Financial Management

Unit 2 Techniques of Financial Analysis:

Meaning, Nature, Objectives and limitations of financial
analysis. Tools of analysis and interpretation,, fund flow
statement analysis ( Working capital basis) ,Cash flow
statement analysis (Cash basis) ,Ratio analysis
(Interpretations of ratios only) (8+2)
HBPS case:
West Jet Airlines- Investment Strategy on 1
st
and 2
nd
Unit.
Lowes Companies Incorporation
FINANCIAL MANAGEMENT

Introduction:
Financial Management studies about
the process of procuring and judicious
use of financial resources with a view
to maximizing the value of the firm
there by the value of the owners.

Functions of Finance
In modern sense it can be broken down
into three major decisions as functions
of finance:
a. The Investment Decision
b. the Financing Decision
c. the Dividend Policy Decision.

FINANCIAL STATEMENT
A financial statement is an organized
collection of data according to logical and
consistent accounting procedures.
Its purpose is to convey an understanding of
some financial aspects of a business firm.
FS are also called as Financial Reports/
Financial Information
Functions of Financial
Statements
Financial Statements (FS) serve important functions:
FS provide information on how the firm has
performed in the past and what is its current financial
position.
FS are a convenient device for the stakeholders (i.e.
shareholders, creditors, regulators and others) to set
performance norms and impose restrictions on the
management of the firm.
FS provide useful templates for financial forecasting
and planning.

OBJECTIVES OF FINANCIAL STATEMENT
The objective of financial statements is to provide
information about the financial position, performance and
changes in financial position of an enterprise that is useful
to a wide range of users in making economic decisions.
To meet the common needs of most users.
Providing information for economic decision:
Providing information about the financial position.
Providing information about performance of an enterprise.
Providing information about changes in financial position.
Assumptions of Financial Statements/
Concept used in Financial Statement
Separate Entity Concept:
According to this concept the company (business) is
considered as a separate legal entity from its
shareholders or stakeholders.
Double Entry:
This concept states that every transaction has
minimum two effects. The receiving and giving
effect.
Principal of Double Entry System
Every debit has corresponding credit and
Every credit has a corresponding debit is the.
Assumptions of Financial
Statements:
Going Concern: It is assumed that accounts are drawn up on the basis
that enterprise will continue in operational existence for the foreseeable
future. This is important assumption for valuation of assets. The value of
the assets are taken to be based on what they cost with adjustment in the
form of depreciation for fixed assets which have been declining in value
over a period of time.
Accrual basis: Profit = Revenue Expenses.
The process of matching is an attempt to ensure that revenues recorded in
a period are matched with the expenses incurred in earning them.
Revenues are recognized at the point of sale ( when they are earned
usually at the date of a transaction with a third party), and not when
collected and expenses when they are incurred rather than when actually
paid.. The costs of running the business should not be treated as a flow of
cash.
Characteristics of Financial Statements
Understandability: understand by users
Relevance: useful and relevant to decision making needs of users.
Materiality: nature of information. materialistic
Reliability: information must be reliable, free from errors and bias.
Substance: presented& accounted with substance and eco reliability.
Neutrality: free from bias
Prudence: assume losses but no overstating profits.
Completeness: complete within the bound of material and cost.
Comparability: to compare trends in financial position and performance
through time.

Forms of Consistency:

While preparing financial statements the following form of
consistency are taken into consideration.
Vertical Consistency: It is achieved when the same accounting
policies, methods and practices are adopted while preparing
interrelated financial statements of the same date.
Horizontal Consistency:
It is achieved when the same entity adopts the same accounting
policies, methods and practices from year to year.
Third Dimensional Consistency:
It is the consistency in accounting policies, methods and practices
followed by different units in the same industry.
Types of Financial Statements:
Income Statement: Prepared vertically or
horizontally as per statue.
Balance Sheet : The Companies Act 1956 stipulates
that the Balance Sheet of a joint stock company
should be prepared as per Part I of Schedule VI of
the Act. Prepared vertically or horizontally as per
statutory provisions.
Statement of Retained Earnings
Fund Flow statement
Cash Flow statement
Schedules

