1. Mr.

Berrybell wants to assess the ability of an enterprise named Anyway, so as to

confirm whether the enterprise is capable to generate sufficient cash flows or not. Anyway
submits the following information for the year ended 31 March2017.

Particulars (Rs. In lacs)

Shares issued during the year 5
Capital assets purchased 1.5
Proceed from sale of an asset 2
Dividend declared and paid 1
Increase in debtors 1.5
Loss on sale of asset 0.2
Net income before taxes 8.8
Depreciation & Amortisation 3.8

Discuss the relevance of preparing the cash flow statement. Indicate and comment on the
following
• Cash from operation
• Cash from investing activities
• Cash from financing activities
• Closing balance

Answer: Cash flow analysis is an important tool of financial analysis. It is the process of
understanding the change in position with respect to cash in the current year and the reasons
responsible for such a change. Incidentally, the analysis also helps us to understand whether the
investing and financing decision taken by the company during the year are appropriate are not.

Cash flow analysis is done with the objective of understanding some of the following important
questions:
• What is the change in the cash position of the firm for the current year as compared to the
previous year?
• How good was the liquidity position of the firm?
• What were the sources of cash during the current year?
• How much cash was generated from operations?
• What were the applications of cash during the current year?
• How much cash was spent on investment activities, such as purchase of new plant and
machinery, purchase of land?

Preparation of Cash Flow Statement

The preparation of cash flow statement is similar to the preparation of fund flow statement. It
requires the identification of the sources of cash and the uses of cash. A source of cash is a
transaction which brings an inflow of cash. An application of cash is a transaction which leads to
an outflow of cash.

As per Accounting standard-3, some of the definitions are: Operating activities are the principal
revenue-producing activities of the enterprise and other activities that are not investing or
financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments not
included in cash equivalents.

Financing activities are activities that result in changes in the size and composition of the
owners’ capital (including preference share capital in the case of a company) and borrowings of
the enterprise.

Examples of cash flows from Operating activities are:

a) cash receipts from the sale of goods and the rendering of services;
b) cash receipts from royalties, fees, commissions and other revenue;
c) cash payments to suppliers for goods and services;
d) cash payments to and on behalf of employees;
e) cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities
and other policy benefits;

Examples of cash flows arising from Investing activities are:

a) cash payments to acquire fixed assets (including intangibles). These payments include those
relating to capitalised research and development costs and self-constructed fixed assets;
b) cash receipts from disposal of fixed assets (including intangibles);
c) cash payments to acquire shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
d) cash receipts from disposal of shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than receipts from those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
e) cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise);
f) cash receipts from the repayment of advances and loans made to third parties (other than
advances and loans of a financial enterprise);
g) cash payments for futures contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes, or the payments are classified
as financing activities;

Examples of cash flows arising from Financing activities are:

a) cash proceeds from issuing shares or other similar instruments;
b) cash proceeds from issuing debentures, loans, notes, bonds, and other short or long-term
borrowings; and
c) cash repayments of amounts borrowed

Calculation of Cash from operation

Net income before taxes Rs. 8.8 lakhs
Add: Depreciation & Amortisation Rs. 3.8 lakhs
Less: Increase in Debtors Rs. 1.5 lakhs
Net Cash flow from operation Rs.11.1 lakhs
Calculation of Cash from investing activities
Add: Proceed from sale of an asset Rs. 2.0 lakhs
Less: Capital assets purchased Rs. 1.5 lakhs
Less: Loss on sale of asset Rs. 0.2 lakhs
Net Cash flow from investing activities Rs. 0.3 lakhs

Calculation of Cash from financing activities

Add: Shares issued during the year Rs. 5.0 lakhs
Less: Dividend paid Rs. 1.0 lakhs
Net Cash flow from financing activities Rs. 4.0 lakhs

Calculation of closing balance of Cash from operation

Net Cash flow from operation Rs.11.1 lakhs
Net Cash flow from investing activities Rs. 0.3 lakhs
Net Cash flow from financing activities Rs. 4.0 lakhs
Closing balance of Cash Rs.15.4 lakhs

2. You are being appointed as the accounts executive of Jayesh Motiwala & Company. The
principal business of the company is dealing in pearl ornaments at its retail outlet in
Jaipur. The management is unaware about the relevance of accounting standard applicable
while accounting for the business. Your responsibility is to convince them to comply with
the Accounting Standards, by giving a brief presentation on the objectives behind
complying with the accounting standard and the benefits to the enterprise by following the
same.

