Category: Business & Finance

[vc_row][vc_column][vc_column_text]The word ‘transaction’ is commonly used in business and finance circles. We hear sentences like “how many transactions you did today”, “how much are your monthly transactions”, “What is the value of this transaction” and “I have not done any transaction recently” etc.

If we try to put a formal definition of a transaction, it would be something like this:

“a transaction is a performance of a deal between two or more parties having a financial impact which can be measured reliably.”

An easy example would be: Company Dokia purchases one laptop from Walmart for $500 on cash.

Now, we need to dig down deep into this definition to understand it’s components:

 

First of all, it is a ‘performance of a deal’. So, it is not merely entering into a deal or doing an agreement or a contract. Instead, the transaction is an ‘actual performance’ of that agreement or arrangement. Just entering into a contract would not be considered as a transaction.

The second important point is that it has to be between two parties, at least. One person cannot do a transaction on its own. Let’s say that if sales department borrows a car from the HR department for three months, this cannot be recorded as a transaction in books of accounts of the company, because both departments are under the same organization.

Thirdly, there should be a financial impact. In the above-given example of purchase of laptop from Walmart, there is a financial impact on Company Dokia. However, if there is a deal performed between two entities without any economic impact, then this is not an accounting transaction. For example, Company Dokia makes a deal with Walmart to invite each other’s CEOs at their respective premises and show them around their offices. So, in this deal, there is no (apparent) financial impact. So, this deal of visiting CEOs will not be recorded and considered as an accounting transaction.

 

 

It is essential to understand the difference between an accounting transaction and an accounting event. Sometimes, an event may happen, which has a financial impact. So, this event shall also be recorded in the books of accounts of the organization. However, this cannot be termed as a financial transaction. For example, if an employee of company Dokia accidentally drops the laptop purchased from Walmart, this will be considered as an accounting event and will not be considered as an accounting transaction.[/vc_column_text][/vc_column][/vc_row]

[vc_row][vc_column][vc_column_text]Hello, welcome to your new role. In this role as an external auditor of company ABC (i.e., as a member of the external audit team), you have to ‘audit’ bank balances of the company as well as cash in hand. The term ‘audit’ would mean that you need to apply auditing procedures on cash and bank accounts of the company.

 

 

Identifying audit risks in cash and bank balances

Now, before we devise and apply audit procedures for testing cash and bank balances of the company, let’s firstly understand what the possible business and audit risks in the bank accounts of the company are.

Below are some of the examples of audit risks in cash and bank balances:

• There might not be proper authorization procedures defined for opening a bank account.
• Bank accounts may be opened or closed without due internal authorization process of the company.
• There might not be any adequate segregation of duties, i.e., the person who is preparing the cheque may be signing it as well as an authorized signatory.
• Bank accounts of the company may be overstated in the financial statements or understated or not disclosed in the financial statements at all
• The balances in the bank accounts may be misappropriated, stolen, misused for personal purposes
• Money laundering activities might be carried out through bank accounts.
• There is a risk that the balances available in the bank accounts are not available for the company for withdrawal either due to some restrictions or some other reason
• Some bank accounts which are owners or employees personal accounts may be reported as the company’s accounts.
• Bank may wrongly debit or credit company’s account for the transactions which are not carried.
• Bank may charge excessive bank charges not agreed with the company beforehand.
• Some fake cheques may be presented by any party in the bank to withdraw money from the company’s bank account.
• Authorization limits may be breached by staff by preparing multiple cheques of smaller amounts in the name of the same supplier.
• Payments may be processed in the names of third parties without due purchase orders and receiving goods or services.
• Fictitious transactions may be designed only to show economic activity on the bank statements. Such movement may be within the company’s bank accounts or in collision with some supplier or customer.
• Fictitious transactions may be passed temporarily to increase or decrease a particular bank account balance, and such transactions may be reversed after the closing date.
• There is a risk that the bank accounts which are being reported do not exist at all, or even in a worst-case scenario, the bank itself doesn’t exist in which accounts are being reported.
• The company reported balances which are outdated and do not exist on the reporting date.
• Bank reconciliation statements may not be prepared and reviewed at regular intervals.
• There might be a significant number of pending items in bank reconciliation statements.
• Cash-in-hand may be used for personal purposes and later reimbursed (or not reimbursed).
• Cash-in-hand maybe misappropriated by making unauthorized transactions.
• Cash in hand amount may be short of what it should be.
• Accountant may not correctly record petty cash expenses in the correct expense code.
• Expenses which should be paid through the bank only might be paid through petty cash.
• There might be no defined petty cash limit and the designated person for handling petty cash.
• The policy and procedure for obtaining petty cash may not be well defined (or not defined at all).

