UNIT 4: THE CASH MANAGEMENT PROCEDURES IN ORGANIZATION
Key unit competence: Describe the cash management procedures in organization
Introductory activity
1. Analyze the above picture and answer the questions that follow:
i) Identify the different activities shown on above picture.
ii) Which kind of agents intervening in the specified activities?
iii) Are all agents having the same intention? Which ones and in which
way?
iv)Which cash management procedures are involved in the above
activities?
1.1. Introduction to cash management
Learning Activity 4.1
HEMA PLC is profit oriented company processing many products from two
cereals, which are maize and wheat, for sales in Rwanda. The products
produced in that enterprise are Maize flour super, Maize flour Bugesera,
Wheat flour porridge and Wheat Flour Baker all of which were experiencing
sharp growth of sales and profitability to the whole business.
In the post Covid-19 period, HEMA PLC improved its organizational
management strategy and announced an implementation plan of 2 years.
The plan shows that Cash receipts from sales and Investments are estimated
to be FRW 10,000,000 and FRW 35,500,000, respectively; FRW 12,500,000
cash payments on supplies; Salaries of FRW 25,000,000 payables in the
period in which they occur; Other cash payments estimated as being
FRW 4,200,000 and Opening cash balance was FRW 300,000. Because
of external factors from business environment which made cereals to
become scarce, HEMA PLC borrowed FRW 3,000,000, as liquid cash, from
its Comercial bank to finance its new strategy. Its strategic restructuring
of the management strategy, the expected results are high financial and
non-financial performance. As shown in the financial statements and other
report of performance, as the story of HEMA PLC illustrates, management
accountant must understand how cash management procedures are
followed, analyzed, and reported to managerial decision makers.
Management accountant must be able reconcile financial and nonfinancial
information from various business activities for internal and externalreporting.
Questions:
1. According to the story of HEMA PLC explain the situation faced up to
liquidity borrowing.2. Name the management accounting terms used in HEMA PLC story.
4.1.1. Definition of concepts
a. Cash-flows
Cash flows are inflows and outflows in cash equivalent. These cash equivalent
are cash received and paid on operating, investing, or financing activities in thestatement of cash flows, and depending also on the nature of the transaction.
These cash equivalents consist of the temporary investments of cash not
required at present by the business, such as funds put on short-term deposit
with a bank. Such investments must be readily convertible into cash, or availableas cash within three months.
b. Cash management
Cash management is about dealing with liquidity management and the
investment of funds. Cash management function ensures that minimum
requirements for liquidity in the organization are met and that any investments
are within the organization’s rules and regulations, as well as offering the bestreturn, risk and liquidity available.
c. Cash flow statement
Cash flow statement is a statement that provides valuable information about
a company’s gross payments and receipts and allows insights into its future
income needs.
Frank W. (2005) notes that Cash-Flow shows us exactly where the cash has
come from during the year, exactly what we have done with it and helps us to
throw some light on to the cash situation. For him, it is important to ensure
that:
– Sufficient profits are made to finance the business activities.– Sufficient cash funds are available as and when needed.
4.1.2. Types of cash flow activities
The three categories of cash flow activities are operating activities, investing
activities, and financing activities. Operating activities include cash activities
related to net income. Investing activities include cash activities related
to noncurrent assets. Financing activities include cash activities related to
noncurrent liabilities and owners’ equity.
Operating activities include cash activities related to net income. For example,
cash generated from the sale of goods (revenue) and cash paid for merchandise
(expense) are operating activities because revenues and expenses are included
in net income.
Investing activities include cash activities related to noncurrent assets.
Noncurrent assets include (1) long-term investments; (2) property, plant, and
equipment; and (3) the principal amount of loans made to other entities. For
example, cash generated from the sale of land and cash paid for an investment
in another company are included in this category.
Financing activities include cash activities related to noncurrent liabilities
and owners’ equity. Noncurrent liabilities and owners’ equity items include (1)
the principal amount of long-term debt, (2) stock sales and repurchases, and
(3) dividend payments. (Note that interest paid on long-term debt is included
in operating activities.)
Examples of Cash-flow Activity by category
Operating Activity (activities related to net income)
Cash receipts from the following: 1) Sales of goods or services, 2), 3);
Cash payments for the following: 1) Merchandise purchases from suppliers, 2)
material used to manufacture products, 3) employee payroll, 4) interests paid
to lenders, 5) Income taxes, 6) other operating expenses.
