Understanding Cash Flow Statement, Capital Budgeting Techniques, And Budget Importance

Importance of Cash Flow Statement

Requirement A:

Cash flow statement forms an important component of the overall financial statements of any company and the information generated by such statement is important for the investors and other users in assessing the firm’s ability to generate cash flow and the requirement to use that cash flow. In addition to this, it also helps the users in developing the model that helps in comparing and assessing the present value of the expected future cash flow by the cash flow projections creation. The company’s ability to generate cash flow requires to be evaluated when taking economic decisis alongside the certainty and timing of the generation of cash flow. Cash flow statement information importance lies in the benefits provided by the information related to the cash flow (Prihartono and Asandimitra 2018). When the information generated from the cash flow statement is used in conjunction with the other statements, it helps the users and the business as well to evaluate the changes in their financial structure including solvency and liquidity, changes in the net assets and the ability to affect the timing and the amount of cash flow with the intent of adopting to the changing circumstances and opportunities. Historical information generated from the cash flow statements is used in verifying the accuracy of the past cash flow assessment and furthermore, it also assists in examining the relationship between net cash flow and profitability.

The main activities of the cash flow statement include operating, financing and investing activities and the classification of the activities is done based on the nature of the transactions. Cash flow generated from operating activities is considered as the key indicator of whether adequate cash has been generated by the business to maintain their operating capability such as making new investment, repaying loans and paying off dividends. Such activities are primarily derived from the revenue generating activities. Some of the examples of operating activities are cash received from rendering services or from sales of goods, cash payment to suppliers and employees, cash refund and payment to the income tax, cash receipt and payment for annuities, premium and claims and cash receipt and paid to different contracts such as forward, option and future.

Investing activities represents the cash flow to the extent where the business has incurred expenses for the resources intended to generate future income and cash flow. Any changes in the long-term investment and capital expenditure are reported by investing activities. Some of the examples of investing activities includes payment made to acquire assets such as development cost and capitalized research, cash received from debt instruments, warrants and disposal of shares, advances and loans made to the third parties and receipt and payment to different future contracts (Siziba and Hall 2021).

Financing activities helps in the prediction of the future cash flow by way of borrowings and capital of enterprise. Some of the examples of the financial activities that helps in generation of cash flow includes cash proceeds from issuing bond, notes, debenture, long term and short-term borrowings, cash proceeds from issuing shares or any other similar instruments, repaying the borrowed amounts in cash (Widagdo et al. 2020).

Operating Activities

Requirement B:

Expected profitability out of any investment capital is measured using accounting rate of return (ARR) and is widely used in the investment decision making process. Some of the advantages of using ARR in evaluating the capital project investment is that they make use of simple estimates.

• It helps the investors to decide on the profitability and viability of the investment project by analysing the involvement of risks and making conclusion whether adequate earnings would be yield by the investment to cover the level of risk (Sarwary 2020).
• Factors such as inflation, taxes an interest rate accrued is not considered in the calculation using ARR and therefore, this particular method is not sufficient for the evaluation of long term and huge capital investments.
• In addition to this, this method does not take into account time value of money and time factor is important in determining the investment viability (Sarwary 2019). Furthermore, when it comes to assess two different projects, the life period of such investments is not considered by ARR and thereby accurate results might not be produced.

Another technique of capital budgeting is the payback process that refers to the time period needed to recover the money expended in the investment. That is, the time requires for the cash flow generated by the project to cover the initial investment is determined by the payback period (Yuniningsih et al. 2019).

Advantages of payback period:

• One of the biggest advantages of using payback period is its simplicity in calculating and understanding.
• Comparing of various projects become easy using payback period and the project with the shortest payback period is considered desirable.
• Business making relatively small investment finds payback period to be useful because it avoids calculation complexities.

Disadvantages of Payback period:

• This method does not take into account the time value of money because the cash flow that is received in the initial years is given higher weightage compared to cash flow received in the later years. No clear determination is provided when it comes to select the two projects.
• Profitability of the project is ignored under this method because it does not mean that the project is profitable just because it has shorter payback period. Profit would never return from the project if there is drastic reduction in the cash flow (Gorshkov et al.2018).

When comparing both the methods, it is understood that both ARR and payback suffers from the drawback as they ignore the time value of money factor. Hence, the usage of the methods depends upon the suitability of the projects. Payback period is usually suitable for the small projects compared to ARR. However, for the big projects, using ARR along with the NPV is recommended.