It is vital to consider WCGW (What Could Go Wrong) when identifying audit risks and devising audit procedures for cash and bank accounts, as well as any other account type. The higher the number of audit risks you can generate, the better. Because we’ll be devising our audit procedures to tackle these audit risks, if we couldn’t identify an audit risk, we might not want to formulate an audit procedure to assess that particular risk.

 

 

Identifying audit procedures to be performed on cash and bank balances

Once we have identified audit risks related to cash and bank, we need to perform audit procedures. Please note that we may not need to perform all audit procedures. The results of some of the audit procedures would guide us on our further action. So, some audit procedures are dependent upon the results of some other audit procedures.

Let’s review, what could be all (or maximum) possible audit procedures which may be performed on cash and bank balances of an audit client.

• Inquire with the management about their cash handling policy as well as bank accounts policy.
• Obtain the policy manual related to cash and banks (if available).
• Obtain a list of bank accounts along with the closing balances and locations of the banks.
• Understand if there has been any change in the payment process and what is the reason for the same.
• Match the balances as per the lists provided with the trial balance and inquire if there is any difference.
• Review the policies related to cash and bank and identify if there is any weakness in the designing of internal controls.
• Inquire if historically there has been any instance of fraud or misappropriation in the cash and bank balances.
• Send out bank balance confirmation letters to the bank accounts to verify the balances as well as any loans.
• Obtain signed bank reconciliation statements for all bank accounts as at the reporting date as well as at any previous periods on a sample basis.
• Review bank reconciliation statements carefully matching the balances as per general ledger and balances as per bank statement.
• Inquire about unreconciled items on the bank reconciliation statements and understand the impact of these items.
• Perform subsequent positioning test of the unreconciled items on the bank reconciliation statement.
• Review bank ledgers subsequent to the closing date and check if there is any reversal of material transactions in the following accounting period.
• Propose adjustment entries to rectify any errors found and to account for any pending items in the bank reconciliation statements.
• Match the confirmations letters replied by banks with the bank balances in the bank reconciliation statements.
• Obtain proforma samples of signatures of authorized signatories and assess the risk of copying these signatures by any party.
• Ensure that the company’s cheque books are kept in a secure place with proper accountability of a specific person(s).
• Perform a walk-through of the process explained by the management by reviewing one transaction each for cash and bank balances.
• Select a sample of transactions to for detailed testing. Perform thorough testing for all sampled transactions and identify the non-compliance with the standard procedure.
• Inquire about new bank accounts opened during the year and understand the need for opening these banks. Assess if this is in line with the requirement of the business. Discuss any suspicion with the management as well with your team.
• Obtain a list of petty cash handlers, the amount authorized, and the current balance in hand.
• Perform physical cash count as on the reporting date. Alternatively, Obtain a certificate of cash in hand as on the closing date.
• Review cash replenishment requests on a sample basis and verify source documents.
• Requester and approver should appropriately sign all cash disbursement requests.
• Obtain a list of bank accounts closed during the year and understand the reason for closing these accounts.
• Check that the balance in the accounts closed was successfully moved and accounted in the active bank accounts of the company.
• Obtain a list of dormant bank accounts of the company and understand the reason of not closing these accounts or ask for the management’s plan regarding these accounts, whether these accounts will be used in future or will be closed.
• Inquire with the management if there has been any instance or attempt of money laundering.
• Obtain a list of authorized signatories, assess whether they are at a suitable level of responsibility.
• Inquire if there has been additions or deletions in the list of authorized signatories. Check if all the deletions and additions have been timely informed to the bank.
• Perform analytical testing on the bank account balances; let’s see how much bank balances have been increased or decreased. Observe the movements in the closing balances of bank accounts. Inquire with the management of any significant variance or unusual trends.
• Wherever there is no satisfactory response from the management on the significant variations, perform further detailed procedures and obtain new audit evidence to validate the points raised during analytical testing.
• All performed audit procedures have to be appropriately documented. This includes writing down the audit procedure performed, the result obtained and the conclusion drawn. All audit documents have to be dated with proper authorization by the preparer and reviewer of the material.

