BY ONYEIWU CHARLES,DEPARTMENT OF FINANCE,UNILAG

FINANCIAL STATEMENT ANALYSIS

Introduction
This section examines a very important document in financial reporting. Inability to
analyze the financial statements is the reason for massive loss which some investors
encounter. Financial statement provides sight on the health of an Organization and
with it, it is possible to detect when performance is deteriorating or when an
Organization performance is below industrial average or that of competition.

Financial statement:
One of the most important documents to stakeholders in the corporate world is the financial
statement. It is also referred as annual report or audited accounts.
Financial statement is a quantitative and qualitative statement of the operations and performance
of an Organization for a specific time usually one year and it’s component include:

(1) Report of directors

(2) Auditors report
(3) Statement of financial position (Balance sheet)
(4) Income Statement (Profit and Loss Account)
(5) Notes to the Financial Statement
(6) Statement of cash flows
(7) Statement of Accounting policies and notes
(8) Five years financial summary
(9) Statement of value added
(10) Statutory declaration by officers of the organization.
USERS OF FINANCIAL STATEMENT
The users of the financial statement can be classified as follows:
(1) A shareholder or Prospective Investors: the shareholder requires the financial
statement to ascertain how well his investment is doing. He is able to do this by
calculating the profitability ratios to see if profit is as high as the competitor
and/or if it is moving up or slowing down.
(2) Government and its agencies: government requires financial statement to be able raise
appropriate tax assessment, grant tax reliefs and assess the social impact of operation.
(3) Lenders & Creditors; the creditor uses the financial statement to assess how
liquid, levered, profitable and risky an Organization is.
(4) Employees; they use it as basis to negotiate salary increases based on profit-Performance
and to measure their productivity.
(5) Customers; A customer is interested in an organization that can provide quality product
and services at a fair price and also provide credit facilities.
(6) Management; it is entrusted the responsibility to properly utilize the resources of the
organization to increase wealth of owners and the financial statement gives indication of
how successful it is.

FRAMEWORK FOR ANALYSING FINANCIAL STATEMENT

The financial statement can be analyzed using any or a combination of the following
techniques/methods:
(1) Time Series Method; (Also known as trend Analysis). This helps identify financial
trends over time for a single company. The analysis may identify the rate of growth
of turnover, earning per share or dividend per share.

E.G.
U.B.E PLC
Data is ROE
Years A B C
2000 20% 30% 30%
2001 25% 27% 30%
 2002 27% 25% 30%
2003 30% 20% 30%
The above analysis shows different scenarios , A, reflects a progressive performance,
B, a deteriorating performance and C, a stagnant one.

(2) Cross sectional method (industrial average); This is used to identify similarities or
differences across businesses within a point in time. An analyst may compare the 2018
performance with that of its major competitors.

Item is ROE in 2018

Firm ROE
U.B.A PLC 30%
Union bank 27%
Zenith 32%
From the above analysis , Zenith, outperformed the other Organizations

(3) The peer group method; this entails analyzing firms with the same pedigree or history.
Eg.

Item is ROE in 2019

Firm ROE
U.B.A PLC 30%
Union bank 27%
First bank 31%

.
FINANCIAL RATIOS. Tool for analyzing financial statement is called the financial ratio.
A financial ratio is used for evaluating company's profit performance and assessing credit risk.
There are different kinds of ratios and some of them would be examined as follows:
- Profitability or efficiency ratios
- Liquidity ratios
- Activity ratios
- Leverage or solvency ratio
- Market value ratios

.Profitability or Efficiency ratio:

Thi ratios sometimes also known as performance ratios are used to measure how the
resources have been used to create wealth and some of them include,

(i) Return on asset (ROA).

ROA = profit before interest and tax

. total assets

(ii) Sales to total asset or sales to asset ratio

= Sales
Average total asset

This ratio shows how efficiently a firm's assets are being utilized. From the equation above, a
company that intends to increase its rate of return may do it in two ways, by increasing its
operating profit margin or by increasing the intensity of asset utilization which is reflected in
the equation below.

