N. Ramachandran and Ram Kumar Kakani have come up with a series of ‘How to' books, on reading a cash flow statement and profit and loss statement, and analysing financial statements (www.tatamcgrawhill.com).
Let's begin with the P&L book, which opens by distinguishing between costs and expenses. Costs refer to all the outlays of the company, explains ‘Finnova,' the brainy character in the series. “The company may pay for items such as purchasing land, purchasing raw materials, paying salary to staff, paying for electricity, etc. All these items will be referred to as costs of the company.” He clarifies that expenses refer to that portion of costs incurred by the company in some revenue-generating activity.
For starters, the book offers a simple example. “Suppose you need to supply 100 pens to a company. For that you need plastic as raw material. Now, instead of buying plastic to manufacture 100 pens, you buy enough to manufacture 1,500 pens. You do this for future orders and also to ensure that you do not run out of plastic (raw material stock).” If you have followed the story up to this point, you would appreciate that plastic for only 100 pens is used while the rest is kept in the godown as raw material inventory.
In this case, as Finnova elaborates, the money spent on buying plastics for 100 pens can only be termed as expenses, because only that part of your money was used towards a revenue-generating activity, that is, of selling pens, while the money spent on the entire 1,500 pens is your cost. “In future, however, when you decide to manufacture the remaining 1,400 pens, those costs will also become expenses.”
Solvency is the star
Moving on to the book on the analysis of financial statements, one learns that solvency is the ‘star' of an organisation, because it is a situation where it is capable of meeting all its liabilities with its existing assets. Liquidity of a company is of a major concern for short-term creditors and the management, the authors remind.
Adding that debts falling due within the current year require the use of not only cash held by the company, but also cash generated from sale of merchandise and collection of receivables, the authors underline that it is this premise which prompts the analysis of the relationship between current assets and current liabilities, with a view to evaluating the liquidity of a company, through the current ratio. “The most rigorous way of evaluating liquidity is by relating the current liabilities to cash and other quickly-realisable current assets, referred to as the quick ratio or the acid test ratio.”
To those who wonder which is more important – the current or the quick ratio – the answer from the book is that it depends on the situation of the company and industry. Inventories remain as inventories in a few companies that are unable to sell them off owing to competitive pressures, the authors caution. They advise that for such companies quick ratio should be given more importance than current ratio while taking a call on the short-term solvency position of the company.
Cash flow vs fund flow
In the ‘cash flow' book, many of us may relate to the question of ‘Bholuram,' the naïve conversation-mate of Finnova, on what the difference between cash flow and fund flow is. In a cash flow statement, the difference between the sources and application of cash represents the closing cash balance, whereas in a fund flow statement, the difference between sources and applications of funds represents the increase or decrease in the working capital, the authors instruct. “Secondly, cash flow statement helps to assess the firm's capacity to meet short-term obligations, whereas funds flow statement helps to assess firm's capacity to meet its long-term obligations.”
Starter material for finance students.