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	$	Businance.com
Cost amount	12
Profit	3
Sales price	15
Markup	25.00%	Profit divided by cost
GP margin	20.00%	Profit divided by sales

 

A markup is a profit as a percentage of the cost. (markup = profit divided by cost of sales)

A gross profit margin is a profit as a percentage of the sales price. (margin = profit divided by sales)

Markup is also known as cost markup or only Markup.

A gross profit margin is also known as GP margin, margin.

 

Let’s take an example of a company called Mokia Telecom LLC, which produces a product Nobile 111 and then sales it. The cost of sales for the company per product is $12 and the company sales this product by adding a profit of $3, for $15.

Now, how much is the Markup for this product, and how much is the gross profit margin?

We calculate Markup by dividing profit with the cost. So the profit of $3 is divided by the cost of $12 and by multiplying with 100 we will reach a markup of 25%.

For calculating GP margin, we divided the profit of $3 with the sales price of $15 and then we reach a gross profit margin of 20%.

 

 

Another example

Let’s say that Botania Pvt. Ltd made sales of $1,000,000 in a year. The company incurred a cost of sales of $650,000. Can you calculate Markup and margin for this company, before scrolling down further?

Ok, the answer is:

In this case, profit of the company is $350,000 ($1,000,000 minus $650,000). To calculate Markup, we will divide profit with cost, i.e., $350,000 divided by $650,000 will give us an answer for Markup of 53.85%.

For calculating margin the gross profit of $350,000 will be divided with sales amount of $1,000,000, giving us an answer of 35%.

 

 

Some complex examples

In some exams and assignments, you’ll find questions like below:

1. A company has a profit margin of 25%, and its gross profit is $2,000. Calculate the sales amount.
2. If a company’s sales are $50,000, what will be the Markup if GP margin is 20%?
3. If a company want to achieve 20% GP margin, how much profit it will have to add to its cost of $100,000.
4. Assuming that a company adds Markup of 30% to its cost, how much it needs to make sales to achieve a profit of $1,000,000.

 

Now, here, the trick is, you need to understand how to calculate markup and profit margin quickly. Always bear in mind that Markup is a percentage of cost, and GP margin (or gross profit margin or margin) is a percentage of sales amount.

Below formulas are given for answering the above questions (or any similar question). You can use that formula for which you have the maximum number of inputs available in the question.

 

 

1. The answer is $ 8,000: Calculated by dividing $2,000 with 25%.
2. The answer is 25%: This is calculated by first determining profit amount using gross margin formula and then applying that profit amount using mark up formula.
3. Answer is $25,000: This is calculated by dividing $100,000 by 80% and then subtracting $ 125,000 from $100,000.
4. The answer is $4,333,000: This is calculated by applying the markup formula to determine the amount of cost of sales.

 

 

General points

It is important to note that for both GP margin and Markup, we use only cost of sales and not the total cost. The cost of sales would include direct material, direct labour and direct overhead expenses absorbed.

Cost markup and profit margin are used in various industries and for multiple purposes, including pricing decisions and budgeting and planning. In financial sector mostly, the bank charge a markup, i.e., a profit on the value of the loan. So, if a banker says that bank will charge you a markup of 5%, this means that on the amount of the loan, an interest rate of 5% is applicable. Many financial analysts use GP margin for financial analysis in numerous sectors. Financial Analysts compare GP margin of companies to assess the financial performance of the company.[/vc_column_text][/vc_column][/vc_row]

[vc_row][vc_column][vc_column_text]You might be wondering which audit is better, internal audit or external audit. Which audit is more efficient, effective and cost-effective? Or Which audit is more productive for the owner and the company?

Well, there is no one right answer here. Both internal audit and external audit are unique and do not compete with each other. Both complement each other, and both of the audit types serve their own purposes.

In the below table, we’ll have a comparison of internal audit and external audit and evaluate their respective strengths and unique features.