NOPAT NOPAT x Sales

Total Asset = Sales Total Assets
 = Operating Profit x Asset
Margin Turnover

(iii)Gross Profit Margin = Sales - Cost of goods sold = Gross profit * 100
Sale Sales

Gross profit margin shows the efficiency with which management produces each unit of output.

(iv)Net Profit Margin = Profit after tax * 100

Sales
Net profit margin shows management efficiency in manufacturing, Administering and selling the
product. A firm with high net profit margin may be able to withstand falling selling prices,
declining demand for the product and rising production cost.

v. Return on Equity (ROE)

ROE = Profit after tax

Net worth or shareholders fund

Note (Net worth = Total Assets - Total Liabilities)

It indicates how well the firm is utilizing the resources of the owners of business in earning a
satisfactory return consistent with the objective of wealth maximization.

(vi) Return on capital employed (RCE) = Profit before Interest and Tax
Capital employed
Capital employed = total asset - current liabilities

All these are used to determine the profitability of a company.

LIQUIDITY: It refers to the company's ability to generate cash from floating assets and
immediate debt repayment. Ratios for measuring liquidity include:

(1) Current Ratio = Current Asset

Current liability

Current asset include cash, account receivable (debtor) and stock or account receivable is one step to
cash, inventory is two steps and can turn - to cash by:
i. Being sold usually on credit.
ii. The Credit being collected, this may not allow immediate
settlement of matured obligation, and may lead to low credit rating, loss of creditors or
some legal battle that could lead to closure. This situation leads to the use of quick ratio as a
better measure of liquidity.

(iii) Quick ratio/Acid test = Current asset - Stock

Current liability

Current ratio of 2:1 and quick ratio, of 1 : 1 are considered adequate. Excessive cash may result in
Loss of profitable opportunity and too little of it is a threat to survival.
 iii. Cash Ratio: Cash is the most liquid financial Asset and an analyst may wish to compare
cash balance with outstanding current liability. In this case all outstanding marketable
securities will be added to the cash balance.

Cash Ratio = Cash + Marketable Securities

Current Liability
If this ratio is low but the company has outstanding overdraft facility. It has nothing to worry
about.

Activity Ratio: this ratio indicates how efficiently an organization is using its asset and
can highlight causes of operating cash flow mismatch.

Account receivable turnover ratio is an activity ratio that can help an analyst to determine whether
receivable are excessive when compared with the existing level of credit sales.

Liquidity of an organization is affected by quality of debtors and

three ratios are used to judge this (a) Account Receivable turnover (b) collection period (c) Ageing
schedule of debtors.

Account Receivable turnover = Net Credit sales

Average account Receivable

360 days
Collected period = Account Receivable Turnover

= Average account Receivable x 360

Net Credit sales
Collection period indicates the quality of debtors because it shows the speed of collection. The shorter
the time the better is the quality. This ratio should be compared with firm’s credit terms and policy.
An excessive long collection period indicates a liberal and inefficient credit recovery performance. This
delays receipt of cash and increases the chance of loss through bad debt. Too short collection period may
restrict sales and also reduce profit.

Inventory Turnover Ratio: This is another activity ratio which shows how effectively inventory is
managed. High inventory turnover is indicative of good inventory management. Slow inventory, ties
up funds, reduces profit and increases holding cost.

High inventory turnover may also show that average inventory is low which many lead to stock-
out.
Inventory turnover = Cost of good sold
Average inventory

Account Payable Turnover Ratio: Accounts payable and day payable outstanding counterpart
helps the analyst to understand the company pattern of payment to suppliers.

Account Payable Turnover = Inventory Purchases

Average account payable

Average account payable x 360

day account payable will be = Inventory Purchase

C. Leverage Ratios
Long Term Solvency: A firm should generate a stream of cash inflows to maintain its productive
activities and still pay interest and principal amounts when due. Leverage refers to the level of the
organization's financial leverage (the proportion of debt in the capital structure). The leverage
ratios measure the level of debt in the financing mix or capital structure or/and the ability of such
organization to pay interest and principal from cash flows when due.
However, the higher the debt ratio the higher the solvency risk. The common Leverage ratios are:

debt ratio = Long term debt

Total assets

(b) Long-term debt to tangible asset = Long term debt.