Profit and loss Appropriation A/c
Statement of Retained Earnings:
It is prepared to show how the balance
in Profit and loss account is
appropriated for various purposes like
transfer to reserves, dividend etc
Limitations of Financial Statements:
Net profit/loss is ascertained on historical cost basis.
Actual profit can be ascertained only after the firm achieves its
maximum capacity.
Fails to disclose quality of product, management efficiency etc.
Balance sheet shows past positions of the company and not
present and future.
The net income disclosed is only relative and not absolute.
Use of FS are limited in decision making by management,
investors, creditors etc.
FS cannot be formed as a reliable basis basis of judgement as FS
are based on accounting policies which may vary from company
to company.
Financial Statement Analysis:

It means study of relationship among
various factors in a business as disclosed by
financial statements of a firm. It shows the
trend of the factors and will help in
evaluation of component parts. It is done to
obtain a better insight into a firms position
and performance.
Objectives of Financial Statement
Analysis:
To judge the financial health of the firm.
To evaluate the profitability of the
enterprise.
To gauge the debt servicing capacity of the
firm.
To understand the long term and short term
solvency of the firm.
To know the return on capital employed or
invested.
Types of Financial Statement Analysis:
External Analysis: It is done by the outside agencies like
investors, financial analysts, lenders, government agencies,
research scholars etc.
Internal Analysis: The management is interested in the
analysis of financial statements for measuring the
effectiveness of its own policies and decisions.
Horizontal Analysis: It is done for finding the trend ratios
and in comparative financial statements. When evaluation is
done for several years simultaneously at a time for making
conclusions, it is called horizontal analysis.
Vertical Analysis: It is the study of quantitative
relationship of one financial item to another based on
financial statement on a particular date. For eg. Ratio
analysis, Common size statement.
Types of Financial Statement Analysis
Long Term Analysis:
The objective of long term analysis is to determine
whether the earning capacity of the firm is sufficient
to meet the targeted rate of return on investment,
and is adequate for future growth and expansion of
business. It is done to evaluate long term solvency,
profitability, liquidity, financial health, earning
capacity of the firm etc.
Short Term Analysis:
It is done to determine the liquidity position of the
firm and short term solvency of the firm. The
analysis is oriented on efficiency of working capital
management and profitability of current operations.

Methods of Analyzing Financial Statements:
Comparative Financial Statements:
CFS are statements of financial position of a
business designed to provide time perspective to the
consideration of various elements of financial
position embodied in such statements.
It includes :
Comparative Financial Statement
(Income and Balance Sheet)
It reveals :
absolute data (money value or rupee value),
Increase or reduction in absolute data in terms of
money values
Increase or reduction in absolute data in terms
percentages,
Comparison in terms of ratios,
Percentage of totals
Inter firm comparison (means two or more firms
financial statements are compared for drawing
inferences)


Common Size Financial Statements
Common Size Financial Statements are percentage conversion
of Financial Statements i.e. P& L accounts and Balance Sheet to
establish each element to the total figure of the statement.
Useful to analyse the performance of the company
It includes
1. Common size Income Statement: In this the sale figure is
taken as 100 and all other figures of costs and expenses are
expressed as percentage of sales.
Profit = Sales (cost + other expenses). It reveals the
efficiency of the firm in generating components of cost as
proportion to sales. Inter firm comparison of common size
income statement reveals the relative efficiency of costs
incurred.
Common Size Financial Statements
2. Common Size Balance Sheet: In this the total of
asset or liability side is taken as 100 and all figures
of assets and liabilities, capital and reserves are
expressed as proportion to the total i.e. 100. It
reveals the proportion of fixed assets to current
assets, proportion of long term funds to current
liabilities; inter firm comparison, financial health
and long term solvency of the firm etc.

TREND RATIOS
Trend Ratios: are the index numbers of the movements of
reported financial items in the financial statements which are
calculated for more than one financial year. Trend ratio help in
making horizontal analysis of comparative statements. It reflects
the behavior of items over a period of time.
Computation of trend ratio:
1. Follow accounting principles and policies consistently
throughout the period for which trend ratios are calculated.
2. It is calculated only for the item having logical relationship
with one another.
3. It should be made at least for 4 consecutive years.

TREND RATIOS
One years financial statement should be selected as
a base statement and financial items of it should be
assigned with value as 100.
Following formula is used to calculate trend ratios
of subsequent years:
= Absolute figure of financial statement under study X 100
Absolute figure of same item in base financial statement
Tabulate the trend ratios for analysis of trend over a
period.




Ratio Analysis
RATIO
Ratio: A ratio is an arithmetical relationship between two
figures.
Ratios are relative figures reflecting the relationship
between related variables.
Ratio analysis is defined as the systematic use of ratio to
interpret the financial statements so that the strengths,
weaknesses, historical performance and current financial
condition of the business can be determined.
Financial ratio analysis is a study of ratios between various
items or groups of items in financial statements.

