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CHAPTER 24

FINANCIAL STATEMENTS AND CASH FLOW ANALYSIS 

Q.1. Explain the concept of ‘working capital flow.’ Give examples of transactions that affect

working capital, and that do not affect working capital.

A1. The working capital flow means increase or decrease in the amount of working capital onaccount of effect of any transaction. There are some transactions which will not change the

working capital flow. The most of the items of Profit & Loss Account and also the business

events, affecting simultaneously both current and non-current items of Balance Sheet, aregoing to affect the working capital flow. For example, issuance of ordinary shares for cash,

purchase of machinery for cash, etc. The transactions that affect only the current items of

Balance Sheet are not going to affect the working capital flow. For example, receipt of fundsfrom debtors and release of cash payment to creditors.

Q.2. ‘Deprecation is an important source of working capital (funds).’ Do you agree? Defend youranswer.

A.2. Depreciation is not a source of funds. The depreciation is added back in the profit after tax todetermine the funds from operations, because depreciation is notional entry for charging capital

consumption costs against income or revenue of firm, on account of matching concept ofaccountancy.

Funds mean change in cash only or change in working capital only. The depreciation is

a non- cash payment entry in the books of account, so it does not change cash. As depreciationis provided on fixed assets, e.g., non-current assets, so it does not affect the working capital

also.

Depreciation does not use cash or working capital, but it indirectly influences the flowof funds by affecting the tax liability of the business or firm since depreciation is a deductible

expense.

Q.3. Explain the major sources and uses of working capital.A.3. The major sources of working capital are as follows:

1.  Net Profit from operations: The net profit as shown by P&L a/c to be adjusted for non-

cash transactions considered in P&L a/c, and also gain or loss on sale of non-currentassets, etc.

2.  The amount realized on account of sale of long-term investments, tangible and

intangible assets.3.

 

Finance obtained by issuance of long-term instruments like bonds, debentures, shares;

borrowing of funds from financial institutions, banks, and non-banking finance

companies, etc.

The major uses of working capital are as follows:1.

 

Net cash loss from operations.

2.  Purchase of long-term investments, tangible and intangible assets.

3.  Repayment of long-term debt like bonds, debentures, bank loans and short-term debtlike overdraft, cash credit, etc.

Q.4. Explain and illustrate the preparation of a statement of changes in working capital.A.4. A statement of changes in working capital supports the management to reveal the way in which

working capital was obtained and used. If used for long-term planning, it provides estimates of

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working capital flow and the firm’s capacity to repay long-term debt and also to determinewhether or not adequate working capital will be generated to meet firm’s expansion,

diversification, modernization, etc.

The flow of working capital may be summarized as follows:1.

 

The net working capital increases or decreases when a transaction involves a current

account and a non-current account.

2. 

The net working capital remains unaffected when transaction involves only currentaccounts.

3. 

The net working capital remains unaffected when transaction involves only non-current

accounts.

Q.5. What is the utility of a funds flow statement in which ‘funds’ refer to ‘all financial resources’?

A.5. The ‘all financial resources’ funds flow statement is an important evaluation and planning tool.

It gives a clear picture of the causes of changes to the company’s working capital. It alsoindicates the financing and investment policies followed by firms, the non-current assets

acquired and the manner in which the funds have been obtained. It also indicates the liquidity

position, significant investment, repayment capacity, etc.

Q.6. How can a statement of changes in cash flows be prepared? How does it differ from the

statement prepared on working capital basis?A.6. Cash flow statement is a tool for short-term planning, and also useful to evaluate the short-term

liquidity position of a firm. Cash flow statement is prepared after considering the cash inflows

and cash outflows. Cash flow statement summarizes the causes of changes in cash position 

between dates of the two balance sheets. The funds flows statement, on the other hand, focusesthe attention on working capital, i.e., medium-term liquidity; the cash flow statement focuses

attention on cash, i.e., short-term liquidity.

Q.7. Explain why transactions such as depreciation expense, amortization of debenture discount and

similar internal items are neither sources nor applications of financial resources yet are treatedas adjustments to net profit.

A.7. The transactions like depreciation expenses, amortization of expenses (prepaid), etc., do not

involve use of cash or working capital. The depreciation as well as amortization of prepaid

expenses simply spread the outflows incurred earlier over the life of the assets for measuringthe results of the operations. These items are deducted from revenue of the firm to find out the

net profit as per matching concept.

Q.8. How can a statement of changes in working capital or cash position be converted into astatement of changes in financial position on ‘all financial resources’ basis? Illustrate your

answer.

A.8. The statement of changes in working capital or cash position can be expanded to disclose allthose transactions which significantly influence the firm’s financial position, but do not

increase or decrease working capital or cash. For example, it is event if a company converts its

debentures of, say, Rs 300 million (Rs 30 crore) into equity shares. This is a significant eventas it changes the company’s debt-equity position. This transaction should be disclosed in the

statement. Similarly, the issuance of bonus shares (stock dividend) does not involve working

capital or cash but changes the paid-up share capital. The statement of changes in working

capital or cash position is recast to incorporate changes in all financial resources to convert intoa statement of changes in financial position on all financial resource basis.

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Q.9. Is it possible for a company, with sizeable net profit, not to be in a position to pay dividends to

shareholders? Illustrate your answer.

A.9. Yes it is possible for a company with sizeable net profit not to be in a position to pay dividendsto shareholders. Payment of dividend requires cash. Company might have earned profits but

profits are used to meet the investing and financing needs of the company with no surplus cash

to pay dividends.

Q.10. What is a statement of changes in financial position? How does it differ from funds flow or

cash flow statement?A.10. The statement of changes in financial position is a more comprehensive statement

incorporating all changes; it has an analytical value as well as it is an important planning tool.

It gives a clear picture of the causes of changes in the company’s financial position with or

without affecting working capital or cash flow position. Funds flow statement helps the firm toknow its liquidity position, capital expenditure incurred, dividend paid and the extent of

external financing. A projected funds or cash flow statement guides the firm to plan the

matching of inflow and outflow of funds or cash.

Q.11. What are the uses of a statement of sources and uses of working capital? When is it more

appropriate to prepare a statement of cash flow?A.11. Uses of statement of sources and uses of working capital are as follows:

a) 

Indicates the liquidity position of the firm.

b)  Indicates the extent of the firm’s working capital needs being met by the internally

generated funds.c)

 

Indicates whether the firm used external sources of finances to meet its needs of funds.

d)  Indicates if the firm sold any of its non-current assets, and the proceeds from such sales.

e)  Indicates if the non-currents were sold for repayment of current liabilities (or long termliabilities).

f) 

Indicates the significant investment and financing activities of the firm, and also thosewhich did not involve working capital.

In the long run, the firm is interested in working capital because the items of working

capital will ultimately change into cash. But to make the payment in immediate future the firm

needs cash, so for short-term financial planning cash flow statement is needed.