Tangible asset.

(c) Debt-Equity Ratio = Total Debt/Networth

Suppose a company has NI0m of outstanding long term debt and N120m of total asset of which N3m
are made up of Intangible asset like goodwill, patent, trademarks and copy right. The two debt ratios
will be

Long term debt ratio = Long term debt = 10

Total asset 120 = 0.083 or 8.2%

Long term to tangible asset = 10

120 - 5 = 10.
115 = 0.087 or 8.7%

(d) Interest coverage: (times interest earned)

= Profit before Interest and tax.

 Interest expenses

This ratio indicates how many times interest expenses are covered by operating profit before
interest and tax. It indicates the ability of a company to generate cash flow to pay interest and
principal amount

(D) MARKET VALUE RATIOS

(a) Return on Equity = Earning Per Share

Price Per Share

This shows the return on shareholder investment in the business and gives a clear indication of how
efficiently the shareholder’s fund is being utilized.

(b) Dividend Per Share = Dividend paid

Number of Share
This shows dividend for every unit of share held and enables the shareholder compare the unit of
shares of different companies to access which one has superior performance.

(c) Pay Out Ratio = Dividend Per Share

Earning Per Share
The pay Out Ratio shows the fraction of the Earnings which is paid as dividend and the fraction
retained

SUMMARY
This section examined the Financial Statement which is a very important financial document to diverse
stakeholders. The section covers the meaning, components, users and techniques of analyzing financial
statements and finally it examined the use of financial ratio which is a well accepted tool to gauge the
financial health and performance of an organization. However, financial ratio has the following
limitations.
- Inflation makes the ratio meaningless
- The ratio calculated at one point in time is limited as a basis of decision because of
continuous changes in situation
- They are usually calculated from past performance and may not readily represent the future
reality.
- Comparison may be rendered futile because of differences in two companies or one company
overtime.
- It is difficult to decide on proper basis of comparison.

SELF –TEST

1. i. Examine the meaning and components of Financial statement

ii. Examine with quantitative illustrations the techniques for analyzing Financial
statements

2. Irewole plc is a retail out-let into importation and retail of USB cables . It started business
with capital of N2.0 million consisting of 50 percent equity and 50 percent debt . It has
1 million shares, 60 percent pay out ratio and interest payable on debt is 12 percent. In
each month of 2020 , 8000 units of cables were purchased at a rate of N50 and sold at a
 rate of N75. The monthly wage bill was 10 percent of sales and in January,2021, 1200
units of the cables were yet to be sold. Term of sales was 50% cash on sales, 30% a
month after and balance subsequent month while term of purchase is 60% 0n purchase
and balance paid two months after. Other information include rent that rent was
N250,000 transport was N340,000 and maintenance was N435,000. You are required to
calculate
i. Gross profit margin
ii. Net profit margin
iii. Return on equity
iv. Return on investment
v. Times interest earned
vi. Dividend per share
Vii. Current ratio
vii. Acid test

3. Critical examine the users of Financial Statement and what interest it is to them
REFERENCES
(1) I.M. Pandey: Financial Management: Vikas Publishing House PVT Ltd Eight
Edition.

(2) Richard A. Breadley & Stewart c Myers. Principles of

Corporate Finance McGraw-Hill Company Inc.