Investing activities (activities related to noncurrent assets)
Cash receipts from the following: 1) Sale of long-term Investment (e.g., bonds
and stocks of other companies), 2) sale of property, equipment, and plant, 3)
collection of principal for loans made to other entities
Cash payments for the following: 1) Purchase of long-term Investment (e.g.,
bonds and stocks of other companies), 2) purchase of property, plant andEquipment, 3) loans made to other entities
Financing activities (related to noncurrent liabilities and owners’ equity)
Cash receipts from the following: 1) Issuance of notes (e.g., a loan with bank),2) issuance of bonds, 3) issuance of common bonds,
Cash payments for the following: 1) principal amount of loans, principal amountof bonds, 3) repurchase of common stocks (treasury stocks), 4) cash dividends.
Example of Cash Activity at UMUMARARUNGU Company and UWINEZA
Company. UMUMARARUNGU Company and UWINEZA Company are wholesale
business which has stores of cooking oil and throughout Kigali. A review of
the statements of cash flows for both companies reveals the following cash
activities. Positive amounts are cash inflows, and negative amounts are cashoutflows.
This information shows that both companies generated significant amounts of
cash from daily operating activities; FRW 4,585 for UMUMARARUNGU Company
and FRW 3,852 for UWINEZA Company. It is interesting to note both companies
spent significant amounts of cash to acquire property and equipment and long term
investments as reflected in the negative investing activities amounts. For
both companies, a significant amount of cash outflows from financing activities
were for the repurchase of common stock. Apparently, both companies chose toreturn cash to owners by repurchasing stock.
4.1.3. Objectives of cash management
The prime objective of cash management is to channelize the flow of cash from
the surplus to deficit units to maintain the appropriate liquidity position of the
organization. Other important objectives of cash management are discussed asfollows:
a. Planning of Cash Flows
This objective refers to scheduling the cash inflow and outflow of an organization
over a period of time. The planning of cash flow helps in maintaining an adequateamount of capital to finance day-to-day- functions of the organization.
b. Synchronizing Cash Flows
This objective refers to developing equilibrium between inflow and outflow of
cash in the business. If the amount of cash receipts (inflow) is equal to the cashpayment (outflow) then there would be no requirement of holding extra cash.
c. Optimizing Cash Holding
This objective refers to determining the appropriate amount of cash to be kept
in the business to meet the contingency needs. It is the duty of the finance
manager to decide the optimal cash holding to avoid any excess or deficit ofcash.
4.1.4. Tools of cash management
Cash management tools are financial management mechanism that determine
the expected cash inflows and cash requirements. They assist the business in
determining the optimum level of cash. There are a number of tools that cash
managers can draw on to support an efficient cash management structure.
These include:
Working capital tools to improve the liquidity available to the organizations
using only commercial flows, and not requiring the assistance of any externalfinancial institution.
Control over the cycle of payments and receipts to reduce the volatility
of intra-month cash balances and improve application of corporate policies
regarding supplier and customer payment terms.
Internal processes to accelerate the allocation of receipts to customer
accounts, thereby increasing the liquidity available for corporate uses and
better customer credit management.
An optimized banking structure that uses a limited number of banks and
bank accounts,
Structures that concentrate available balances in fewer locations and thereby
enabling economies of scale, greater risk diversification and a reduction inoperational risk.
4.1.5. Techniques of cash-flow management
There are various techniques of cash-flow management used in an organization.
Some of the cash-flow management techniques are mainly related to
1) Accelerating Cash Inflows and
2) Slowing Cash Outflows.
Accelerating cash inflows includes:
a) Prompting Customers for Timely Payment,
b) Quick Conversion of Payment into Cash,
c) Improving Average Collection Period;
Slowing cash outflows includes:
a) Paying on Last Date,
b) Paying by Draft,
c) Centralization of Payment,
d) Adjusting Payroll Funds,
e) Use of Float.
Also, some additional cash-flow management techniques include:
1) Effective Inventory Management,
2) Minimizing Operational Cost,
3) Reducing the Time Span of Production Cycle,
4) Fast Cash Transaction,
5) Speedy Conversion of Securities into Cash,
6) Effective Management of Account Receivable,
7) Concentration Banking,8) Lock-Box System.
