- Importance of cash flow statements and its main activities
Cash flow statement is one of the financial statements a company or an organization makes to aggregate all the cash inflows (cash in) and cash out flow (cash out) within a certain period of time. A cash flow statement is prepared for a number of purposes. For instance, investors can use it to make a decision on whether they should invest in any given business or not. Secondly, entrepreneurs and business owners use the cash flow statement to help them understand how the business if performing and whether they should adjust their key strategies or initiatives (Weytjens et al.,2021). Further, managers use cash flow statements to properly manage their budgets, come up with closer relationships, and oversee their teams.
Importance of cash flow statement
- It gives an insight into in the spending activities by an organization
The cash flow statement gives an insight of the activities which an organization pays within a certain period (Ratnasingam et al.,2020). There are some payments which do not appear in the profit and loss but will be found in the cash flow statement for example loan repayment.
- Planning
Cash flow statement is better tool for planning for any organization. The organization will be able to know its current obligations and how much they have for the purposes of meeting its obligations like wages, and any other operating costs. According to Weytjens et al., (2021) planning enables companies to understand future risks associated with the current opportunities and threats. Comprehending this enables stakeholders to understand approaches to manage the risks such that they become eliminated or their occurrence impact is reduced.
Management of any cash crisis
Cash flow statement enables the shareholders an opportunity to know how much an organization has in terms of cash at both hand and bank, the management will be able to have adequate cash to manage any crisis which may arise due to shortage or excess cash.
- Working capital
Working capital is the available funds held by an organization for day-to-day operational expenses. According to Bhattacharya (2021) it is also referred to as net working capital which is the difference between a company’s current liabilities (debts and accounts payable) and current assets (accounts receivable /inventories of raw materials, finished goods and customer’s unpaid bills). The comparison allows the prediction of the company’s short-term financial health, liquidity and operational efficiency. When the difference between the two is positive it indicates the company’s ability to grow.
Main activities of cash flow statement are;
Financing activities:
These are cash from long-term liability and stockholder equity accounts, including notes payable, retained earnings and dividend payments. The financing activities are cash in or out from financing activities like ordinary capital or debt financing. Omag (2016) claims that a positive number in this section indicates that the money coming in is more than what is coming out. Consequentially showing that the company has the capability of managing their debts increasing the stakeholders and creditor’s confidence in investing into the company. Financing activities cash be identified through looking at changes in the company’s long-term liabilities as well as equity. Examples of cash flow activities include money received from the issuance of debt instruments such as bonds and noted payable, money received from stock that has been issues, money payments for distribution of dividend, purchase of treasury stock, and redemption of bonds or noted payable.
Investing activities:
These are the information about the business’s purchase or sale of long-term investments, such as property, buildings, vehicles, furniture or equipment. Although a positive number is preferred from these section investors prefer having cash flow from business operation rather than the investing activities (Weytjens et al., 2021). The investing activities from a cash flow statement can be easily identified by looking at the changes that take place in the cash flow activities of a balance sheet. Examples of investing activities are cash flow emanating from the purchase of equipment, buildings, land, and any other investment assets or even cash received from the sale of equipment, buildings, land, and any other investment activities.
Operating activities
These are the activities done in the normal cause of business. They costs incurred includes operating costs and profit items that are also found on an income statement, such as accounts receivable and payable, inventory, wages payable and income taxes payable. Operating activities may also include cash flow arising from dividend revenue interest expense as well as income tax.
- Advantages and disadvantages of ARR and Payback period in evaluating investments
The accounting rate of return is the average of return on investment for any company. It divides the profit by the average investment.
Advantages are;
- Simple to compute: Abor (2017) claims that compared to ARR computation of accounting rate of return is not complicated.
- Easy to understand: Any investor, including the small ones will be able to understand the accounting rate of return
- Ability to compare different firms or organization: The methods allow for the comparison of different firms with different sizes.
- It enables organization to calculate current performance based on the profitability measured
Disadvantages of ARR
- Accounting profits: Tax and other cash inflow and cash out flows are not considered
- Accounting Rate of Return is not applicable in situations where investment is made in different times or in part (Franklin, Grayvbeal & Cooper, 2019).
- It does not factor in time value of money. It assumes that the value of money received in different periods is equal.
- The results from different projects may not compare as it does not consider investments whose life period are different.
- The method does not consider other external factor which may affect the viability of a particular project or investment
Payback period: This is the number of period (days, weeks, months or years ) a project takes to recoup its initial investment amount.