(3) Lawrence Revsine et al Financial Reporting & Analysis

Prentice Hall Upper Saddle River, New Jersey.
 BY ONYEIWU CHARLES,DEPARTMENT OF FINANCE,UNILAG
COURSE TITLE: BUSINESS FINANCE 2
COURSE CODE: FIN320
TITLE OF MODULE: BUSINESS FINANCE
TITLE OF THE UNIT: FINANCIAL STATEMENT ANALYSIS 2(CASHFLOW
STATEMENT)
UNIT NUMBER: 10
OBJECTIVE OF UNIT:
This module aims at,
 Exposing reader to the concept of Cash Flow Statement
 Guiding reader to appreciate the relevance of Cash Flow Statement in management
 Imparting knowledge and skill in preparation of this important document
 Building the confidence of reader to be able to discuss the topic intelligibly

1.0 Intrduction
The importance of cash in an Organization can not be over emphasized as cash is very important
for smooth running of every Organization. In literature, the role of cash has effectively been
discussed both by the classical and keynesian economists and they agree that cash is needed for
transactionary. precautionary and speculative motives. This module emphasizes the role of cash
in facilitating transaction and meeting business needs. Cash flow Statement is a statement of
changes in financial position on cash basis and summarizes the cause of changes in cash position
between two balance sheet dates.

2.0 Components and Benefits

A cash flow statement, along with the balance sheet and income statement, are the three most
common financial statements used to gauge a company’s performance and overall health. The
same accounting data is used in preparing all three statements, but each takes a company’s pulse
in a different area.
The cash flow statement discloses how a company raised money and how it spent those funds
during a given period. It is also an analytical tool, measuring an enterprise’s ability to cover its
expenses in the near term. Generally speaking, if a company is consistently bringing in more
cash than it spends, that company is considered to be of good value.

A cash flow statement is divided into three parts: operations, investing and financing. The
following is an analysis of a real-world cash flow statement belonging to Target Corp. Note that
all figures represent millions of naira.

A typical cash flow statement is divided into three parts: cash from operations (from daily
business activities like collecting payments from customers or making payments to suppliers and
employees); cash from investment activities (the purchase or sale of assets); and cash from
financing activities (the issuing of stock or borrowing of funds). The final total shows the net
increase or decrease in cash for the period.

Cash flow statements facilitate decision making by providing a basis for judgments concerning
the profitability, financial condition, and financial management of a company. While historical
cash flow statements facilitate the systematic evaluation of past cash flows, projected (or pro
forma) cash flow statements provide insights regarding future cash flows. Projected cash flow
statements are typically developed using historical cash flow data modified for anticipated
changes in price, volume, interest rates, and so on.

To enhance evaluation, a properly-prepared cash flow statement distinguishes between recurring

and nonrecurring cash flows. For example, collection of cash from customers is a recurring
activity in the normal course of operations, whereas collections of cash proceeds from secured
bank loans (or issuances of stock, or transfers of personal assets to the company) is typically not
considered a recurring activity. Similarly, cash payments to vendors is a recurring activity,
whereas repayments of secured bank loans (or the purchase of certain investments or capital
assets) is typically not considered a recurring activity in the normal course of operations.

In contrast to nonrecurring cash inflows or outflows, most recurring cash inflows or outflows
occur (often frequently) within each cash cycle (i.e., within the average time horizon of the cash
cycle). The cash cycle (also known as the operating cycle or the earnings cycle) is the series of
transactions or economic events in a given company whereby:

1. Cash is converted into goods and services.

2. Goods and services are sold to customers.
3. Cash is collected from customers.

To a large degree, the volatility of the individual cash inflows and outflows within the cash cycle
will dictate the working-capital requirements of a company. Working capital generally refers to
the average level of unrestricted cash required by a company to ensure that all stakeholders are
paid on a timely basis. In most cases, working capital can be monitored through the use of a cash
budget.

ADDITIONAL BENEFITS

In his book, Buy Low, Sell High, Collect Early, and Pay Late: The Manager's Guide to Financial
Survival, Dick Levin suggests the following benefits that stem from cash forecasting (i.e.,
preparing a projected cash flow statement or cash budget):

1. Knowing what the cash position of the company is and what it is likely to be avoids
embarrassment. For example, it helps avoid having to lie that the check is in the mail.
2. A firm that understands its cash position can borrow exactly what it needs and no more,
there by minimizing interest or, if applicable, the firm can invest its idle cash.
3. Walking into the bank with a cash flow analysis impresses loan officers.
4. Cash flow analyses deter surprises by enabling proactive cash flow strategies.
5. Cash flow analysis ensures that a company does not have to bounce a check before it
realizes that it needs to borrow money to cover expenses. In contrast, if the cash flow
analysis indicates that a loan will be needed several months from now, the firm can turn
down the first two offers of terms and have time for further negotiations.