4.1.7. Purpose of cash management
a. To Control Cash Flows
This purpose is clear-cut because most business owners want to increase the
amount of money flowing into their business and at the same time minimizing
the cash leaving their business, by reducing operational expenses and other
costs. A currency recycler, for example, recycles the same cash that comes in
through transactions to fund the employee floats and cash registers.
b. To Optimize Cash Levels for the Business
Optimizing cash levels is essential to control the cash flow. If the business inflow
in terms of cash are not available for use (e.g., when the business manager has
outstanding unpaid invoices or money is held in the cash registers), he may
not have liquidity that business needs. The cash management system allows
optimizing the cash levels by creating a better liquidity. A good example is the
store float. If the manager of the company is unsure about what the inflows will
look like for the day, he might set the float higher than he need to. However,
the money is held in the petty cash fund or smart safe, when it could be paying
debts or held in a deposit account earning interests.Equally, if the manager of
the company puts all his/her cash on deposit, he/she has hampered his/her
liquidity. When an unexpected cost comes up, he/she may find him/her-self
without the cash to cover them.
Thus, the need of any cash management software which might have functions
that help optimize the cash levels, including:
Cash analytics: Provide data around the movement of cash from tills to vault
holdings. This allows to manage cash balances, reconciliation, and deposit
reporting more effectively
Cash forecasting: Provides insights into trends to forecast the cash needs and
replenishments, while enabling to see cash on hand and what one need on a
frequent basis to operate the business efficiently.
Cash status: Gives the view into the available cash on hand and frequency of
denomination usage. One would better understand which notes and coins are
most in demand, so that he/she may always have enough cash on hand.
c. To Enable More Efficient Cash Planning
The right cash management system helps optimize cash and this allows cash
manager to plan more effectively. The use of Automated cash management
systems to collect and provide data, will help to make more informed decisions.
d. To enable more Effective Cash Management
A good management system allows the business owner to see cash movements
through the business, giving him/her a bird’s eye view of where and when cash
is leaving the business and where and when it’s entering. The business owner
will also make better decisions about how to manage cashflow in the business,
such as when to deposit it or how much to hold back. All of his/her decisions
will be backed by data to both streamline and improve cash management andcashflows.
Application activity 4.1
1. Define the following concepts:
– Cash flows
– Cash flow statement
– Cash management
2. Which section of the statement of cash flows is regarded by most
financial experts to be most important?
3. State the objectives of cash management
4. Explain the purpose of cash management
4.2. Cash-flow statement
Learning Activity 4.2
John Karamaga, CEO and founder of Home Furniture Company has
reviewed the company’s income statement and balance sheet for the most
recent fiscal year ended December 31, 2021. Home furniture Company
has grown rapidly this year, with sales and net income showing significant
gains compared to 2020. Although John is satisfied with the increase in
profitability, he noticed a significant decline in cash. John decides to pursue
this with Linda Uwimana (CFO) and Steve Kayira (treasurer) in their
regular meeting:
John
I just received the income statement and balance sheet for 2021. Profits
look great, but our cash position seems to have deteriorated. We had
FRW130,000 in cash to start the year and ended with only FRW32,000.
I noticed cash was declining throughout the year when I reviewed our
monthly financial statements, but I’m concerned about how far our cash
balance has dropped.
Steve
You’re right, John. We encountered cash flow problems several times
throughout the year despite increased sales and profits. On several
occasions, I had to delay payments to creditors because of cash flow issues.
John
Seems to me we shouldn’t have this problem. Where is our cash going?
Linda
Good question. Let me round up our cash flow information for the year.
I’ll have something for you by next week.
John
Great! I’d like to start next week’s meeting by discussing how much cash we
generated in 2021 from our daily operations. I realize net income is shown
on an accrual basis, but I’d like to know how much net income was received
in the form of cash.
Linda
No problem. I’ll have it for you next week.
Question
a) What kind of employees are having discussion?
b) Which finance report must be prepared by Steve, Joh and Linda ?c) Which are the ways in which cash flows are reported? Give ideas.
4.2.1. Purpose of cash-flow statement
Financial accounting courses covered in the first three statements in detail and
often provide an overview of the statement of cash flows. The preparation of
cash flows statement and using the resulting cash flow information for analytical
purposes, leads to the purpose of information provided in the statement of cashflows.
The purpose of the statement of cash flows is to provide a summary of cash
inflows and cash outflows information for a period of time and to reconcile
the difference between beginning and ending cash balances shown on thestatement of financial position.
4.2.2. Steps of preparing the cash-flow statement
The four steps required to prepare the statement of cash flows are described
as follows:
Step1.