Advantages of payback period
- Simple to compute: It’s not complicated when it comes to computing it.
- Easy to understand: Does not require specialized/technical knowledge to understand the method
Disadvantages of payback period method
- It does not consider time value of money: Value of money changes with time, however, payback period gives same value to same amount of money received in different period of an investment (Franklin, Grayvbeal & Cooper, 2019).
- It does not factor risk: An organization operates under various risks which should be factored in while calculating the value of money; payback period is short of this.
- Opportunity cost: Opportunity cost is the benefit from the best alternative investment forgone. Payback period do not put into consideration.
- Payback period do not consider cash inflows received after the initial cash out had been received.
I would use Accounting Rate of Return instead of Payback period because of the following reasons
- Accounting rate of return would factor in opportunity cost unlike payback period. This implies that, unlike the payback methods, accounting rate of return takes into consideration the comparison between the income and the initial investment instead of the cash flows (Franklin, Grayvbeal & Cooper, 2019). Such an approach is beneficial since it looks into the cost savings, revenues, and any expenses that may be associated with the investment that has been made. Normally, this gives a better picture of the impact as opposed to simply focusing on the cash flows that are to be produced.
- Accounting rate of return would put into consideration all benefit form an investment, regardless of whether initial cash out lay had been received or not (Franklin, Grayvbeal & Cooper, 2019).This is unlike what happens when using the payback period approach. By applying this approach, accounting rate of return shows the user not only the revenues that are generated from the asset but also the profit which is generated from the same.
- Budget is an estimation of how much money or funds an organization would get inform of income and how much, to be spent by an organization inform of expenditure within a certain period of time, which could be monthly, quarterly, semiannually or annually.
Importance of preparing budgets.
- An organization is able to identify its long and short term goals and develop strategies towards achieving the same
- It enables an organization to spend within its means; a firm will be able to spend only what they have.
- It facilitates communication and coordination within an organization: With budget in place, there would be a clear communication on what is required when and by how much and through this top hierarchy will be communicating with other staff
- It’s a tool of planning: Through budget, an organization is able to plan its activities systematically.
- It enables delegation of work: Each department is made aware of its budget hence have some responsibilities in terms of delegation to ensure that they achieve their targets within the budget.
- Motivation to staff: If the target for example revenue targeted is achieved, there would be motivation to staff.
Limitations of budget
- Assumptions: Unrealistic and inaccurate assumptions in budget may make it not achievable.
- Fixed budgets may not change as there are changes in the environment, they are very inflexible
- Time: Preparation of budgets takes time and consumes a lot of time which could have been spent in other activities
- Costly: In large organization, preparation of budgets consumes huge sums of money whose opportunity costs are enormous.
- Managers may forget other issues affecting an organization and focus more on achieving budgets.
Senthilnathan (2020) explains that percentage rate of return expected on an investment or asset, compared to the initial investment’s cost. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.
| QUESTION 2: TAN Plc | ||||||||||||||||||
| Part A: Income Statement and Balance Sheet | ||||||||||||||||||
| TAN Plc | ||||||||||||||||||
| Income | Statement | |||||||||||||||||
| For the Period Ending 31/12/2022 | ||||||||||||||||||
| $ | $ | $ | ||||||||||||||||
| Sales | 150000 | |||||||||||||||||
| Opening stock | 1500 | |||||||||||||||||
| Purchases | 60000 | |||||||||||||||||
| Less | Closing stock | -40000 | ||||||||||||||||
| Cost of goods sold | 35000 | -35000 | ||||||||||||||||
| Gross profit | 115000 | |||||||||||||||||
| Expenses | ||||||||||||||||||
| Bills expense | 37500 | |||||||||||||||||
| prepaid bills | -12000 | 25500 | ||||||||||||||||
| salary expense | 33000 | |||||||||||||||||
| Accrued salaries | 6500 | 39500 | 65000 | |||||||||||||||
| Net income | 50000 | |||||||||||||||||
| TAN Plc | ||||||||||||||||||
