EFSB313 Financial Statement Analysis

Tutorial 8 – Answer Guide

1. Describe the major activities the statement of cash flows reports. Cite examples of cash flows
for each activity.

Operating activities encompass all the earning related activities of the enterprise. They
encompass, in addition to all the income and expense items found on the income statement, all
the net inflows and outflows of cash that operations impose on the enterprise. Such operations
include activities such as the extension of credit to customers, investment in inventories, and
obtaining credit from suppliers. This means operating activities relate to all items in the
statement of income (with minor exceptions) as well as to balance sheet items that relate to
operations mostly working capital accounts such as accounts receivable, inventories,
prepayments, accounts payable, and accruals. SFAS 95 also specifies that operating activities
include all transactions and events that are not of an investing or financing nature.

Financing activities include obtaining resources from owners and providing them with a return
of or a return on (dividends) their investment. They also include obtaining resources from
creditors and repaying the amounts borrowed or otherwise settling the obligations.

Investing activities include acquiring and selling or otherwise disposing of both securities that
are not cash equivalents and productive assets that are expected to generate revenues over the
long term. They also include lending money and collecting on such loans.

2. Describe the two methods of reporting cash flow from operations.

Indirect Method: Under this method net income is adjusted for noncash items required to
convert it to CFO. The advantage of this method is that it is a reconciliation that discloses the
differences between net income and CFO. Some analysts estimate future cash flows by first
estimating future income levels and then adjusting these for leads and lags between income
and CFO (that is, noncash adjustments).
Direct (or Inflow-Outflow) Method: This method lists the gross cash receipts and
disbursements related to operations. Most companies preferred this method because this
presentation discloses the total amount of cash that flows into the enterprise and out of the
enterprise due to operations. This gives analysts a better measure of the size of cash inflows
and outflows over which management has some degree of discretion. As the risks that lenders
are exposed to relate more to fluctuations in CFO than to fluctuations in net income,
information on the amounts of operating cash receipts and payments is important in assessing
the nature of those fluctuations.

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3. Based on the following information, determine the net cash from operating activities:

Statement of Cash Flows

RM
Profit before tax 18,341,000
Adjustments for:
Gain on disposal of plant and equipment (405,000)
Unrealised foreign exchange gain (249,000)
Interest income (270,000)
Profit sharing from associates (934,000)
Depreciation of plant and equipment 15,854,000
Amortisation of intangible assets 23,000
Interest expense 21,055,000
Operating profit/(loss) before working capital changes 53,415,000
Changes in working capital:
Decrease in inventories 10,846,000
Decrease in trade and other receivables 35,072,000
Decrease in trade and other payables (3,492,000)
Cash generated from/(used in) operations 95,841,000
Income tax refund 3,902,000
Net cash from operating activities 99,743,000

Past Years Questions – Answer Scheme

Solution One

Required:
(a) List TWO (2) importance of the statement of cash flows to our analysis.

• Feasibility of financing capital expenditures and possible sources of such financing. ✓✓

• Sources of cash to finance an expansion in the business. ✓✓
• Dependence of the firm on external sources of financing (such as debt or equity). ✓✓
• Future dividend policies. ✓✓
• Ability to meet future debt service requirements. ✓✓
• Financial flexibility, that is, the firm's ability to generate sufficient cash so as to
respond to unanticipated needs and opportunities. ✓✓
• Insight into the financial habits of management and indications of future policies. ✓✓

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• Signals regarding the quality of earnings. ✓✓

Any ✓4 x ½ m = 2 marks

(b) Explain how operating cash flows could be employed as one gauge of earnings quality.

Operating cash flows can serve as one indicator of earnings quality because over a number
of years, cash flows should approximate earnings. ✓✓ If cash flows from operations are
consistently lower than earnings, ✓ it is possible that the reported earnings are not of high
quality. ✓ (As with any broad guideline, one must look for corroborating evidence).
✓4 x ½ m = 2 marks

(c) Using indirect method, prepare a statement of cash flows for the year ended 31 December
2020.

Crops & Food Bhd

Cash Flow Statement for the year ended 31 December 20210
Cash flows from operations RM ‘000 RM ‘000
Net income 205✓
Add (less) adjustment to cash basis:
Amortisation (25 – 0) ✓ 25
Depreciation (600 – 550) + (200 – 120) ✓✓✓✓ 130
Increase in accounts payable (794 – 750) ✓✓ 44
Increase in deferred income tax (105 – 82) ✓✓ 23
Increase in other current liabilities (99 – 76) ✓✓ 23
Increase in accounts receivable (920 – 170) ✓✓ (210)
Increase in inventories (2105 – 920) ✓✓ (1,185)
Increase in prepaid expenses (70 – 20) ✓✓ (50)
Cash from operations -995✓
Cash flows from investing activities