Prepare the operating activities section by converting net income from an
accrual basis to a cash basis. This step will be done using indirect method
throughout this chapter. The indirect method begins with net income from
the income statement and makes several adjustments related to changes in
current assets, current liabilities, and other items to arrive at cash provided
by operating activities (or used by operating activities if the result is a cash
outflow). Cash provided by operating activities represents net income on a cash
basis. It tells the reader how much cash was received from the daily operations
of the business.
Step 2.
Prepare the investing activities section by presenting cash activity for
noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash.
Noncurrent asset balances found on the the statement of financial position or
balance sheet, coupled with other information (e.g., cash proceeds from sale of
equipment) are used to perform this step.
Step 3.
Prepare the financing activities section by presenting cash activity for
noncurrent liabilities and owners’ equity. This step focuses on the effect changes
in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities
and owners’ equity balances found on the balance sheet, coupled with other
information (e.g., cash dividends paid) are used to perform this step.
Step 4.
Reconcile the change in cash. Each section of the statement of cash flows
described in steps 1, 2, and 3, will show the total cash provided by (increase)
or used by (decrease) the activity. Step 4 simply confirms that the net of these
changes equates to the change in cash on the statement of financial positionbalance sheet
Example 1,
Using the information extracted in the accounting information system of Home
Furniture Company, assume the balance sheet shows cash totaled FRW100
at the end of last year from 2020 and FRW140 at the end of the current year
2021. Thus cash increased by FRW40 over the course of the current year. Step
4 reconciles this change with the changes shown in the three sections of the
statement of cash flows. Suppose operating activities provided cash of FRW170,
investing activities used cash of FRW160, and financing activities provided cash
of FRW30. These 3 amounts netted together reconcile to the FRW40 increase in
cash shown on the balance sheet (= FRW170 − FRW160 + FRW30).
4.2.3. Methods used to prepare the cash-flow statements
There are two Methods of preparing a cashflow statement:
a. Direct method for the preparation of cash flow statement
The direct method for creating a cash flow statement reports major classes of
gross cash receipts and payments (Cash inflow and cash outflow). At the end
of that given period, the business will have a surplus if cash inflows are morethan the cash outflows or deficit if cash inflows are less than the cash outflows.
Illustration:
Prepare Iraguha’s cash flow for the years 2015, 2016, 2017 and 2018, given the
following information below:
Cash balance b/d or b/f in January 2015 was FRW 15,000,000
Yearly rent income was FRW 5,000,000
Yearly credit sales to be paid in the next year were FRW 4,000,000
Sold a business van in 2016 FRW 14,500,000
Yearly commission received was FRW 3,000,000
Yearly cash sales FRW 10,000,000
Yearly cash purchases FRW 12,000,000
Bought a truck in 2015 for FRW 800,000
Yearly salaries and wages FRW 5,000,000
Bought machinery worth FRW 15,000,000, payment of FRW 8,000,000 was
made in 2015 and the balance was paid in two equal instalments during themonth of February and March.
SolutionIRAGUHA’S CASH FLOW STATEMENT FOR 2015, 2016, 2017 and 2018
b. Indirect method for the preparation of cash flow statement
The indirect method uses net-income as a starting point, makes adjustments
for all transactions for non-cash items, then adjusts from all cash-based
transactions. An increase in currentasset account is subtracted from net income,
and an increase in a current liability account is added back to net income. This
method converts accrual-basis net income (or loss) into cash flow by using aseries of additions and deductions.
4.2.3. Prepare cash-flow statement
As stated earlier, the information needed to prepare the statement of cash
flows includes the statement of financial position, income statement, and otherselected data.
Illustration
Using the financial statement’s information below and Other additional data of
Home Furniture Company for 2021, let’s prepare the statement of cash flows
as follows:
Sold equipment with a book value of FRW11,000 (= FRW21,000 cost −
FRW10,000 accumulated depreciation) for FRW5,000 cash, purchased
equipment for FRW67,000 cash, Long-term investments were purchased
for FRW12,000 cash. There were no sales of long-term investments, Bonds
were paid with a principal amount of FRW18,000, Issued common stock forFRW4,000 cash, Declared and paid FRW32,000 in cash dividends
With these information provided, we can start preparing the statement of
cash flows using the indirect method. It is important to note that all positive
amounts shown in the statement of cash flows denote an increase in cash, and
all negative amounts denote a decrease in cash.