PURPOSE/USES OF RATIO
Financial ratios are used to compare the risk and return of different
firms in order to help equity investors and creditors make intelligent
investment and credit decisions.
Enable comparison of the performance of the company
- in different years
- with its budgets and forecasts
- with other companies in similar trades (inter firm comparison).
Provide information of the company in respect of the liquidity,
profitability, use of assets and capital structure
Eliminate the effects of the scale and size of different companies or
different years of the same company so comparison can be provided.
Appraise the performance of the company, make predictions for future
performance and assist in future planning




Purpose/Uses of accounting ratios

To identify aspects of a businesss
performance to aid decision making
Quantitative process may need to be
supplemented by qualitative factors to get
a complete picture.
Ratios can be classified into liquidity,
capital structure or leverage , profitability
and activity. The firm uses these ratios as
per the requirement in decision making.

Areas or Types of Ratios
1. Liquidity the ability of the firm to pay its way.
2. Profitability how effective the firm is at generating
profits given sales and or its capital assets.
Investment/shareholders information to enable
decisions to be made on the extent of the risk and the
earning potential of a business investment.
Financial the rate at which the company sells its stock
and the efficiency with which it uses its assets.
3. Activity/Turnover /Efficiency / Asset Management
Ratios - are concerned with efficiency in asset
management. It is a test of relationship between sales or
cost of goods sold and assets.
4. Solvency/Capital structure or Leverage ratios
information on the long term solvency of a firm.
Accounting ratios and interpretation
I . LIQUIDITY:
Liquidity is a measure of the amount of funds a company can quickly
use to settle its debts.
It Measure the ability of a firm to meet its short term obligations and
reflect its short term financial strength or solvency.
Following are the important liquidity ratios:
1. current ratio / working capital ratio
2. acid test ratio / quick ratio / liquid ratio
3. stock turnover rate
4. stock turnover period
5. debtors collection period
6. creditors payment period
Liquidity Current ratio
Current ratio is the ratio of total current assets to total current
liabilities.
This ratio indicates the ability of a business to meet its short-term
liabilities from its current assets.
It is also known as solvency ratio as it indicates how current
obligations are covered by current assets.
The ratio indicates the proportion of CA to meet CL.
The norm or standard ratio is 2:1.
If the ratio is too high, the company may be holding too many idle
short-term assets. (They may be used in a more profitable way.)
The excess investment in CA results in decrease in profitability due
to blocking of large funds in working capital.
If the ratio is too low, the company may not have sufficient funds
to meet its short-term liabilities.
Liquidity Current ratio
Formula : Current ratio = Currents Assets/Current Liabilities
Current Assets means assets which have been purchased to convert
them into money or cash within a short period of time i.e. a year.
Current assets includes Cash, Bank balance, Debtors, B/R,
Inventories (stock), A/c Receivables, short term investments, short
term loans, and prepaid expenses.
Currents Liabilities means liabilities with a short term period i.e. up
to one year.
Currents Liabilities includes creditors, A/c payables, Bills Payable
(B/P), Bank overdraft, provision for taxation, outstanding expenses,
unclaimed dividend, short term loans, o/s interest, advance payment
received , debt of less than a period of one year.
Liquidity Acid test/Quick ratio
This ratio indicates the ability of the business to meet its
short-term liabilities from its quick assets.
This ratio is a better tool to measure the ability to meet day
to day obligations.
It represents the ratio between quick current assets and the
total current liabilities excluding bank overdraft.
The norm is 1:1.
If the ratio is too high, the company may be holding
excessive liquid assets.
If the ratio is too low, the company may have a liquidity
problem / cash flow problem.
Liquidity Acid test/Quick ratio
Formula : Liquid ratio = Current Assets- Stock Prepaid
expenses/ Current Liabilities Bank Overdraft
Liquid assets includes Cash, Bank balance, Debtors, B/R,
A/c Receivables, short term investments, short term loans.
Liquid Liabilities includes creditors, A/c payables, Bills
Payable (B/P), provision for taxation, outstanding expenses,
unclaimed dividend, short term loans, o/s interest, advance
payment received , debt of less than a period of one year.