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Purchase of patents (330 – 0) ✓ (330)
Purchase of plant and equipment (3,200 – 3,000) ✓✓ (200)
Purchase other assets (400 – 200) ✓✓ (200)
Cash used for investing activities -730✓
Cash flows from financing activities
Addition to long term debt (1,700 – 1,470) ✓✓ 230
Issuance of common stock (3,700 – 2,250) ✓✓ 1,450
Dividends paid (150)✓
Cash used for financing activities 1,530✓
Net increase / decrease in cash -195✓
✓32 x ½ m = 16 marks

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Question 2 marks]

a) Describe two methods of reporting cash flow

Indirect Method: Under this method net income is adjusted for noncash items required to
convert it to CFO. The advantage of this method is that it is a reconciliation that discloses
the differences between net income and CFO. Some analysts estimate future cash flows by
first estimating future income levels and then adjusting these for leads and lags between
income and CFO (that is, noncash adjustments).

Direct (or Inflow-Outflow) Method: This method lists the gross cash receipts and
disbursements related to operations. Some preferred this method because this presentation
discloses the total amount of cash that flows into the enterprise and out of the enterprise
due to operations. This gives analysts a better measure of the size of cash inflows and
outflows over which management has some degree of discretion. As the risks that lenders
are exposed to relate more to fluctuations in CFO than to fluctuations in net income,
information on the amounts of operating cash receipts and payments is important in
assessing the nature of those fluctuations.

b) List THREE (3) insights that the statement of cash flows can provide to your analysis.
• Feasibility of financing capital expenditures and possible sources of such financing.
• Sources of cash to finance an expansion in the business.
• Dependence of the firm on external sources of financing (such as debt or equity).
• Future dividend policies.
• Ability to meet future debt service requirements.
• Financial flexibility, that is, the firm's ability to generate sufficient cash so as to respond to
unanticipated needs and opportunities.
• Insight into the financial habits of management and indications of future policies.
• Signals regarding the quality of earnings.

c) Helang Berhad (HB) is considering to acquire Garuda Berhad (GB), a construction

company involves in tunneling works for Mass Rapit Transit in Klang Valley. As a part of
your feasibility study, you are required to have in-depth analysis on the cash flow from
operation of the company. Below is the financial information extracted from GB.

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 Garuda Berhad

Balance Sheet for the year ended 31 December 2015

2014 2015 Changes

RM RM RM
Current Assets
Cash & equivalents 40,000 65,800 25,800
Account receivables 160,000 169,720 9,720
Inventories 158,000 163,000 5,000
Prepaid Expenses 40,000 44,000 4,000
Total Current Assets 398,000 442,520 44,520

Property, Plant and Equipment (PPE) 1,560,000 1,644,000 84,000

Accumulated Deprectaition 932,000 1,000,000 68,000
Net PPE 628,000 644,000 16,000
Other amortization assets 108,000 172,000 64,000

Total Assets 1,134,000 1,258,520 124,520

Current liabilities
Loan overdue 48,000 52,000 4,000
Notes payable 120,000 124,000 4,000
Account payable 158,000 173,800 15,800
Accrued liabilities 86,280 72,200 -14,080
Taxes payable 35,600 39,600 4,000
Total Current liabilities 447,880 461,600 13,720

Total Long-term liabilities 508,000 557,400 49,400

Paid-up capital 100,000 120,000 20,000

Retained Earning 56,400 94,640 38,240
Reserve 21,720 24,880 3,160
Total Equity 178,120 239,520 61,400
Total Liabilities and Equity 1,134,000 1,258,520 62,260

Required:

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(a) Compute the cash flow from operation of Garuda Berhad for 2015.

Garuda Corporation
Cash Flow from Operation for the year ended 2014
Items (RM)
Cash from operating RM
Net Income 72,880
Change in account receivable -9,720
Change in inventories -5,000
Change in prepaid expenses -4,000
Change in account payable 15,800
Change in accrued liabilities -14,080
Change in taxes payable 4,000
Other amortization assets 64,000
Accumulated depreciation 68,000
Cash from operating 191,880

(b) Using cash flow approach, compute the 2015 Earnings to Fixed Charges ratio for Garuda
Berhad.

= CFO/Interest Expenses
= 193,880/12,450
= 15.5 x

Given the current level of CFO, the company has ability to pay its interest expenses for
15.5 years.

(c) The Bank Negara Malaysia had decided to reduce the Overnight Policy Rate by 25 basis
point to 3% at its Monetary Policy Committee (MPC) recently. This move resulting a lower
interest cost for Garuda Berhad. Comment the implication of your answer in part (b) above.

Earnings to FC increase as interest rate drop