3.0 Cash Flow Statement Preparation and model

Basically Cash Flow Statement indicates the sources and uses of cash as follows:
Sources and Uses of cash in an Organization

The sources of cash include:

 Profit from operation
 Decrease in assets ( except cash)
 Increase in liabilities ( including debenture and bond) and
 Sales proceed from ordinary or preference share issue

The uses of cash are:

 The loss from operation
 Increase in assets(except cash)
 Decrease in liabilities (including redemption of debenture or bond)
 Redemption of redeemable preference shares, and
 Cash dividend

Uses Of Statement of Changes In Financial Position

The above is useful not only for analytical value but also as a planning tool. It gives indication of
cause of changes in financial position or cash flow and indicates the financial and investment
policies adopted by the Organization in the past. The statement reveals the non current assets that
have been acquired by the Organization and if it is acquired from internal or external sources.
The statement helps to answer the following questions(Pandey 2001)

 What is the liquidity position of the firm?

 What are the causes of changes in the firm’s working capital or cash position?
 Did the firm pay dividend to its shareholders or not, was it because of shortage of funds
or cash?
 What fixed asset are acquired by the firm?
  How much of the firm’s working capital needs were met by the funds generated from
current operations?
 Did the firm use external sources of finance to meet its need of fund?
 If the external financing was used, what ratio of debt and equity was maintained?
 Did the firm sell any of its non current assets? if so, what were the proceed from such
sales?
 Could the firm pay its long term debt as per schedule?
 What were the significant investment and financing activities of the firm which did not
involve working capital?

USING HYPOTHETICAL FINANCIAL STATEMENT TO ANALYZE THE CASH

FLOW STATEMENT

The information below consists of the comparative balance Sheet of Ajayi PLC as at 31st
December, 2010 and 2009 and Profit and Loss Accounts for the year ended 31st December,
2010. The following additional information are provided

1.during the year plant costing N40000(accumulated depreciation N15000) was sold

2.Debenture of N25000 were converted to share capital at par

3.The company declared a cash dividend of N30000 and Bonus share of N15000 during the
year
4.The company issued 4000 additional shares, at N8 per share, at a premium of N1.50 per
share during the year