Furniture Company, statement of financial position as at December31st,2020 and December 31st, 2021
Home Furniture Company’s Income Statement, for the Year Ended December
31st, 2021
Step 1: Prepare the Operating Activities Section
The Format of Cash Flows from Operating activities
The first adjustment to net income involves adding back expenses that do not
affect cash (often called noncash expenses). The second adjustment to net
income involves adding back losses and deducting gains related to investing
activities. However, this loss is not related to the daily operations of the business.
Remember, we are trying to find the cash provided by operating activities in
this section of the statement of cash flows. Since equipment is a noncurrent
asset, cash activity related to the disposal of equipment should be included in
the investment activities section of the statement of cash flows. The third type
of adjustment to net income involves analyzing the changes in all current assets
(except cash) and current liabilities from the beginning of the period to the
end of the period. Two important rules must be followed to determine how the
change is reflected as an adjustment to net income.Study these two rules carefully:
1. Current assets. Increases in current assets are deducted from net income;
decreases in current assets are added to net income.
2. Current liabilities. Increases in current liabilities are added to netincome; decreases in current liabilities are deducted from net income.
Operating Activities Section of Statement of Cash Flows for Home FurnitureCompany
With the above information, Home Furniture Company received FRW 22,000 in
cash for the year related to daily operations of the business.
Step 2: Prepare the Investing Activities Section
Now that we have completed the operating activities section for Home
Furniture Company, the next step is to prepare the investing activities section.
The statement of cash flows focuses on cash activities related to noncurrent
assets. Three noncurrent asset items must be analyzed to determine how to
present cash flow information in the investing activities section.
1. Property, plant, and equipment increased by FRW46,000.
The additional information provided for 2021 indicates two types of transactions
which caused this increase. First, the company purchased equipment for
FRW67,000 cash and Second, the company sold equipment for FRW5,000 cash
(often called a disposal of equipment). The net effect of these 2 entries is an
increase of FRW46,000 (= FRW67,000 − FRW21,000). This is summarized in
the following T-account:
2. Accumulated depreciation decreased noncurrent assets by
FRW14,000.
Two items caused the change in the accumulated depreciation account. First,
the sale of equipment during the year caused the company to take FRW10,000
in accumulated depreciation off the books. Second, FRW24,000 in depreciation
expense was recorded during the year (with a corresponding entry to
acc4.2.5. Cash-flow information analysis
Companies and analysts tend to use income statement and balance sheet
information to evaluate financial performance. In fact, financial results
presented to the investing public typically focus on earnings per share. Analysis
of cash flow information is becoming increasingly important to managers,
auditors, and financial analysts. Three common cash flow measures used to
evaluate organizations are (1) operating cash flow ratio, (2) capital expenditure
ratio, and (3) free cash flow. umulated depreciation). This information is summarized in the followingT-account:
How is accumulated depreciation information used in the statement of cash
flows for Home Furniture Company?
3. Long-term investments increased by FRW12,000.
The additional information provided for 2021 indicates there were no sales of
long-term investments during the year. The increase of FRW12,000 is solelyfrom purchasing long-term investments with cash.
The following paragraph shows the three investing activities described
previously:
1. a FRW67,000 decrease in cash from the purchase of equipment,
2. a FRW5,000 increase in cash from the sale of equipment, and
3. a FRW12,000 decrease in cash from the purchase of long-term
investments.
There is also the impact of these three items on cash and the resulting cashused by investing activities of FRW74,000.
The company used FRW 74,000 in cash for investing activities.
Step 3: Prepare the Financing Activities Section
What information is used for this section, and how is it prepared? The financing
activities section of the statement of cash flows focuses on cash activities related
to noncurrent liabilities and owners’ equity (i.e., cash activities related to long term
company financing). One noncurrent liability item (bonds payable) and
two owners’ equity items (common stock and retained earnings) must be
analyzed to determine how to present cash flow information in the financing
activities section. How is this information used in the statement of cash flows?
Step 4: Reconcile the Change in Cash
The following table provides a summary of cash flows for operating activities,
investing activities, and financing activities for Home Furniture Company,along with the resulting total decrease in cash of FRW 98,000
4.2.5. Cash-flow information analysis
Companies and analysts tend to use income statement and balance sheet
information to evaluate financial performance. In fact, financial results
presented to the investing public typically focus on earnings per share. Analysis
of cash flow information is becoming increasingly important to managers,
auditors, and financial analysts. Three common cash flow measures used to
evaluate organizations are (1) operating cash flow ratio, (2) capital expenditure
ratio, and (3) free cash flow.