Liquidity Super Quick ratio
Super Quick ratio or absolute liquid ratio or cash
position ratio consider only cash in hand and at
bank and marketable securities i.e. short term
investments in current assets.
The optimum value for this ratio should be 1:2. If
ratio is less than one it indicates companys day to
day cash management is poor.
Formula :
Super Quick ratio = cash + marketable
securities/Current Liabilities


Liquidity stock turnover rate
It shows the number of times that a business
can sell its average stock in a period.
A high ratio means high sales, fast stock
turnover and a low stock level.
A low ratio means low sales, low stock
turnover and a high stock level. (goods may
become obsolete, high storage cost)
Liquidity debtors collection
period
This ratio measures the debt collection
period of a business.
A low ratio means debtors pay back their
debts in a short period of time. The
company may have sufficient liquid fund.
A high ratio indicates a poor credit control
and a high risk of bad debts.
Liquidity creditors payment
period
This shows the length of time taken to pay
the creditors.
A long payment period may indicate that
the company has a liquidity problem. The
relationship between the company and the
suppliers may be affected.
Accounting ratio and interpretation
II. PROFITABILITY: ratios helps to measure the
profitability of the firm.
Difference between Profit and Profitability:
Profit: = Income /Revenue- Expenses
Profitability: is a measure by comparing the profit with other
parameters like sales, investment , total assets , capital employed etc.
The profitability ratios based on Sales indicates the proportion of
sales consumed by operating cost and proportion available to meet
financial & other expenses.
The profitability ratios based on Sales are :
- Gross and Net Profit Ratio
- Expenses or Operating ratios
Accounting ratio and interpretation
II. PROFITABILITY ratios related to sales:
1. Gross profit or margin ratio= Gross profit/net sales X 100
Gross profit = Sales- Cost of goods sold
Net sales = Gross Sales- Sales return
2. Net profit ratio= Net Profit or Earning After Tax/ Net sales X 100
3. Operating Net Profit ratio
= operating net profit or PBIT or EBIT / Net sales X 100
Operating net profit= Net Profit + Non operating expenses-non operating income
OR Gross profit- Operating expenses
4.Cost of goods sold ratio= Cost of goods sold / Net sales X 100
5. Operating Ratio = Cost of goods sold+ Operating expenses or EBIT / Net sales
X 100
(Non operating income and expenses are excluded from above ratio)
6. Operating Expenses ratio = Administrative exp + Selling & Distribution
expenses / Net sales X 100
7. Selling Expenses ratio = Selling expenses / Net sales X 100

Profitability gross profit ratio
It shows the gross profit on sales.
A low ratio means the stock is being sold at
lower prices. It may be a policy to stimulate
sales.
A high ratio may not result in high gross
profit figure unless a large volume of sales
is achieved.
Profitability net profit ratio
It shows the net profit as a percentage of
sales.
It gives some ideas of the companys
pricing policy and cost control.
A low ratio may be the result of lower
selling prices or higher operating costs.
Profitability return on capital employed
This ratio shows the profitability of a
business and the management effectiveness
in terms of the use of capital.
A higher ratio means a higher profitability
and a better management efficiency.

Capital employed (Sole trader)
Closing capital
Average capital
Capital balance + long term loans
Capital employed (Partnership)
Closing balance on fluctuating capital accounts
Average of opening and closing balances on the
fluctuating capital accounts
Total of fixed capital accounts plus total of current
accounts
Average of fixed capital accounts plus total of
current accounts
Any of the above plus long term loans to the
partnership
Capital employed
(Limited company)
- total assets
- long term suppliers of capital (ordinary
shares + preference shares + reserves +
long-term loans)
- shareholders capital (ordinary shares +
preference shares + reserves)
- shareholders equity (ordinary shares +
reserves)

