performance because it shows how much money the company is making for
it's shareholders, not only due to changes in profit, but also after all the effects of issuance
of new shares.
3. Book Value Per Share: The book value of equity per share metric is used by the investors to
understand if the company’s share value is accurate by comparing it to the firm’s market
value per share. This is calculated as the aggregate amount of stockholder’s equity, divided
by the numbers of shares outstanding. F a company’s BVPS is higher than its market value
per share, the the stock is considered undervalue.
BVPS is the amount the share holder will receive if the firm is liquidated and all liabilities are
paid. If a company's share price falls below its BVPS a corporate raider could make a risk-free
profit by buying the company and liquidating it. If book value is negative, where a company's
liabilities exceed its assets, this is known as balance sheet insolvency.
Book value per share = Total Shareholders’ equity/ Total no of ordinary shares
Importance: It helps to measure equity per share basis.
4. Dividend Yield: The dividend yield is an important ratio for investors as it illustrates the
return on their investment. It is calculated as the total dividend paid per year, divided by the
market price of the share. A higher value indicates that the company is doing well. A lower
dividend does not always implies that the company is performing poor as companies
sometimes reinvest all the earnings, so that the share holders earn good return in long term.
This is the return on investment to investors if they were to buy the shares at the current
market price.
Dividend Yield = Dividend per share/ Market price per share
Importance: It helps in understanding the dividend earn by a share relative its market value.
5. Dividend pay-out ratio: The dividend pay out ratio is the ratio of the total amount of
dividends paid out to the shareholders relative to the net income of the company. It is the
 percentage of earnings paid to shareholders in dividends. The amount that is not paid to
shareholders is retained by the company to pay off debt or to reinvest in core operations. It
is sometimes simply referred to as the 'payout ratio’.
It provides the shareholders an indication of how much money is the company returning to
them versus how much it is keeping to reinvest in growth, pay off debt, or add to cash
reserves (retained earnings).
Dividend Payout ratio = Dividend per share/ Earnings per share
Importance: It helps the shareholder understand the percentage of earnings paid out as
dividend.

Financial ratio analysing helps n assessing important factors like efficiency, risk, profitability,
management quality and macro economic situation, however it is equally important to study
industry outlook in detail while investing in a stock. The market ratios are not always closely
watched by the organisations as they ate more concerned with running the operations. However it is
always advisable for the investor relations officer, to see the company’s performance from the
perspective of potential investors so that it is easier to keep a track the values and ratios.

Market value ratios are not applied to the shares of privately-held entities, since there is no accurate
way to assign a market value to their shares.

Answer 3 a:

The cash flow statement allows the investors to assess the performance of an organisation based on
its sources and outflows of cash and cash equivalent. It is considered as one of the most important
financial statement of an organisation.

Operating activities are the primary activities of a business. Cash flows from operating activities
includes the changes in cash due to these revenue producing activities, like sales of good as well as
expenses like purchase of goods and services and other operating expenses. It deals with major
activities of buying and selling of goods and services in the organisation. It includes important
operations like manufacturing, distributing, selling, marketing, etc.

The cash flows falling under the operating activities can be classified into:

Direct method: In this method, gross cost receipts and gross cash payments for the major items are
disclosed like all the cash received and cash paid to suppliers and employees. Under this method the
information can be gathered, from accounting records or the Profit and loss statement of the
organisation.

Cash inflows from operating activities includes receipts from the sale of goods or/and services. It
also includes cash receives from the sale of patents. Cash outflows from operating activities are
basically payments made to suppliers or salaries paid to employees.

Cash flow calculation in direct method:

Cash Flow from Operating Activities = Earnings before interest and Tax + depreciation – Taxes +/-
Change in working capital
Indirect method: In this method the company begins with net income on an accrual accounting basis
and works backwards to achieve a cash basis figure for the period. In this method of accounting the
revenue is accounted when earned and not when the cash is received.

In this method P&L account is adjusted for the following heads:

 Transaction effects of non cash nature like depreciations, amortisation, deferred taxes, loss
of sale of fixed assets and unrealised foreign exchange gains and losses.
 Changes during the period in operating receivables, payables and inventories.
 Any other item for which cash effects are shown.

Cash flow calculation in indirect method:

Cash Flow from Operating Activities = Net Income + Depreciation, Depletion, & Amortization +
Adjustments To Net Income + Changes In Accounts Receivables + Changes In Liabilities + Changes In
Inventories + Changes In Other Operating Activities

Both the methods yield the same value.

Examples of cash flows from operating activities include:

 Cash paid to vendors and suppliers

 Salaries paid out to employees
 Income tax paid and interest paid
 Cash collected from customers from the sale of products or services.
 Interest income and dividends received
 Cash received from royalties, fees, commissions, etc.
 Cash receipts from an insurance enterprise for premiums and claims or any other benefits.

From the workings of Britannia Baby Company, cash flow falling under operational activities are:

1. Depreciation charged on Tangible assets

Reason: Tangible asset purchased for operations of the business. It’s non cash expense
2. Stock sold for the year
Reason: Cash generated from the sale of goods.
3. Interest received from Big Boy company.
Reason: Because it is related to net income
4. Dividend received from Arvind Mills.
Reason: It’s also related to net income
5. Taxes Paid for the year
Reason: It’s paid on operating income

Answer 3 b:

Cash flows from investing activities are another important section of cash flows that reports the
amount of cash spent on various investment activities for a mentioned period of a time. In addition
to analysing the positive and negative cash flows from investing activities, it is also important to
assess where the company’s investment activity falls in the financial statement. The three financial
statements that are used to assess the cash flow of the organisations are: the balance sheet, income
statement and cash flow statement.

The balance sheet provides an overview of a company's assets, liabilities, and owner's equity as of a
specific date. The income statement provides an overview of company revenues and expenses
during a period. The cash flow statement bridges the gap between the income statement and the
balance sheet by showing how much cash is generated or spent on operating, investing, and
financing activities for a specific period.

The importance of assessing the cash flow is that it helps the users to understand if the company is
investing in right resources which will help in increasing profit in future or is it spending cash on
resources that company already owns. If the cash flow is negative, it indicates company’s poor
performance. The cause for negative cash flow might be due to significant amount of cash invested
in research and development or other long term health of the company.

Investment activities are important aspect of growth and capital. Activities like purchase of physical
assets, investment in securities or the sale of assets/securities are considered to be investment
activities. Capital expenditure is also part of investment activity and it is popular measure used in
valuation of stocks. It also provides details of cash flow related to acquisition and disposal of
company’s long term investments like property, plant and investment in equipments.

These activities include money spent on long-term assets, shares, debentures etc.

Cash inflow from investment activities includes:

 Sale of assets
 Interest on loans and cash received from the advances given to third parties
 Cash receipts received on the investment made in the other companies or firms.
 Receipts received on trading of shares, debentures, bonds etc.

Cash outflow from investment activities include:

 Cash payments on purchasing long-term assets and other intangible goods like patents.
 Payments made on acquiring of other company shares, debentures and other debt issues.
 Advances and loans given to third parties.

From the workings of Britannia Baby Company, cash flow falling under investment activities are:
1. Purchase of Tangible assets
Reason: Related to non current assets
2. Loan given to Big Boy Company
Reason: It’s an investment activity from which company will receive interest.
3. Share purchased of Arvind Mills
Reason: Investment activity for long term period.