AJAYI PLC

COMPARATIVE BALANCE SHEETS N N N

For the year ended 31st December 2010 2009 Change

Current Assets

Cash 60000 40000 (+) 20000

Debtors 30000 35000 (-) 5000

Inventory 115000 70000 (+) 45000

Total Current Assets 205000 145000 (+) 60000

Fixed Assets

Land and building 140000 90000 (+) 50000

Plant and machinery 210000 190000 (+) 20000

Less accumulated depreciation (40000) ( 38000) (-) 2000

Total net fixed assets 310000 242000 (+) 68000

Total Assets 515000 387000 (+) 128000

Current Liabilities
C reditors 10000 15000 (-) 5000

Salaries payable 10000 5000 (+) 5000

Provision for tax 60000 70000 (-) 10000

Provision for dividend 30000 30000 -

Total Current Liabilities 110000 120000 (-) 10000

Long term liabilities

Institutional loans 30000 22000 (+) 8000

Debentures 95000 120000 (-) 25000

Total long term liabs 125000 142000 (-) 17000

Total Liabs 235000 262000 (-) 27000

Shareholders Equity

Share Capital 147000 75000 (+) 72000

Share premium 21000 15000 (+) 6000

Reserve and Surplus 1120000 35000 (+)77000

Net worth 280000 125000 (+) 155000

Total Fund 515000 387000 (+) 128000

 Profit and Loss account

For the year ended 31st, December,2010 N

Sales 450000

Less: Cost of goods sold 195000

GP 255000

Less: Operating expenses

Office and administrative 35000

Selling and distribution 17000

Interest 9000

Depreciation 17000 78000

Operating profit 177000

Add gain on sales of assets 8000

Profit before tax 185000

Less tax liabilities 630000

Net Profit 122000

Statement of Cash from operation

N N

Net Profit 122000

Add depreciation 17000

Decrease in debtors 5000

Increase in salaries payable 5000 149000

Less gains from sales of assets 8000

Increase in inventory 45000

Decrease in creditors 5000

Decrease in tax provision 10000 68000

Cash from operation 81000

 Cash Flow Statement

For the year ended 31st December 2010

Sources N N

Cash from operation 81000

Sales of plant 33000

Institutional loan 8000

Issuance of equity shares 38000

Cash provided 160000

Uses

Purchase of land and building 50000

Purchase of plant and machinery 60000

Payment of cash dividend 30000

Cash applied 140000

Increase in Cash 20000

Cash from operations: This is cash that was generated over the year from the company’s core
business transactions. Note how the statement starts with net earnings and works backward,
adding in depreciation and subtracting out inventory and accounts receivable. In simple terms,
this is earnings before interest and taxes (EBIT) plus depreciation minus taxes.

Interpretation :This may serve as a better indicator than earnings, since noncash earnings can’t
be used to pay off bills.

Cash from investing: Some businesses will invest outside their core operations or acquire new
companies to expand their reach. Basically investment in this case consists of acquisition of new
plants and machines of N60000

Interpretation: This portion of the cash flow statement accounts for cash used to make new
investments, as well as proceeds gained from previous investments.

Cash from financing: This last section refers to the movement of cash from financing activities.
Two common financing activities are taking on a loan or issuing stock to new investors.
Dividends to current investors also fit in here.

Interpretation: Investors will like these last two items, since they reap the dividends, and it
signals that Target is confident in its stock performance and wants to keep it for the company’s
gain. A simple formula for this section: cash from issuing stock minus dividends paid, minus
cash used to acquire stock.

The final step in analyzing cash flow is to subtract the cash balances from the reporting year
(2010) and the previous year (2009); in Target’s case that’s N60000 plus minus N40000, which
equals N20000. This gives a positive cash balance.

Cash flow analysis is a method of analyzing the financing, investing, and operating activities of a
company. The primary goal of cash flow analysis is to identify, in a timely manner, cash flow
problems as well as cash flow opportunities. The primary document used in cash flow analysis is
the cash flow statement. Since 1988, the Securities and Exchange Commission (SEC) has
required every company that files reports to include a cash flow statement with its quarterly and
annual reports. The cash flow statement is useful to managers, lenders, and investors because it
translates the earnings reported on the income statement—which are subject to reporting
regulations and accounting decisions—into a simple summary of how much cash the company
has generated during the period in question. "Cash flow measures real money flowing into, or out
of, a company's bank account," Harry Domash notes on his Web site, WinningInvesting.com.
"Unlike reported earnings, there is little a company can do to overstate its bank balance."

4.0 Cash Flow Statement And Other Related Management Courses

THE CASH BUDGET

In contrast to cash flow statements, cash budgets provide much more timely information
regarding cash inflows and outflows. For example, whereas cash flow statements are often
prepared on a monthly, quarterly, or annual basis, cash budgets are often prepared on a daily,
weekly, or monthly basis. Thus, cash budgets may be said to be prepared on a continuous rolling
basis (e.g., are updated every month for the next twelve months). Additionally, cash budgets
provide much more detailed information than cash flow statements. For example, cash budgets
will typically distinguish between cash collections from credit customers and cash collections
from cash customers.

A thorough understanding of company operations is necessary to reasonably assure that the

nature and timing of cash inflows and outflows is properly reflected in the cash budget. Such an
understanding becomes increasingly important as the precision of the cash budget increases. For
example, a 360-day rolling budget requires a greater knowledge of a company than a two-month
rolling budget.