Example
The following statement of cash flow for L. Holmes Ltd., were prepared for theperiod ending 31 January 2022
Is cash provided by operating activities divided by current liabilities. This ratio
measures the company’s ability to generate enough cash from daily operations
over the course of a year to cover current obligations. Although similar to the
commonly used current ratio, this ratio replaces current assets in the numerator
with cash provided by operating activities. The operating cash flow ratio is asfollows for L. Holmes Ltd.:
The numerator, cash provided by operating activities, comes from the
bottom of the operating activities section of the statement of cash flows. The
denominator, current liabilities, comes from the liabilities section of thestatement of financial position/balance sheet.
– CAPITAL EXPENDITURE RATIO
Is cash provided by operating activities divided by capital expenditures. Thisratio measures the company’s ability to generate enough cash from daily
operations to cover capital expenditures. A ratio in excess of 1.0, for example,indicates the company was able to generate enough operating cash to cover
investments in property, plant, and equipment. The capital expenditure ratio
for L. Holmes Ltd.is as follows:
Free cash flow is cash provided by operating activities minus capital expenditures
as follows:
Free cash flow = Cash provided by operating activities − Capital
expenditures
The cash provided by operating activities comes from the bottom of the
operating activities section of the statement of cash flows. The capital
expenditures amount comes from information within the investing activities
section of the statement of cash flows. The free cash flow amount is calculatedusing information from each company’s statement of cash flows.
The results tell us that the company generates enough cash (FRW 1,668 ) from
daily operations to cover capital expenditures (FRW2,184)
Application activity 3.2
Question 1
Define the following ratios, and how they are calculated.
a) Free cash flow ratio
b) capital expenditure ratio
c) operating cash flow ratio
Question 2The following information is from the consolidated statement of cashflows for BMC Motors for the year ended December 31, 2022
Required:
An investment advisor recently reviewed BMC Motors’ statement of cash
flows and statement of financial position and stated: “BMC Motors is doing
great! They are holding cash of more than FRW 30,000. There is no cash
flow problem with this company!”
Do you agree with this statement.? Support your conclusion with an
analysis of BMC Motors’ cash flows.
Question 3
Using the statement of financial position and income statement attached
herewith, you are required to prepare the statement of cash flows using the
indirect method
4.3. Use of financial and nonfinancial performancemeasuresLearning Activity 4.3
Sandy Masaka is the CEO of a fast-food restaurant called Chicken Remix.
The company operates five restaurants throughout Kigali City and is
choosing between two suppliers of soft drinks: ABC Fizz Ltd and BIG Fizz
Ltd. Consumer surveys indicate no significant preference between the
two. Sandy is meeting with Dave Gasana, the CFO, and Karen Mugwiza, the
purchasing manager, to discuss the company’s options. Chicken Remix is
facing a supplier choice decision which is common to many companies.
Financial stability is an important factor in choosing on a supplier, along
with the quality of product and reliability of service. Chicken Remix must
analyse financial information for ABC Fizz Ltd and BIG Fizz Ltd to determine
the financial condition of each company. The analysis of a company’s
financial information typically follows a three-pronged approach. First,
trends within a company’s own financial information are analyzed, such as
sales and earnings from one year to the next, using two methods. Second,
financial measures are compared between competitors. Finally, the ratios
are analyzed and are compared to industry averages.
Question
What should be the accounting responsibilities of each person attending
the meeting?
Do you have any idea about the kind of analysis which might be made by
Finance Department?
Which one may be appropriate?
4.3.1. Introduction to Financial and non-financial performance measures
For any business which is a going concern, the owner is always afraid of business
activities performances. For different reasons the performances are measured
on one hand using financial criteria (statistical) and non financial measures
(Qualitative assumptions) on other hand.
4.3.2. Financial performance measures
a. Trend analysis
Trend analysis evaluates an organization’s financial information over a period
of time. Periods may be measured in months, quarters, or years, depending
on the circumstances. The goal is to calculate and analyze the amount change
and percent change from one period to the next. Trend analysis is often used
to evaluate each line item on the income statement and statement of financial
position. The percent change is calculated as the current year amount minus
the base year amount, divided by the base year amount.