 

	External Audit	Internal Audit
Purpose	The purpose of an external audit is to provide an opinion on the financial statements of the company.	Purpose of internal audit is to have an independent check on different internal controls of the organization, identification of control weaknesses and suggesting improvements.
Who performs it	Third-party auditors, known as external auditors, perform an external audit. An external audit cannot be done by the company, or by its employees.	Most of the times, companies have a separate department where it employs internal auditors. So, internal auditors are the employees of the company, but these employees are not involved in the operations. Sometimes, internal audit function can be outsourced as well to some audit firm, however, not to the same audit firm, which is the external auditor of the company.
Deliverable	Once an external audit is complete, the external auditors of the company will issue an external audit report. The title of this report is ‘independent auditors’ report on financial statements’.	Depending upon the nature of the assignment, there are different kinds of reports issued by the internal audit team. Mostly, the title of these reports is “internal auditor report on [subject]”.
Frequency	The external audit is usually performed once a year. Once annual financial statements are prepared, the annual audit is conducted by external auditors. However, some companies prepare and publish quarterly summarized financial statements as well. In such cases, a quarterly review of the financial statements is also performed by external auditors. However, a review is not as detailed as a full-fledge annual audit.	Internal audit team keeps working throughout the year in the company. They work on different account heads from time to time. Usually, the annual internal audit plan will define a schedule of which areas will be testing during a particular year. For example, in year 1, the internal audit team may review internal controls systems of revenue, receivables, cash and bank. In year 2, they may decide to review operations of accounts payables, inventories and production etc.
Independence	The external auditor is always a third party. Therefore, the opinion of the external auditor is considered an independent view, free of bias.	Internal auditors are not involved in the routine operations of the company. They are not engaged in sales, production or accounting operations of the organization. Therefore, internal auditors are also independent up to a reasonable extent.
Appointment and Removal	The owners of the company appoint external auditors. Owners select external auditors to review financial statements of the company which are prepared by the management of the company. If owners and management are same, then auditors are appointed either for regulatory purposes or for submission of financial statements to third parties like banks etc. Since external auditor is appointed by shareholders only, the removal of the auditor or the change of external auditor is also done by shareholders only.	Board of Directors of the company appoint internal auditors. As part of good corporate governance practices, head of internal audit (or chief internal auditor) is supposed to report directly to the board of directors. Board of the Director (or top management) of the company can change internal audit staff or the outsourced internal auditor.
Time-line	External auditors usually have a tight timeline to provide their report after the closing period. This timeline varies but typically ranges from 1 month to 4 months. Deadline for the review reports of quarterly financial statements is usually less at 15 to 45 days.	Internal auditor’s timeline is governed based on the nature of the assignment on which they are working. Further, since they are working throughout the year on the same company’s audit, they will have rolling deadlines.
Requirement/ Regulation	Conducting an external audit is usually a statutory requirement for many registered companies, depending upon local legislation. Most of the times, all public companies, listed companies, regulated companies and private companies above a certain limit of revenue are compulsorily required to have it’s annual accounts audited from an external auditor.	Internal audit is mostly a voluntary activity. However, in certain jurisdictions, corporate governance rules require an internal audit to be mandatory for listed companies and public companies. Many private companies have also started to build and enhance their internal audit teams as an additional check.
US GAAP / IFRS and IAS	External auditors have to check compliance of financial statements with US GAAP or IFRS. Further, external auditors are required to perform their audit procedures as per International Accounting Standards.	Internal auditors have to work under IIA’s International Standards for the Professional Practice of Internal Auditing (Standards).
Objective	The objective of an external audit is to enhance reliance by introducing a third party check, on the financial statements of the company.	The objectives of internal audit may include identification of control weaknesses, finding instances of internal controls violations, reducing operational losses, introducing efficiencies, finding fraud, detailed investigation, ensuring correct recording of accounting entries and true and fair view of the financial statements.
Scope	The scope of external audit is limited to providing an opinion on the financial statements of the company. The scope of the work of an external audit is usually defined in the statutory laws or company laws of the respective jurisdiction.	The scope of internal audit is much bigger and may include various additional items such as detailed investigation, finding fraud, identifying weaknesses, suggesting improvements etc.
Conflict of interest	External auditors have to be necessarily independent of the organization’s performance and profitability. Therefore, they cannot work on any business assignment or investment advisory function, in addition to being the external auditor.	The internal auditor (whether employed in-house or outsourced) can provide additional business services like investment advisory, mergers & acquisitions, business development, business setup, deal negotiation etc.
Fee	External auditors charge a fee in consideration of their audit services.	If the internal auditor is in-house, they are paid salaries. In the case of outsourcing, the company will pay an agreed fee to the third party to whom internal audit is outsourced.
Qualifications	The signing partner of the audit report has to be a qualified member of an IFAC member body. Usually, partners of external audit firms are Certified Public Accountants or Chartered Accountants.	In some jurisdictions, it is now mandatory for the head of internal auditor to be a Certified Internal Auditor.
Cooperation	External auditor usually takes input from internal audit reports issued by the internal auditor of the company. Based on these reports, the external auditor may enhance or decrease the extent of its audit procedures.	Internal auditors may take note of the points raised by external auditors in their management letter.
Report format	The external auditors’ reports are highly regulated and are in a particular format. There is minimal scope available to the external auditor to amend it’s report.	The reports of the internal auditor may vary in length, size and structure, depending significantly upon the nature of the assignment being reported.
Users	External auditor’s reports are mostly for external users. This report is shared usually with regulators, banks, stock exchanges, potential investors, fund managers, tax authorities etc.	Internal audit reports are usually confidential and are not shared externally. However, external auditors may require to review reports issued by internal auditors.
Terminologies	The external audit is also referred to as ‘statutory audit’ or ‘annual audit’ or ‘regulatory audit’ or just ‘audit’.	Internal audit is referred as ‘internal audit’.
Assurance level	External audit provides a moderate level of assurance in their audit report.	The internal auditor may provide a high, medium or low level of assurance, depending upon the extent of the work done by the internal auditor.