Return
Net profit after tax and preference share
dividends (for ordinary shareholders)
Net profit after tax + any preference share
dividends + debenture and long-term loan
interest (for all long-term suppliers of
capital)
Profitability assets turnover
This indicates the efficiency of the business
in using its assets to generate revenues.
A higher ratio means the company is more
efficient to use its assets to generate
revenues. This results in higher profitability.
Accounting ratios and interpretation
III. Activity/Turnover /Efficiency / Asset Management Ratios:
These ratios are concerned with measuring the efficiency in asset management.
Turnover or activity ratios are a test of relationship between sales/Cost of
goods sold and assets.
First it indicates number of times inventory is replaced during the year or
how quickly the goods are sold.
The second category of turnover indicates the efficiency of receivables
management ands how quickly trade credit is collected.
Total asset turnover reveals the efficiency in managing and utilizing the total
assets.
Depending upon type of asset activity ratio may be
- Inventory or stock turnover ratio
- Receivable or debtors turnover ratio
- Total asset turnover ratio
Management efficiency/Turnover ratio
Stock turnover rate measures the efficiency of sales
and stock levels of a company.
Debtors ratio indicates the credit control of the
company. (lenient credit control?)
Creditors ratio indicates the ability of the company
to obtain long-term financing.
Assets turnover shows the efficiency of the business
in using its assets to generate revenues.
Accounting ratios and interpretation
Formulas:
1. Working capital turnover ratio = Cost of goods sold/Sales
average net working capital
2. Raw material turnover = Cost of raw material used
Average raw material inventory
3. Work in process turnover = Cost of goods manufactured
Average work in process inventory
4. Finished goods inventory turnover = Cost of goods sold/Sales
Average finished goods inventory
5. Debtors turnover ratio = Credit sales / (Average debtors +Avg. B/R) or
accounts receivables.
The higher the ratio, lower is the collection period.
The lower ratio indicates higher collection period.
Accounting ratios and interpretation
Formulas:
6. Average collection period (days) =
Months or days in a year i.e.365 days
Debtors turnover ratio

7. Total Assets turnover = Cost of goods sold/Sales
average total assets
8. Fixed assets turnover = Cost of goods sold/Sales
average fixed assets
Note: If cost of goods sold is not available , sales figure is
used in the numerator.
Accounting ratios and interpretation
IV. Solvency/Capital structure or Leverage
ratios:
Solvency refers to the capacity of the business to meet
its short term and long term obligations.
It shows light on Long-term solvency and stability.
There are two types of such ratios:
1. Debt equity or Debt Asset ratio
2. Coverage ratios

Long-term solvency Debt ratio
Debt to total asset ratio :
Total debts
= Total assets X 100%
Debt ratio shows the total amount of liabilities to total assets.
If the debt ratio is too high (more than 50%), it is difficult to
obtain further financing and it also has a heavy burden of
interest expense.


Gearing ratio
Gearing ratio
Prior charge capital
= --------------------------------------- X 100%
Total capital
Prior charge capital = preference shares + long term loans
Total capital = ordinary share capital + reserves +
preference shares + long term loans
Long-term solvency gearing ratio
It is concerned with the companys long-term
capital structure.
A high gearing ratio indicates a high portion of
funds is obtained from borrowings. It may lead
to long-term insolvency. It is difficult to obtain
further financing and has to bear a high
interest burden.
Ordinary shareholders may not get any
dividends in bad times as very little profit is
left over for them
Gearing ratio
High geared company
Investment is more
risky
Larger dividends will be
available in good times
Low geared company
The risk of investment
is relatively lower
It is more certain to
have dividends.
Changing the gearing
To reduce gearing
By issuing new ordinary
shares
By redeeming
debentures
By retaining profits
To increase gearing
By issuing debentures
By buying back
ordinary shares in issue
By issuing new
preference shares
Accounting ratio and
interpretation
Investment appraisal
- earnings per share
- price earning ratio
- dividend cover
- dividend yield
Earnings per share
Earnings per share (EPS)
Net profit after tax and preference dividends
= ------------------------------------------------------
No. of ordinary shares issued
(ranked for dividends)
Investment appraisal earning
per share
It shows the profit in dollars associated with
each ordinary share.
A higher earnings per share indicates the
investors may have higher confidence in the
company. It is more profitable to invest in
the shares.
Price / earning ratio
Price / earning ratio
Market price per share
= -----------------------------------------
Earnings per share
It shows the profit in rupees associated with each
ordinary share.
A higher earnings per share indicates the investors
may have higher confidence in the company. It is
more profitable to invest in the shares.

Dividend cover
Dividend cover
Net profit after tax and preference dividends
= -------------------------------------------------------
Ordinary dividends paid and proposed
It shows the amount of profit that has been distributed as
dividends.
A low ratio means a large amount of profits has been retained as
reserves which can help to finance the operations of the
company.
A high ratio means a large amount of profits has been distributed
as dividends. The dividend payment is vulnerable unless the
company becomes more profitable.

Dividend yield
Dividend yield
Dividend per share for the year
= -------------------------------------------- X 100%
Current market price of the share
This ratio measures the rate of return obtained from
dividends on an investment in shares.
A high dividend yield may imply the company is
more successful and efficient. It is more profitable to
invest in these shares.