Example: The following shows ABC Fizz Ltd.’s income statement trend analysisor horizontal analysis
resulting in a 12.7% increase in gross margin. Good news for ABC Fizz Ltd! Selling
and administrative expenses increased 15.8%, while other operating expenses
increased 161.7%. operating income increased 2.6%, interest expense increased
106.5%, and other income increased 555.6% (related to a one-time acquisition
gain). Income before taxes increased 60.1% resulting in a 16.9% increase in income
tax expense. Net income increased a substantial 73.1% (much of this was related toa one-time acquisition gain).
b. Common-size analysis of Financial statement
Common-size analysis (also called vertical analysis) converts each line of
financial statement data to an easily comparable, or common-size, amount
measured as a percent. This is done by stating income statement items as a
percent of net sales and statement of financial position items as a percent of
total assets (or total liabilities and shareholders’ equity). For example, ABC Fizz
Ltd had net income of FRW 11,809 and net sales of FRW 35,119 for 2020. The
common-size percent is simply net income divided by net sales, or 33.6 percent
(= FRW 1,809 / FRW 35,119).
There are two reasons to use common-size analysis:
1. To evaluate information from one period to the next within a company
and
2. To evaluate a company relative to its competitors.
Common-size analysis answers such questions as “how do our current assets
as a percentage of total assets compare with last year?” and “how does our net
income as a percentage of net sales compare with that of our competitors?”
Example: The following presents the common-size analysis for ABC Fizz Ltd.’s
income statement. As you look at these figures, notice that net sales are used as
the base for the income Statement. That is, for the income statement, each item
is measured as a percent of net sales.
Cost of goods sold increased from 35.8% of net sales in 2020 to 36.1% in 2021,
which resulted in a decrease in gross margin from 64.2% to 63.9%. selling and
administrative expenses increased from 36.7% to 37.5%, while other operating
expenses increased from 1% to 2.3%. operating income decreased from 26.6%
to 24.1%. interest expense increased from 1.1% to 2.1% and other income
increased from 3.2% to 18.4%. income before taxes increased from 28.6% to
40.4%. income taxes increased slightly. Net income increased from 22% to
33.6%.
In general, managers prefer expenses as a percentage of net sales to decrease
over time, and profit figures as a percent of net sales to increase over time.C. Ratio analysis
Although trends and common-size analysis provides an excellent starting
point for analyzing financial information, managers, investors, and other
stakeholders also use various ratios to assess the financial performance and
financial condition of organizations.
The four categories of ratios presented in this point are as follows:
• Ratios used to measure profitability (focus is on the income statement)
• Ratios used to measure short-term liquidity (focus is on short-term
liabilities)
• Ratios used to measure long-term solvency (focus is on long-term liabilities)
• Ratios used to measure market valuation (focus is on market value of thecompany)
Profitability Measures for ABC Fizz Ltd for the year ended December 31,
2020
– Gross margin ratio indicates the gross margin generated for each
Rwandan franc in net sales and is calculated as gross margin (which isnet sales minus cost of goods sold) divided by net sales
– Profit margin ratio indicates the profit generated for each Rwandan
franc in net sales and It is calculated as net income divided by net sales:
– Return on assets indicates how much net income was generated from
each Rwandan franc in average assets invested. Return on assets is netincome divided by average total assets:
– Return on common shareholder’s equity ratio indicates how much
net income was generated from each Rwandan Franc of common
shareholders’ equity. If the company does not have any outstanding
preferred stock, as is the case with ABC Fizz Ltd, the preferred
dividends amount is zero. Average common shareholders’ equity in the
denominator is found by adding together all items in the shareholders’
equity section of the statement of financial position at the end of the
current year and previous year (2020 and 2021 for this example),except preferred stock items, and dividing by two.\
• Short-Term Liquidity Measures
– Current ratio indicates whether a company has sufficient current
assets to cover current liabilities. It is found by dividing current assets
by current liabilities (Current assts/current liabilities). In general, a
current ratio above 2 to 1 is preferable, which indicates the company
has sufficient current assets to cover current liabilities. However,
finding the ideal minimum current ratio is dependent on many factors,
such as the industry, the overall financial condition of the company and
the composition of the company’s current assets and current liabilities.
Because of variations in these factors from one company to the next, amore stringent measure of short-term liquidity is often used.
– Quick ratio (also called acid-test ratio) indicates whether a company
has sufficient quick assets to cover current liabilities. The quick ratio is
quick assets divided by current liabilities (current assets – Inventory /current liabilities).