| Balance | Sheet | |||||||||||||||||
| For | Period | Ending | 31/12/2022 | |||||||||||||||
| ASSETS | $ | $ | ||||||||||||||||
| properties | 45000 | |||||||||||||||||
| machine | 30000 | |||||||||||||||||
| prepayments | 75000 | |||||||||||||||||
| stock | 40000 | |||||||||||||||||
| debtors | 22000 | |||||||||||||||||
| prepaid bills | 12000 | |||||||||||||||||
| cash | 37500 | 261500 | ||||||||||||||||
| financed by share capital | 112500 | |||||||||||||||||
| accruals | 44000 | |||||||||||||||||
| creditors | 55000 | |||||||||||||||||
| net profit | 50000 | |||||||||||||||||
| 261500 | ||||||||||||||||||
| Part B: Analysis of Financial Position through Ratio analysis Through ratio analysis, the financial position of TAN plc can be assessed quantitatively looking at the liquidity, efficiency, and profitability of the company. This is done by doing an analysis of TAN plc financial statements such as the balance sheet and the income statement. Profitability ratios are those that will be used to ascertain whether TAN plc is generating sufficient profits relative to the company’s operating costs, revenues, assets shown in the balance sheet, and the equity of shareholders. The specific profitability ratios that will be calculated include gross profit ratio, net profit ratio, and operating ratio. Liquidity ratios will be used to indicate whether TAN plc is capable of paying off the company’s current financial liabilities without necessarily having to borrow from external sources (Warren, Jonick & Schneider, 2020). The liquidity ratios that will be calculated include quick ratio and current ratio. On the other hand, efficiency ratios will be applied to show how well TAN plc is using its assets as well as liabilities internally. Efficiency ratios can be used to calculate the receivables of the company, its process of repayment of liabilities, and the manner in which it users in machinery and inventory. |
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| Profitability Ratios | ||||||||||||||||||
| i. Gross profit ratio =( GI/Sales) x 100 | ||||||||||||||||||
| (115000/150000) x100 = 76.65% | ||||||||||||||||||
| ii. Net profit ratio = (Net profit/Sales) x 100 | ||||||||||||||||||
| (50000/150000) x 100 = 33.33% | ||||||||||||||||||
| iii. Operating ratio = (Cost of goods sold plus operating expenses)/ sales x 100 | ||||||||||||||||||
| (100000/150000) x 100 =66.66% | ||||||||||||||||||
| The profitability ratios calculated above, indicate that TAN Plc is able to generate profit from its operations. The gross profit ratio of the company is high at 76.65 % which is shows that the Company is generating high enough profit. Further, the net profit ratio stands at 33.33% which is also good enough for the company since its generating sufficient revenues. The general implication of these three ratios is that TAN plc is efficiently using its re4sources to generate income. |
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| Liquidity Ratios | ||||||||||||||||||
| Quick ratio =( Current assets -inventory)/Current liabilities | ||||||||||||||||||
| (186500-40000)/99000 x 100 | ||||||||||||||||||
| 147.98% | ||||||||||||||||||
| Current ratio = Current assets/current liabilities x 100 | ||||||||||||||||||
| 186500/99000 x 100 | ||||||||||||||||||
| 188.38% | ||||||||||||||||||
| The company has got the ability to meet its short time liabilities with a lot of ease. The Quick Ratio of TAN plc is 147.98%. This ratio is greater than 1. Typically, this means that the company is healthy and can pay off its liabilities with ease since the greater the quick ratio of a company the healthier it is. If the quick ratio was less than 1, it would mean that the company is performing poorly and is not in a position to pay off its liabilities. Looking at the current ratio, TAN plc has a current ratio of 188.38%. Since this ratio is greater than 100% or even greater than 1, the company will manage to easily pay off its debts. The except current ratio of the company is 1.8838. A good current ratio should lie between 1.2 and 2 (Warren, Jonick & Schneider, 2020). This implies that the current ratio of TAN is higher than the recommended figure, so the company is healthy. |
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| Efficiency Ratios Debtors days = Year end debts/Sales x 365 |
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| 22000/150000 x365 | ||||||||||||||||||
| 53.53 days | ||||||||||||||||||
| This is approximately equal to 54 days | ||||||||||||||||||
| Creditors days = Creditors at end of year/purchases x365 | ||||||||||||||||||
| (55000/60000) x 365 | ||||||||||||||||||
| 334.58 days | ||||||||||||||||||
| This is approximately 335 days | ||||||||||||||||||