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Usage and Application

Usage of the debt-equity ratio is essential in the following cases:

1. Investments decisions: When a potential investor is considering to buy shares of a company (called prospect), that investor has to analyze what is the current debt-equity ratio (gearing) of the company. Similarly, when an investor is considering purchasing bonds of a company, they need to understand the significance of the existing debt burden of the prospect. It might be unsafe to invest further in a highly geared company.
2. Financial Management: A company’s management would need to keep an eye on it’s reported figures. Finance managers have to comply with the lenders’ covenants restricting specific ratios within defined ranges.
3. Let’s say that a company is required to maintain a debt-equity ratio (gearing) of 2:1. Then the management would keep calculating this ratio on periodic intervals and at the time of critical decisions making to ensure that gearing ratio is under the limits.
4. Credit Risk Management: Many banks and other lenders need to keep track of the financial strengths and weaknesses of their borrowers. This monitoring is a part of the credit control process to avoid the risk of bad debts or to book the provisions of bad debts (if required). Bank’s would calculate the debt-equity ratio of their clients firstly at the time of considering loan request or requests for other banking facilities (like an overdraft, letter of credit, letter of guarantee etc.)
5. Regulators, brokers and stock markets: Many analysts are working as information house, and they need to calculate different ratios to update their clients. They advise about different investment options and provide industry figures. Such analysts and brokers estimate debt-equity ratio (gearing) to update their clients. Similarly, many regulators and stock markets also keep an eye on critical ratios of entities regulated by them.
6. In Studies and exams: In many studies and assignments of accounting, finance and economics, students need to calculate debt-equity ratios for the analysis and exam purposes.

Definition, example and formula

So, considering the widespread use of the gearing ratio, let’s first see the definition and formula of debt-equity ratio:

A debt-equity ratio calculates debt as a proportion of the equity of the company. Its formula is as below:

Debt equity ratio (or gearing) = Total Liabilities / Equity of the company

Generally speaking, the wording of ‘debt-equity ratio’ or ‘gearing ratio’ or ‘gearing’ or ‘gearing level’ or ‘financial leverage’ are used interchangeably and refer to the same ratio (or with some slight variations).

Example: Let’s say that if a company has total liabilities of $100,000 and its share capital and reserves sum up to $150,000, then the debt-equity ratio will be calculated as follows:

$ 100,000 / $150,000 = 0.667 or 66.7%

 

 

Interpretation of debt-equity ratio (or gearing)

So now, let’s understand how to interpret this ratio, what is the underlying message, is this a comfortable level of gearing? If not, then what to do when the debt-equity ratio goes high? Or what is the importance of debt-equity ratio in investment decision making? Or Let’s discuss below.

The above calculated debt-equity ratio of 66.7% denotes that the total liabilities on the company is 66.7% of the equity of the company.