While cash budgets are primarily concerned with operational issues, there may be strategic issues
that need to be considered before preparing the cash budget. For example, predetermined cash
amounts may be earmarked for the acquisition of certain investments or capital assets, or for the
liquidation of certain indebtedness. Further, there may be policy issues that need to be considered
prior to preparing a cash budget. For example, should excess cash, if any, be invested in
certificates of deposit or in some form of short-term marketable securities (e.g., commercial
paper or U.S. Treasury bills)?

Generally speaking, the cash budget is grounded in the overall projected cash requirements of a
company for a given period. In turn, the overall projected cash requirements are grounded in the
overall projected free cash flow. Free cash flow is defined as net cash flow from operations less
the following three items:

1. Cash used by essential investing activities (e.g., replacements of critical capital assets).
2. Scheduled repayments of debt.
3. Normal dividend payments.

If the calculated amount of free cash flow is positive, this amount represents the cash available to
invest in new lines of business, retire additional debt, and/or increase dividends. If the calculated
amount of free cash flow is negative, this amount represents the amount of cash that must be
borrowed (and/or obtained through sales of nonessential assets, etc.) in order to support the
strategic goals of the company. To a large degree, the free cash flow paradigm parallels the cash
flow statement.

Using the overall projected cash flow requirements of a company (in conjunction with the free
cash flow paradigm), detailed budgets are developed for the selected time interval within the
overall time horizon of the budget (i.e., the annual budget could be developed on a daily, weekly,
or monthly basis). Typically, the complexity of the company's operations will dictate the level of
detail required for the cash budget. Similarly, the complexity of the corporate operations will
drive the number of assumptions and estimation algorithms required to properly prepare a budget
(e.g., credit customers are assumed to remit cash as follows: 50 percent in the month of sale; 30
percent in the month after sale; and so on). Several basic concepts germane to all cash budgets
are:

1. Current period beginning cash balances plus current period cash inflows less current
period cash outflows equals current period ending cash balances.
 2. The current period ending cash balance equals the new (or next) period's beginning cash
balance.
3. The current period ending cash balance signals either a cash flow opportunity (e.g.,
possible investment of idle cash) or a cash flow problem (e.g., the need to borrow cash or
adjust one or more of the cash budget items giving rise to the borrow signal).

RATIO ANALYSIS

In addition to cash flow statements and cash budgets, ratio analysis can also be employed as an
effective cash flow analysis technique. Ratios often provide insights regarding the relationship of
two numbers (e.g., net cash provided from operations versus capital expenditures) that would not
be readily apparent from the mere inspection of the individual numerator or denominator.
Additionally, ratios facilitate comparisons with similar ratios of prior years of the same company
(i.e., intracompany comparisons) as well as comparisons of other companies (i.e., intercompany
or industry comparisons). While ratio analysis may be used in conjunction with the cash flow
statement and/or the cash budget, ratio analysis is often used as a stand-alone, attention-directing,
or monitoring technique.

LOAN APPLICATIONS

Potential borrowers should be prepared to answer the following questions when applying for
loans:

1. How much cash is needed?

2. How will this cash help the business (i.e., how does the loan help the business accomplish
its business objectives as documented in the business plan)?
3. How will the company pay back the cash?
4. How will the company pay back the cash if the company goes bankrupt?
5. How much do the major stakeholders have invested in the company?

Admittedly, it is in the best interest of the potential borrower to address these questions prior to
requesting a loan. Accordingly, in addition to having a well-prepared cash flow analysis, the
potential borrower should prepare a separate document addressing the following information:
 1. Details of the assumptions underpinning the specific amount needed should be prepared
(with cross-references to relevant information included in the cash flow analysis).
2. The logic underlying the business need for the amount of cash requested should be
clearly stated (and cross-referenced to the relevant objectives stated in the business plan
or some other strategic planning document).
3. The company should clearly state what potential assets would be available to satisfy the
claims of the lender in case of default (i.e., the company should indicate the assets
available for the collateralization of the loan).
4. Details of the equity interests of major stakeholders should be stated.