| PART C: Advice to Current and prospective Shareholders | ||||||||||||||||||
| They should not sell their shares because of the following reasons: | ||||||||||||||||||
| i. The industry profit ratio of 25% is less than the 33.33% for TAN Plc | ||||||||||||||||||
| ii. Industry current ratio of 125% is less than the 188.38% of TAN PLc. | ||||||||||||||||||
| iii. Industry average debtors days of 110 is more than 54 days for TAN PLc. | ||||||||||||||||||
| iv. Industry average creditors days of 13o days is less than 335 days of TAN plc. | ||||||||||||||||||
| Question 3: AMF LTD | ||||||||||||||||||
| Cash budget for AMF Ltd for 6 months | ||||||||||||||||||
| Receipts | October | Nov | Dec | Jan | Feb | March | ||||||||||||
| Opening Balance | 10000 | 5000 | 500 | -7000 | -10000 | -10000 | ||||||||||||
| Sales | 12000 | 12000 | 12000 | 12000 | 16000 | |||||||||||||
| Total | 10000 | 17000 | 12500 | 5000 | 2000 | 6000 | ||||||||||||
| Payments | ||||||||||||||||||
| To receipts credit | 2500 | 2500 | ||||||||||||||||
| Cash purchases | 9000 | 9000 | 9000 | 9000 | 9000 | |||||||||||||
| Bills | 1000 | 1000 | 1000 | 1000 | 1000 | 1000 | ||||||||||||
| Rent | 4000 | 4000 | 4000 | 2000 | 2000 | 2000 | ||||||||||||
| Equipment | 3000 | 3000 | ||||||||||||||||
| Total | 5000 | 16500 | 19500 | 15000 | 12000 | 12000 | ||||||||||||
| Purchases for November to March is 10000 each month. Discount is 10% which is equal to 1000. | ||||||||||||||||||
| Payment for purchases is 9000 from Nov 2022 to March 2023. | ||||||||||||||||||
| B. | Advise to AMF LTD | |||||||||||||||||
There are a number of strategies that the management of AMF Ltd should apply so as to better manage their cash flow. The first strategy is that the company should cut unnecessary expenses. This is done by taking an audit of all the company’s expenses. For instance, the management should decide on whether it is prudent for them to pay for subscription or software that the company does not use. A closer look at the expenses of the company will enable the management decide on whether the biggest expenses are actually providing a good return on investment or whether the expenses are greater than the value that they offer to the company. Alternatively, AMF can adopt a strategy of deferring payment of expenses. Such a strategy would help the company to retain its cash for longer periods. However, care should be taken to ensure that by delaying payment of expenses, it does not end up destroying its credit rating or reputation.
The second strategy that can adopted by AMF Ltd to improve cash flow would be prompt collection of money from customers. One way of achieving this would be by promptly sending out invoices to customers. The faster this is done, the faster the company gets paid. If this is not done, the company may decide to send out payment reminder letters to customers who are late in making their payments. If this fails to work, phone calls can be made to the customers to remind them about their unpaid invoices (Warren, Jonick & Schneider, 2020). Finally, AMF Ltd should offer various methods of to their customers. This is because the more convenient and easier a company makes it for their customers to make payments, the faster the company gets paid. The most common method of facilitating this is by allowing customers to manage their payments online. By making it possible for customers to have various online payment options such as debit cards, credit cards or even mobile payment, the faster they are likely to pay.
References
Abor, J. Y. (2017). Evaluating capital investment decisions: Capital budgeting. In Entrepreneurial Finance for msmes (pp. 293-320). Palgrave Macmillan, Cham.
Bhattacharya, H. (2021). Working capital management: Strategies and techniques. PHI Learning Pvt. Ltd..
Franklin, M., Grayvbeal, P., & Cooper, D. (2019). Principles of Accounting, Volume 1:
Financial Accounting.
Omag, A. (2016). Cash flows from financing activities. Evidence from the automotive industry. International Journal of Academic Research in Accounting, Finance and Management Sciences, 6(1), 115-122.
Ratnasingam, J., Khoo, A., Jegathesan, N., Wei, L. C., Abd Latib, H., Thanasegaran, G., … & Amir, M. A. (2020). How are small and medium enterprises in Malaysia’s furniture industry coping with COVID-19 pandemic? Early evidences from a survey and recommendations for policymakers. BioResources, 15(3), 5951-5964.
Senthilnathan, S. (2020). Capital Budgeting–The Tools for Project Evaluation. Available at SSRN 3748067.
Warren, C. S., Jonick, C., & Schneider, J. (2020). Financial accounting. Cengage Learning.
Weytjens, H., Lohmann, E., & Kleinsteuber, M. (2021). Cash flow prediction: MLP and LSTM compared to ARIMA and Prophet. Electronic Commerce Research, 21(2), 371-391.