The quick ratio indicates that ABC Fizz Ltd had FRW 0.85 in quick assets for every
Rwandan franc in current liabilities.– Receivables Turnover Ratio indicates how many times receivables
are collected in a given period. Receivables Turnover Ratio is found
by dividing credit sales by average accounts receivable (credit sales/accounts receivables).
– Inventory Turnover Ratio indicates how many times inventory is
sold and restocked in a given period. It is calculated as cost of goodssold divided by average inventory(cost of sales/average inventory)
The inventory turnover ratio indicates that ABC Fizz Ltd sold and restocked
inventory 5.07 times during 2021
• Long-Term Solvency Measures– Debt to Assets ratio indicates the percentage of assets funded by
creditors and is used to evaluate the financial leverage of a company. The
higher the percentage, the higher the financial leverage automatically
the higher the percentage of assets funded by the shareholder. Debt to
assets is found by dividing total liabilities by total assets:
– The debt to equity ratio indicates the amount of debt incurred for
each Rwandan franc that owners provide. The debt to equity ratio
is total liabilities divided by total shareholders’ equity indicates the
company’s ability to cover its interest expense related to long-term
debt with current period earnings. This ratio indicates the amount
of debt incurred for each Rwandan franc that owners provide. It also
measures the balance of liabilities and shareholders’ equity used to
fund assets.
The debt to equity ratio is total liabilities divided by total shareholders’ equityThe debt to equity ratio for ABC Fizz Ltd is calculated as follows
The debt to equity ratio indicates that ABC Fizz Ltd had FRW 1.33 in liabilities for
each Rwandan in shareholders’ equity
• Market Valuation Measures
– Market capitalization (also called market cap) indicates the value
of a company at a point in time. is determined by multiplying market
price per share times the number of shares outstanding.
– The price-earnings ratio (also called P/E ratio) indicates the
premium investors are willing to pay for shares of stock relative to
the company’s earnings. The price-earnings ratio is found by dividing
market price per share by earnings per share.
4.3.3. Non-financial performance measures
Many organizations use a mix of financial and nonfinancial measures to evaluate
performance. For example, airlines companies track on-time arrival percentages
carefully, and delivery companies such as those ones which deliver goods
purchased online, monitor percentages of on-time deliveries. The balancedscorecard uses several alternative measures to evaluate performance.
The balanced scorecard is a balanced set of measures that organizations use to
motivate employees and evaluate performance. These measures are typically
separated into four perspectives:
Financial perspective, measures that shareholders, creditors, and other
stakeholders use to evaluate financial performance.
Internal business process perspective, measures that management uses to
evaluate efficiency of existing business processes.
Learning and growth perspective, measures that management uses to
evaluate effectiveness of employee training.
Customer perspective, measures that management uses to evaluate whetherthe organization is meeting customer expectations.
Application activity 4.3
Question 1
Ruhinguka Corneille, has the following statement of financial positionas at 31 December 2022 and 31 December 2021,
And the following Income Statement, Ruhinguka Corneille, for the year
endend 31 December 2022 and 31 December 2022
Required
Use the above financial statement and answer the following questiona) Demonstrate a meaningful trend analysis. Explain how theSkills Lab 4
percent change from one period to the next is calculated.
b) Using the appropriate information from above financial
statement show your financial analysis and interpretation with
the common-size analysis.
c) Name and explain three ratios used to evaluate profitability.
Assess at least two of the profitability ratios and interpret themwith the use of above financial information.
Students visit one of businesses operating near their school “MUGABO
ENTERPRISE”. One businessman called Mugabo presents to them the
financial statements of his Enterprise for the year ended 31 January 2021and 31 January 2022 as follow:
Mugabo Enterprise
Statement of Financial Position (Balance Sheet)
As at 31 January
Mugabo Enterprise Income Statement for the year ended 31 January
Inventory on 1 February 2020 was FRW 5,000,000
You are Required to calculate for 2021 and 2022 the:
i) Gross profit margin
ii) Inventory turnover
iii) Return on sales
iv)Acid test ratio
v) Current ratioEnd of unit assessment 4
Question 1
a) What are the 3 general areas or aspects which analysts are
normally concerned about?
Question 2: Which of the following ratios includes a component that
is not from the Statement of financial position balance sheet?
a) Acid-test ratio
b) Debt ratio
c) Accounts receivable turnover
d) Current ratio
Question 3:
– Use the Free cash flow ratio to explain and interpret the cash flowschanges from one period to the next
– With the information from above financial statements, produce
your financial analysis and interpretation of cash flows with the
capital expenditure ratio