This ratio indicates that lenders’ investment in the company is equal to 66.7% of the investment of the shareholders in the company.

Generally speaking, as a lender, a debt-equity ratio of below 1 (or below 100%) would sigh relief to the lenders that the shareholders have invested their own money more than what lender have invested in the company. This proportion is comforting for lenders as shareholders have a more significant stake in the company than lenders. Now, if the company would go bankrupt, lenders will not be the only one who will be at a loss. It is one of the psychological impacts of debt-equity ratio on the lenders.

It is easily understandable that a zero debt-equity ratio means that there is no loan on the company and that owner’s contributions fully fund the company.

A 100% geared company means that the amount of debt on the company is equivalent to the shareholder’s funds. So it means that both lenders and shareholders are equally financing capital of the company.

 

An acceptable or ideal level of gearing

Now the question is, what is the general or acceptable or ideal ratio of gearing. What is an optimal level of gearing. Well, the answer is, “it depends”. It depends on a lot of factors, including company size, industry, regulations, macro and microeconomics environment, business strategy, future projects and of course, competition. In some companies, it is reasonable to be highly geared. These are those industries which require a high setup cost, involving high investment in plant and machinery. Examples include the airline industry, construction industry, real estate, manufacturing and maritime etc. As such, a gearing level of above 100% to 200% would not be considered alarming in these industries.

While in some industries where initial business setup costs are low and in those industries, the gearing level of companies is generally low. These industries would include retail, trading, service sectors, technological and software companies. As such, a gearing level of 0 to 30% would be considered normal in these sectors.

It is essential to understand that the gearing ratio (leverage level) would not remain the same over the years; it is a ratio which keeps moving with the business. The ratio is changing because of the payment of a portion of loans every year. Similarly, the profits of the company keep adding to the owner’s equity (if not fully drawn). So, the general nature of the gearing ratio is that you may observe a declining trend in the debt-equity ratio over several years. This decrease is on the assumption that the company will not avail new loans or will not reschedule its liabilities.

 

 

Controlling the gearing ratio

If you are handling the finances of the company, and you need to control the debt-equity ratio of the company, you may evaluate one or more of the following options:

1. Avoid distribution of profits or keeping it to a minimum possible level.
2. Say no to new borrowings and issuing bonds
3. Negotiate with lenders for better (low cost) interest rates
4. Fund any new projects with new investment from owners
5. Utilize short term funding sources like money markets for short term requirements
6. Issue bonds with convertible features (i.e., a bond which will be convertible into shares after a defined period)
7. Early payment of loans to reduce the debt burden

 

Variations of debt-equity ratio

One variation of the debt-equity ratio is to utilize only long-term liabilities (instead of total liabilities) and dividing them with equity. The formula will be as follows:

Debt equity ratio = Long Term Debt / equity * 100

Using this formula means that we have to consider only long-term debts when calculating the debit-equity ratio. This formula is another meaningful variation as it ignores current liabilities. The argument is not to double-weight current liabilities in both the current ratio and the debt-equity ratio.

Therefore, the debt-equity ratio should compare only long term liabilities with the equity of the company.

Both ways of calculation of debt-equity ratio are acceptable in general. However, we need to use a consistent formula when comparing gearing of two different companies or when comparing across different accounting periods. When different companies use different methods, then the results of these ratios will not be comparable.

 

Taking benefit of high gearing ratio

Usually, it is considered risky to invest in a highly geared company. Therefore, for a highly geared company, it is typically difficult to obtain further financing, both in terms of debt or equity. A low-risk averse investor can take a significant benefit of such financial situation of the company. A company who is finding it difficult for its upcoming promising projects would be willing to pay a higher premium (i.e., a higher interest rate or lower share price) for the funding needed. If the investor is confident of the company’s prospects, they can take the benefit by investing in the company.

 

 

Final remarks

As an investor, you usually have two ways of investing in a company. Either you can invest in the equity of the company, or you can lend the money to the company. Lending may be either by purchasing bonds or through a loan agreement. However, whether you are a prospective shareholder or a potential lender, you need to keep track of the debt-equity ratio. Investing in a highly geared company is riskier, regardless of the mode of investment.