Requirement C:

Budget implies the company’s financial plan and can be considered as the financial tool that helps in keeping a track of the earnings and expenditure by the translation of the general plans of the business into action oriented and specific objectives and goals. It forms an important part of any business as it serves as an estimation of income and expenses over certain time period usually, quarterly, monthly or yearly (Thomas 2022). For any business, it is expected that the objectives and the identified goals can be fulfilled if they adhere to the budgetary guidelines. The operational changes required to support any business can be anticipated using budget as it helps the business owner in planning their business goals by planning out their expenses. In order to maintain or carry out the operations, most of the businesses have various items that should be paid on a consistent basis and budget is regarded crucial in ensuring such payments so that long tern debts can be prevented by the company. Budgeting is an ongoing process because expenses and revenue generated by the business could change any time (Kembauw et al. 2020).

Developing the budget helps in better understanding the scenario whether the business has sufficient revenue to cover its expenses and thereby helps in making informed financial decisions. Various consequences might be faced by the business if they do not develop budgeting as it helps in attracting investors, prepare them for emergencies, helps in setting sales goals, easily prepaying the taxes, paying off debts and meeting the financial goals. Organizations can get destroyed if they do not follow budgetary process due to constant bickering about the case-to-case decisions of allocation of resources (Sulila 2019). Furthermore, budget importance also lies in the fact that they can be instrumental when it comes to identify bottleneck and constraints. Capacity constraints is always considered by a careful budgetary plan. The information generated out of the budget helps the managers in learning well in advance of any distribution bottleneck and looming production so that they can resolve or avoid such problems (Siziba and Hall 2021). Apart from various advantages that budget offers, it cannot be denied that they suffer from few limitations as well. Some of the limitations of the budget is discussed below.

Investing Activities

Since budget is based on various assumptions, and there is a possibility of radical departure of the expected and actual results. This is because when there is a change in the business environment, then this will also cause the changes in the cost and revenue structure of the company (Husna and Satria 2019).

During the formulation of budget period, the only focus of the process of budgeting is on the strategy of the management team and there is no intent to revisit the strategy. It is because when the market fundamentally changes after the budget preparation, there is often no system so that the changes impacting budget can be reviewed (Maguni et al. 2020).

Creation of budget is quite time consuming and if there is a constant change in the business conditions, the work required to develop the budget can be more extensive.

Requirement A:

Requirement B:

Financial position of TAN Plc is assessed by the computation of different ratios by evaluating liquidity, efficiency and profitability position. Liquidity position of the company is evaluated using current, quick and cash ratios.

Current ratio is computed at 1.88 which is higher than 1 and it indicates that current assets of TAN Plc is adequate to meet the obligations falling due. Quick ratio is recorded at 1.48 which implies that quick assets of the company is sufficient to meet the near-term obligations. Cash ratio is recorded at 0.38 which is less than one and it indicates that TAN plc has not adequate cash to meet the near teem obligations.

Profitability position of TAN Plc is evaluated by computing net profit margin, return on equity and return on assets. Net profit margin is computed at 33% which indicates the percentage of net income generate out of revenue. Return on assets is recorded at 19% which indicates that the company is not effectively utilizing its assets to produce income. On other hand, return on equity is recorded at 44% which indicates that the company is at better position when it comes to utilize shareholder’s equity than assets in generating income (Christiana et al. 2020).

Efficiency position of TAN Plc is assessed by computing ratios such as accounts receivable turnover, inventory turnover and asset turnover ratio (Easton et al. 2018). Creditor ratio is computed at 573.57 days which shows that the company does not make payment to its creditor frequently. Accounts receivable turnover ratio is computed at 6.82 and receivable days is 53.53 and the value indicates that the company collects receivables efficiently. Lastly, inventory turnover in days is recorded at 417.14 days and it implies that company covert its inventory into sales in 417 days.

Requirement C:

In order to determine, whether the shareholders should sell or keep investing in the shares of AMF Ltd, the financial position of the company in terms of ratios can be compared with industry average. It is observed that net profit ratio of company is higher than industry average by 13%, which shows that the company is generating more profits. On other hand, debtor days of the company is 53.5 days and the industry average is 110 days, indicating that the company collects its receivables on a faster basis than the industry. Creditor days on other hand is 130 days for the industry and 573.57 days for the company and this indicates that the company makes payment to the creditors faster than other companies in the industry (Giarto and Fachrurrozie 2020). Therefore, it is inferred that the overall financial position of the company is better in terms of efficiency and hence, shareholders should keep investing in the shares of AMF Ltd.