Other ratios
The company will be able to pay interest on the loan when it
falls due. (short-term liquidity)
- current ratio and acid test ratio
It will be able to repay the loan on maturity. (long-term
solvency)
- operating profit / loan interest
- total external liabilities
- shareholders fund / total assets

Limitations of ratio analysis
1. Different definitions of capital employed may cause
confusion.
2. Changes in price level will affect the comparability of the
ratios between two financial periods.
3. Changes in external environment will affect the comparison.
4. Differences in management and background of various
businesses may affect the comparison.
5. Different accounting definitions, methods, techniques and
policies used by various businesses may affect the
comparability.
6. It is difficult to set up a proper standard for good
performance.
7. Short term fluctuations may not be reflected.


Fund Flow Statement Analysis:
Working Capital Basis
Working capital
Introduction
Working capital typically means the firms
holding of current or short-term assets such
as cash, receivables, inventory and
marketable securities.
These items are also referred to as
circulating capital
Corporate executives devote a considerable
amount of attention to the management of
working capital.













Definition of Working Capital


Working Capital refers to that part of the firms capital,
which is required for financing short-term or current
assets such a cash marketable securities, debtors and
inventories. Funds thus, invested in current assets keep
revolving fast and are constantly converted into cash and
this cash flow out again in exchange for other current
assets. Working Capital is also known as
Revolving or Circulating capital or Short-
term capital.
Concept of working capital
There are two possible interpretations of working
capital concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept:
There are two interpretations of working capital
under the balance sheet concept.
a. Excess of current assets over
current liabilities
b. gross or total current assets.

Excess of current assets over current liabilities are
called the net working capital or net current
assets.
Working capital is really what a part of long term
finance is locked in and used for supporting current
activities.
The balance sheet definition of working capital is
meaningful only as an indication of the firms current
solvency in repaying its creditors.
When firms speak of shortage of working capital they
in fact possibly imply scarcity of cash resources.
In fund flow analysis an increase in working capital,
as conventionally defined, represents employment or
application of funds.
What is Fund Flow Statement?
Fund Flow Statement describes the sources from
which additional funds were derived and the uses to
which these funds were applied.
1.Increase the Current Assets but do not bring any
increase in Current Liabilities, and vice-versa.
2.Decrease the Current Assets but do not bring any
decrease in Current Liabilities and vice-versa.
Why to prepare Funds Flow Statement?
1.Effective tool of managing working capital
2.Knowledge of change in working capital
3.Knowledge of Funds from operation
4.Knowledge of inflow of Funds
5.Knowledge of Application of Funds
6.Knowledge as to the payment of C.L. and C.A.
7.Knowledge as to the purchase of F.A. and C.A.
8.Knowledge of supplementary information
9.Helps in Borrowing Operation 10.Acts as a
process of Budgeting
Funds Flow statement Working Capital Basis


The funds flow statement, on working capital basis, presents (1) the source of
working capital. (2) The use of working capital (3) the net change in working
capital.
Various sources and uses of working capital shown in the table below
Net change in working capital = Uses of working capital Sources of working
capital
Sources and Uses of Funds on working Capital Basis:
Sources
1. Funds from operations
2. sales of non-current assets
3. Long term financing
(i) Long term borrowings (loans/bonds etc)
(ii) Issuance of equity and preference shares.
Uses:
1. Purchase of non-current assets
2. Repayment of long term and short term debt
3. Payment of cash dividends

Funds Flow Statement cash Basis
The funds flow statement, on cash basis, shows (1) the sources of cash (2) the uses of cash (3) the net
change in cash. The sources of cash are the sources of working capital plus changes within the working
capital account which augments the cash resources of the business. The uses of cash again are the
changes which use working capital plus changes within the working capital account which deplete the
cash resources of the business. These latter changes are simply the increase in current assets other than
cash. The sources and uses of cash are shown below. Net change in cash = Sources of cash Uses of
cash.
Sources and Uses of Funds on cash Basis:
Sources
1. Profits from operations
2. Decrease in any asset (other from cash)
3. Increase in liabilities
4. Issue of shares
Uses
1. Loss from operation
2. Increase in any asset (other from cash)
3. Decrease in liability
4. Payment of cash dividends
The main difference between the working capital basis and the cash basis is that, working capital basis
treats increase in inventories and accounts receivable as equivalent to increase in cash. But in statement
on cash basis it summarizes only the cash inflows and outflows over a period of time and as the cash
from inventory is realized after a period, inventory is not treated as a source of cash. So, you can
understand the difference of meaning of fund in working capital basis and in cash basis.