The debt-equity ratio is one of the most important ratios in the financial analysis of a company and evaluation of investments. The ratio, coupled with other ratios and other analysis, can prove useful in making the right investment decision.[/vc_column_text][/vc_column][/vc_row]

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A Statement of Cash Flows (or as formally called cash flow statement) provides an explanation in the movement of the actual cash inflow and outflow from different activities of the entity. There are three broad classifications under which cash flows are categories. We have provided brief explanation of each with abstracts of some of companies for the relevant sections.

• Operating activities
• Investing activities
• Financing activities

 

Cash flows from operating activities:

Refer to the operating aspects of the cash flows. This includes collection and payments to and from trade receivables and trade payables and even other payables and other receivables. Everything which is related to the main trading activity of the entity.

In order to calculate cash flows from operating activities under indirect method, the beginning figure is profit for the year. So, first put profit/(loss) for the year and then make following adjustments to it:

• Add back all non-cash expenses (like depreciation, amortization etc.)
• Exclude interest income and other income (these will be separately calculated on actual cash flow basis)
• Add all decreases in working capital and substract all increases in working capital (stocks, receivables and payables)

 

A positive figure of ‘net cash flows from operating activities’ indicate that the company has collected more than the cash it paid out, related to the operational activities of the entity. A positive figure generally is considered as good because it shows that company’s operations are cash sufficient. It will not need to arrange cash from financing or investing activities to support its operations.

However, a negative cash flow from operating activities cannot be blindly termed as something bad. We need to do a more in-depth analysis to find out the movement of items of cash flow statement and along with other business factors, it needs to be evaluated to find out whether a negative cash flow is actually bad or not for the entity. For example, a negative net cash from operating activities may have arisen to due increase in inventories (resulting in negative cash flows). These inventories may have been purchased to support expanding sales and market demand.

Direct method and Indirect method: These are 2 methods to prepare statement of cash flows. There is no difference in ‘investing activities’ and ‘financing activities’ under these 2 methods. The difference is only in the presentation of figures under ‘operating activities’.

Indirect method is more common and the begins the operating cash flows with ‘profit for the period’ however, in the direct method the beginning point is revenue from sales to customers. Then deduct all expenses like cost of goods sold and admin expenses. After that deduct increase and add decrease in working capital. Remove all non-cash items (like depreciation and amortization) and it will reach to the ‘net cash flows from operating activities’ using direct method.

So, how do you decide whether a cash flow is related to operating activity or an investing activity or a financing activity? So, the key deciding factor is like this, firstly check whether the cash flow is related to a financing activity or not? If it is a financing activity, then straight away classify it under financing activities. Secondly, check if it is an investing activity or not. If it is an investing activity then straight away classify it as investing activity. However, if a cash flow is neither an investing activity nor a financing activity, then as a residual bucket, put that cash flow under operating activity.

 

 

Cash flows from Investing Activities

Cash flow from investing activities usually includes capitation expenditure and doesn’t include cash flows of operational/routine nature. Unlike operating activities, these cash flows are not related to the operational running of the entity. This provides an idea to the investor that how much cash flow is invested or divested from the investment activities of the company.

This segment of cash flow focuses on the items which are related to long term investments of the entity like:

• Purchase or sales of property, plant & equipment
• Investments or divestment in subsidiaries or associates
• Purchasing of shares and debentures of other entities
• Receipt of dividends and interest generated the investments made

In order to prepare this section all investments/purchases in investing activities should be entered as negative value, because these are cash outflows. All collection of money under this section should be added as positive values e.g., proceeds from disposal of fixed assets.

The sum of all amounts under this category is called ‘net cash flows from investing activities’ (whether the net is positive or negative). But if net amount is negative then it may be labelled as ‘net cash flows utilized in investing activities’. If the net amount is positive, then it may be termed as ‘net cash flows generating from investing activities’.

 

 

Cash flows from Financing Activities

This section provides information about how cash flow movement in the financing activities of the company. Like how much loan is obtained by the entity or how much is repaid? Are there any new shares issued? Or how much dividend is paid. This section is about transactions (and their cash flow impact) of matters related to company’s own funding and financing. Has the company borrowed money? If so, then how much? Has it issued more shares? Has it repaid its loans? The details about all these transactions will be available in this section of the statement of cash flows. Therefore, this is an important section from investor’s point of view. A good risk assessment can be made from the company’s cash flow of financing activities whether this is a good choice for investment or not.

 

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