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
loss account, and the statement of cash flows to answer the
above questions
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 BALANCE SHEET
Horizontal Form
Liabilities + Equity Assets
• Share 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
expenditures
and losses

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 BALANCE SHEET
Vertical (or Report) Form
III. Sources of Funds
(1) Shareholders’ funds:
(a) Capital
(b) Reserves and Surplus
(2) Loan funds:
(a) Secured loans
(b) Unsecured loans
X. 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 ON
MARCH 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 ON
MARCH 31, 20 X 1
Rs.in crores
20 x 1 20 x 0
IV. 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
XII.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
Less: Current liabilities and provisions: 10.50 8.10
Net current assets 12.90 7.50
(4) Miscellaneous expenditures and losses 0.50 0.50
47.40 41.20
 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, FOR
THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs.in crore)
Income
Sales 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
THE YEAR ENDING ON MARCH 31, 20 X 1
(Rs. in crore)
20 x 1 20 x 0
Net sales 70.1 62.3
Cost of goods sold 55.2 47.5
Stocks 42.1
Wages and salaries 6.8
Other manufacturing expenses 6.3
Gross profit 14.9 14.8
Operating expenses 6.0 4.9
Depreciation 3.0
General administration 1.2
Selling 1.8
Operating profit 8.9 9.9
Non-operating surplus/deficit – 0.6
Profit before interest and tax 8.9 10.5
Interest 2.1 2.2
Profit before tax 6.8 8.3
Provision for tax 3.4 4.1
Current tax 2.1 2.9
Deferred tax 1.3 1.2
Profit after tax 3.4 4.2
Prior period adjustments 0.8 0.7
Amount available for appropriation 4.2 4.9
Appropriations 3.5 4.0
Balance 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
• Share capital
• Equity Capital structure
• Preference and cost of capital
• Reserves and surplus
• Secured loans
• Debentures
• Loans and advances
• Unsecured loans Working capital
• Current liabilities and provisions financing policy
• Trade creditors
• Provisions
• Fixed assets (net)
• Gross block Capital budgeting
• Less: depreciation
• Investments Portfolio management
• Current assets, loans and advances
• Cash and bank Cash management

• Receivables Credit management

• Inventories Inventory management
• Miscellaneous expenditure and losses
 PROFIT AND LOSS ACCOUNT AND FINANCE TOPICS
• Net sales Revenue risk
• Cost of goods sold
• Stocks
• Wages and salaries
• Other manufacturing expenses
• Gross profit Gross profit margin
• Operating expenses
• Selling and administration expenses
• Depreciation Depreciation policy
• Operating profit
• Non-operating surplus/deficit
• Earnings before income and tax Business risk
• Interest Financial risk
• Profit before tax
• Tax Tax planning
• Profit after tax Return on equity

• Dividends Dividend policy

• Retained earnings
 NET CASH FLOW
When we looked at the profit and loss account, the emphasis was on
profit after tax (also called the bottom line). In finance, however, the
focus is on cash flow.

A firm’s cash flow generally differs from its profit after tax because
some of the revenues/expenses shown on its profit and loss account
may not have received /paid in cash during the year. The relationship
between net cash flow and profit after tax is as follows:

Net cash flow = Profit after tax – Non cash revenues

+ Non cash expenses

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 NET CASH FLOW
An example of non cash revenue is accrued interest income that has
not yet been received. It increases the bottom line but is not matched by
a cash inflow during the accounting period – the cash inflow would
occur in a subsequent period. An example of a non cash expense is
depreciation.

In practice, analysts defined the net cash flow as:

Net cash flow = Profit after tax + Depreciation + Amortisation

However, note that the above expression will not reflect net cash flow
accurately if there are significant noncash items beyond depreciation and
amortisation.
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ACCOUNTING INCOME VERSUS ECONOMIC
INCOME
Accounting income diverges from economic income due to the
following reasons:
• Use of the accrual principle
• Omission of changes in value
• Depreciation
• Treatment of R & D and advertising expenditures
• Inflation
• Creative accounting
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 COMPONENTS OF CASH FLOWS

Operating Cash inflows – Cash outflows Cash flow

from operations = from operations
from operations

+ –

Cash inflows Cash outflows Cash flow

Investing from investing – from investing = from investing
activities activities activities
+ –

Cash inflows Cash outflows Cash flow

Financing from financing – from financing = from financing
activities activities activities
=

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, FOR
THE 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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(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 0.6
Cash and cash equivalents as on 31.03.20x1 1.0

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 MANIPULATION OF THE BOTTOM LINE
1. 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 DEPRECIATION
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 . . IMPR’N . . RESERVES
9. LENGTHEN … ACCOUNTING YEAR . . ATTEMPT COVER POOR PERFORMANCE.

WHY ? PROJECT IMAGE OF LOW RISK

PROMOTE PERCEP’N . . COMPETENT MGT
INCREASE MGRL COMPEN’N

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 company’s taxable income is determined by taking into

account its revenues, expenses, and deductions on account
of various incentives and reliefs. The taxable income is
subject to a tax rate of 30 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

• A variety of exemptions and deductions are granted

under the Income Tax Act.

• If the income tax payable on the total income of a

company, as computed under the Income Tax Act,
is less than 10.0 percent of its book profit, the tax
payable shall be deemed to be 10.0 percent of such book
profit.

• Advance tax is payable on the current income of the

company in four installments during the financial year.

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 CORPORATE INCOME TAX
2. Depreciation is charged on blocks of assets which
represent a group of assets within the broad class of
assets such as buildings, plant, machinery, and
furniture, for which a common rate of depreciation is
applicable.
3. While interest on borrowings is a tax-deductible
expense, dividend on share capital is not.
4. Unabsorbed business loss of any year can be carried
forward and set off against income under the head of
business of subsequent years.

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 INDIRECT TAXES
The three most important indirect taxes are the excise duty,
the sales tax, and the customs duty.

• The excise duty is a levy on the goods manufactured in

the country.

• Sales tax is a levy on “sale of goods.”

• Customs duty is a levy on the import of goods into India

or the export of goods out of India.

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 FREE CASH FLOW

Free cash flow is the cash flow available for

distribution to investors (lenders and shareholders)

after the firm has made investments in fixed assets and

working capital to support its operations.

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 CASH FLOW SUMMARY
A. The cash flow identity
Cash flow from assets = Cash flow to lenders + Cash flow to
shareholders
B. Cash flow from assets
Cash flow from assets = Operating cash flow – Net capital spending –
Change in net working capital
where
Operating cash flow = PBIT – Taxes + Depreciation
Capital 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 paid – Net new borrowing
D. Cash flow to shareholders
Cash flow to shareholders = Dividends paid – Net new share capital
raised
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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.
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 three
important 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

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