In some cases, the lender may also request personal guarantees of loan repayment. If this is
necessary, the document will need to include relevant information regarding the personal assets
of the major stakeholders available to satisfy the claims of the lender in case of default.

INADEQUATE CAPITALIZATION

Many businesses fail due to inadequate capitalization. Inadequate capitalization basically implies
that there were not enough cash and/or credit arrangements secured prior to initiating operations
to ensure that the company could pay its debts during the early stages of operations (when cash
inflows are nominal, if any, and cash outflows are very high). Admittedly, it is extremely
difficult to perform a cash flow analysis when the company does not have a cash flow history.
Accordingly, alternative sources of information should be obtained from trade journals,
government agencies, and potential lenders. Additional information can be solicited from
potential customers, vendors, and competitors, allowing the firm to learn from others's mistakes
and successes.

UNCONSTRAINED GROWTH

While inadequate capitalization represents a front-end problem, unconstrained growth represents

a potential back-end problem. Often, unconstrained growth provokes business failure because the
company is growing faster than their cash flow. While many cash flow problems are operational
in nature, unconstrained growth is a symptom of a much larger strategic problem. Accordingly,
even to the extent that cash flow analyses are performed on a timely basis, such analyses will
never overcome a flawed strategy underpinning the unconstrained growth.

BANKRUPTCY

A company is said to be bankrupt when it experiences financial distress to the extent that the
protection of the bankruptcy laws is employed for the orderly disposition of assets and settlement
of creditors's claims. Significantly, not all bankruptcies are fatal. In some circumstances,
creditors may allow the bankrupt company to reorganize its financial affairs, allowing the
company to continue or reopen. Such a reorganization might include relieving the company from
further liability on the unsatisfied portion of the company's obligations. Admittedly, such
reorganizations are performed in vain if the reasons underlying the financial distress have not
been properly resolved. Unfortunately, properly-prepared and timely cash flow analyses can not
compensate for poor management, poor products, or weak internal controls.

5.0 Conclusion

Cash Flow Statement has been discussed to provide insight into what it is, its usefulness, its
components and how It is prepared. A thorough understanding of the topic is indispensible in
being able to carry out tactical Organizational plans and avoid costly mistakes in handling
operational, investing and financing functions in a business.

Self Test Questions

.1.Examine the importance of Cash Flow Statement in Financial Reporting

2.Examine the main components of Cash Flow Statement

3.Pick the Financial Statement of any publicly quoted company and analyze it in the light of
what you have learnt
SEE ALSO: Budgeting; Financial Issues for Managers; Financial Ratios; Strategic Planning
Tools

Michael S. Luehlfing

I.M. Pandey: Financial Management: Vikas Publishing House PVT Ltd Eight Edition.

Revised by Laurie Hillstrom

FURTHER READING:

Brahmasrene, Tantatape, C.D. Strupeck, and Donna Whitten. "Examining Preferences in Cash
Flow Statement Format." CPA Journal 58 (2004).

Domash, Harry. "Check Cash Flow First." Winninginvesting.com. Available from

http://www.winninginvesting.com/cash_flow.htm.

"Intro to Fundamental Analysis: The Cash Flow Statement." Investopedia.com. Available from
http://www.investopedia.com/university/fundamentalanalysis/... .

Levin, Richard I. Buy Low, Sell High, Collect Early, and Pay Late: The Manager's Guide to
Financial Survival. Englewood Cliffs, NJ: Prentice-Hall, 1983.

Mills, John, and Jeanne H. Yamamura. "The Power of Cash Flow Ratios." Journal of
Accountancy 186, no. 4 (1998): 53–57.

"Preparing Your Cash Flow Statement." U.S. Small Business Administration, Online Women's
Business Center. Available from http://www.onlinewbc.gov/docs/finance/cashflow.html.

Silver, Jay. "Use of Cash Flow Projections." Secured Lender, March/April 1997, 64–68.
Simon, Geoffrey A. "A Cash Flow Statement Says, 'Show Me the Money!'" Tampa Bay Business
Journal 27 (2001).