Answer: Accounting standards are the most important part of financial statements. Accounting
standards help in providing the true and fair view of the financial statements. An accounting
standard is a selected set of accounting policies or broad guidelines regarding the principles and
methods to be chosen out of several alternatives. Standards adhere to certain laws, customs,
usage, and business environment in which they operate. The basic purpose of accounting
standards is to harmonise the diverse accounting policies and practices. The adoption of
accounting standards ensures uniformity, comparability, and qualitative improvement in the
preparation and presentation of financial statements. Accounting standards facilitates more
disclosure of financial information that is beyond the statutory limits.

The Accounting Standards Board is entrusted with the responsibility of formulating standards on
significant accounting matters keeping in view the international developments and legal
requirements in India. The main function of the ASB is to identify areas in which uniformity in
standards is required and to develop draft standards after discussions with representatives of the
Government, public sector undertaking, industries and other agencies. In case of non-
compliance, the companies are required to disclose the reasons for deviations and their financial
effect.

Thus accounting standards deal with the following matters concerning the accounting
transactions:
(i) Recognition of events and transactions in the financial statements;
(ii) Measurement of the above transactions and events;
(iii) Presentation of the above transactions and events in the financial statements in a manner that
is meaningful and readily understandable to the reader;
(iv) The appropriate disclosure as required in respect of the above transactions and events to
enable the stakeholders and the potential investors to get an insight into what these financial
statements are trying to reflect and facilitating them in taking prudent and informed business
decisions.

Objectives of Accounting Standards

The information contained in the published financial statements is of paramount importance to
external users, viz., shareholders, creditors, bankers, and so on. In order to make sure that this
information is relied upon by the user, it is necessary that the information contained in the
financial statements be logical, consistent and fair. It is the responsibility of the accounting
professional to ensure that the information presented satisfies these requirements. There should
not be too much discretion to firms and their accountants to present the financial information the
way they like.

Thus, the objectives of accounting standards can be summarized as under:

(i) To eliminate the non-comparability of financial statements and thereby improve the reliability
of financial statements; and
(ii) To provide a set of standard accounting policies, valuation norms and disclosure
requirements.

Reasons for setting the accounting standards are:

(a) Comparison between two firms is possible if both of them maintain the same principle,
otherwise proper comparison is not possible. For example, if Firm A follows the FIFO method of
valuation of stock whereas Firm B follows the LIFO method for valuing stock, the comparison
between the two firms becomes useless. The same is possible only when both of them follow
identical method of valuing closing stock.

(b) The firms are not allowed to maintain and present their accounts according to their own will
or choice or cannot prepare report of financial statements for various interested groups. The same
is possible only when there is some fixed standard for setting practice.

(c) The Accounting Standards recognise the principle of equity applicable for different users of
accounting information, viz. creditors, investors, shareholders etc. Thus the purpose of setting
Accounting Standards is nothing but to find a uniformity in accounting practice while
formulating financial reports and make consistency and proper comparison of data which are
contained in financial statements for the users of accounting information. Practically, Accounting
standards have been presented in order to maintain fairness, consistency and transparency in
accounting practice which will satisfy the users of accounting.

Benefits of accounting standards

• Accounting standards bring in uniformity in the preparation of financial statements.
 • Accounting standards provide for full disclosure in the interest of the various
stakeholders in the organization.
• Accounting standards facilitate inter-firm and intra-firm comparisons of the financial
performance of different departments, organizations or firms situated in the same region,
country or even in different countries.
• Given the increasing risks, the accounting profession realised that it needed to know what
accounting standards are to prevail. Though individual accountant and chartered
accountancy firm are concerned with their own reputations, the other accountants’ and
firms’ misconduct would prove costly since all accountants belong to a class in the eyes
of public.
• Accounting standards facilitate in determining specific corporate accountability and
regulation of the company and thus help in measuring the effectiveness of management’s
stewardship.