Requirement A:

Requirement B:

It is important for AMF Ltd to manage their cash effectively because the cash balance of the company is recorded at negative value since December, 2022 to March, 2023. Some of the recommendations that can be advised to AMF Ltd to address their cash flow problems are as follows.

• The company should take several steps to speed up the process of receivables and receipts as managing the receivables effectively helps in facilitating the cash flow.
• Credit requirements should be tightened as when the credit requirements are extended, it helps in managing the cash effectively.
• Increase in the sales volume also helps in addressing the cash flow issue. Hence, AMF Ltd should take efforts to increase their turnover by either selling additional goods and services to the existing customers or attracting new customers (Setiany 2021).
• Offering the customers with discount is another option that would help in managing the cash flow. It is because when the customers are offered discount, they are incentivized to make the payment earlier than the usual billing cycles and thereby helps in managing the cash flow (Osiichuk and Mielcarz 2021).
• Inventory should be efficiently managed by analyzing the movement of inventories that helps in determining which items to sell and the items that are soaked up in the working capital. It is recommended to keep the level of inventory lean so that the working capital is not tied unprofitably and unproductively. 

References list:

Christiana, I., Purnama, N.I. and Ardila, I., 2020. Financial ratio in the analysis of earnings management. International Journal of Accounting & Finance in Asia Pasific (IJAFAP), 3(1), pp.8-17.

Easton, P.D., McAnally, M.L., Sommers, G.A. and Zhang, X.J., 2018. Financial statement analysis & valuation. Boston, MA: Cambridge Business Publishers.

Giarto, R.V.D. and Fachrurrozie, F., 2020. The Effect of Leverage, Sales Growth, Cash Flow on Financial Distress with Corporate Governance as a Moderating Variable. Accounting Analysis Journal, 9(1), pp.15-21.

Gorshkov, A.S., Vatin, N.I., Rymkevich, P.P. and Kydrevich, O.O., 2018. Payback period of investments in energy saving. Magazine of Civil Engineering, (2).

Husna, A. and Satria, I., 2019. Effects of return on asset, debt to asset ratio, current ratio, firm size, and dividend payout ratio on firm value. International Journal of Economics and Financial Issues, 9(5), p.50.

Kembauw, E., Munawar, A., Purwanto, M.R., Budiasih, Y. and Utami, Y., 2020. Strategies of Financial Management Quality Control in Business. TEST Engineering & Management, 82, pp.16256-16266.

Maguni, W., Mulu, B., Turmudi, H.M., Insawan, H. and Ni’mah, F., 2020. Analysis of Financial Ratio on Profitability Level (Return on Equity) in PT. Bank Muamalat Indonesia TBK. Al-Ulum, 20(1), pp.191-211.

Osiichuk, D. and Mielcarz, P., 2021. The nonmonotonicity of cash-cash flow relationship: The role of uncertainty and financing constraints. Economic Research-Ekonomska Istraživanja, 34(1), pp.2263-2283.

Prihartono, M.R.D. and Asandimitra, N., 2018. Analysis factors influencing financial management behaviour. International Journal of Academic Research in Business and Social Sciences, 8(8), pp.308-326.

Sarwary, Z., 2019. Capital budgeting techniques in SMEs: A literature review. Journal of Accounting and Finance, 19(3), pp.97-114.

Sarwary, Z., 2020. Strategy and capital budgeting techniques: the moderating role of entrepreneurial structure. International Journal of Managerial and Financial Accounting, 12(1), pp.48-70.

Setiany, E., 2021. The Effect of Investment, Free Cash Flow, Earnings Management, and Interest Coverage Ratio on Financial Distress. Journal of Social Science, 2(1), pp.64-69.

Siziba, S. and Hall, J.H., 2021. The evolution of the application of capital budgeting techniques in enterprises. Global Finance Journal, 47, p.100504.

Sulila, I., 2019. Regional Financial Public Services Evaluation Based on Regional Budget and Expenditure. Jurnal Sosial dan Pembangunan MIMBAR, 35, pp.295-305.

Thomas, M.G., 2022. 6 Budgeting and Cash Flow Management. De Gruyter Handbook of Personal Finance, p.87.

WIDAGDO, B., Jihadi, M., BACHITAR, Y., SAFITRI, O.E. and SINGH, S.K., 2020. Financial Ratio, Macro Economy, and Investment Risk on Sharia Stock Return. The Journal of Asian Finance, Economics, and Business, 7(12), pp.919-926.

Yuniningsih, Y., Pertiwi, T. and Purwanto, E., 2019. Fundamental factor of financial management in determining company values. Management Science Letters, 9(2), pp.205-216.

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