The following are some of the limitations of setting accounting standards:

(i) There may be genuine reasons for alternative solutions to certain accounting problems. It is
difficult to select one accounting treatment out of several accounting treatments concerning a
particular transaction or event.
(ii) The application of accounting standards may tend to bring rigidity in dealing with different
accounting problems.
(iii) The accounting standards cannot go beyond the statute. They are required to be framed
within the scope in accordance with prevailing laws.

As an accounts executive, we should explain the organization about the importance of

accounting standards and how can it help in better presentation of financial statements. We
should tell them the benefits of using accounting standards in the organization and convince
them to start following accounting standards.

3. The following is the Balance Sheet of Caterpillar Ltd as on 31st March 2017
Equity share capital 500000 Fixed assets 695800
Preference share capital 300000 Stock 135000
Reserves & Surplus 255000 Debtors 145000
Creditors 45500 Cash & Bank 150600
Outstanding Liabilities 25900
1126400 1126400

Ascertain -
a) Current ratio and liquid ratio. What if the industry average for the same is 2 and 1
respectively.
b) Capital gearing ratio and interpret the same.

Answer: a) Current ratio= Current Assets/ Current liabilities

Here, Current Assets are Stock, Debtors and Cash & Bank.

Current liabilities are outstanding liabilities and creditors

= 135000+145000+150600
45500+25900

= 430600/ 71400

= 6.03

Interpretation
Ideal current ratio is 2:1. A ratio of 2:1 or higher is considered satisfactory for most of the
companies but analyst should be very careful while interpreting it. Simply computing the ratio
does not disclose the true liquidity of the business because a high current ratio may not always be
a green signal. It requires a deep analysis of the nature of individual current assets and current
liabilities.

A current ratio of around 1.7-2.0 is pretty encouraging for a business. It suggests that the
business has enough cash to be able to pay its debts, but not too much finance tied up in current
assets which could be reinvested or distributed to shareholders.

Current ratio is 6.03 and as industry average is only 2 so we can say that company is doing really
well in the business and its assets are working well to generate good income for the company.

Liquid ratio is known as quick ratio or acid test ratio. It is excluded from CA inventory as it takes
more time to be converted into cash.

Liquid Ratio = Current Assets - (Inventory and Prepaid expenses)

Current Liabilities

= 135000+145000+150600 – 135000
45500+25900

= 295600/71400

= 4.14

Interpretation
The acid test ratio should be 1:1 or higher, however this varies widely by industry. The higher
the ratio, the greater the company’s liquidity will be (better able to meet current obligations using
liquid assets). Here quick ratio is 4.14 which is much higher as compared to industry average so
we can say that company’s liquidity position is very good.
b) Capital gearing ratio is a useful tool to analyze the capital structure of a company and is
computed by dividing the common stockholders’ equity by fixed interest or dividend bearing
funds. Analyzing capital structure means measuring the relationship between the funds provided
by common stockholders and the funds provided by those who receive a periodic interest or
dividend at a fixed rate. A company is said to be low geared if the larger portion of the capital is
composed of common stockholders’ equity. On the other hand, the company is said to be highly
geared if the larger portion of the capital is composed of fixed interest/dividend bearing funds.

Capital gearing ratio = Fixed Income bearing securities

Total Equity

= 300000/(500000+255000)

= 300000/755000

=0.397

Or 39.7%

Interpretation
Capital gearing ratio is the measure of capital structure analysis and financial strength of the
company and is of great importance for actual and potential investors.

Borrowing is a cheap source of funds for many companies but a highly geared company is
considered a risky investment by the potential investors because such a company has to pay more
interest on loans and dividend on preferred stock and, therefore, may have to face problems in
maintaining a good level of dividend for common stockholders during the period of low profits.

Generally, a lower gearing ratio means greater financial stability. However, not all debt is bad
debt. Loans and other fixed interest liabilities are a way for companies to leverage their value to
increase profits for shareholders, so the optimal gearing ratio is largely determined by the
individual company relative to others in its sector. Here capital gearing ratio is less than 1 so it
means company is financially stable.