Friday, September 23, 2011

Mr. Debit and Mr. Credit

Every accounting transactions has two parties involved : Debit and Credit.
I generally believe that the debit and credit concept should be introduced to the students along with the Accounting Equation:
Asset = Liability + Equity
Following are the pointers to be kept in mind before deep diving into the world of accounts:

Asset: Refers to any item which has a future benefit. We always look into the future standing at a point. The point is the date on which I am preparing the account. eg.fixed assets,investment etc.

Liability: Refers to any liabilty to the external world by the orgnization. To determine wether a particular item is a liability we stand on a particular date and look in the future. If there is an obligation as on that date we have a liability. Equity refers to the amount invested by the shareholders/partners/sole traders in the business. This is a class of people who invest to earn profit from a business. Hence whatever profit the company earns is added to the profit.
Owners Equity: Refers to the amount of money owed to the properitor/propertiors. Readers would recall that Profit = Income - Expense
Income is the amount of money earned in a given accounting period. Period could be of any duration depending on the purpose of analysis. It should be noted that the amount received and receivable for a particular accounting period is accounted as income.

Expense refers to economic costs that is made in order to earn revenue in a given period. The word expenses is restricted to cost incurred in meeting operational need. Period could be of any duration depending on the purpose of analysis


  • Expenses decrease profits; while, income increase profits .

  • Profit is added to the owners equity. Profit is the reward for risk the owner takes.

  • Hence income increases equity and expenses decrease equity.

Now the rules:

Any increase in assets and expenses needs to be debited. Any increase in liability and income needs to be credited.

Any decrease in assets and expenses needs to credited. Any increase in liability and income needs to be debited.


Accounts is prepared on double entry accounting concept. Hence every debit should have a corresponding credit.

ILLUSTRATION:
Rent expenses paid Rs. 500

The two aspects of the transaction are Rent and Cash (assumed paid in cash).

Rent is an expense hence an increase in rent needs to be debited. Cash is an asset hence decrease in cash needs to be credited.

As the purpose of this blog is to connect the concept of accounts and finance rather than getting into the nitties and grities of account I am not getting into the details of " Debit and "Credit."






Author: Abhishek Sinha


Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +

Thursday, September 22, 2011

Cash Flow From Investing and Financing- the missing pieces in the cash flow puzzle

My firm belief is preparing a cash flow from investment and cash flow from financing is relatively easier than preparing cash flow from operating activities. This is because as we use direct method for preparing cash flow from investment and financing it is all about being intuitive.
Investment activities here refers to buying and selling of long term assets. As already covered in one of the earlier blogs to determine asset we need to stand at a particular point and look in the future. If the particular item has a future benefit we call it asset. Any asset which provides a benefit of more than one year is know as long term asset.
For the purpose of cash flow from investing activities we need to gauge whether:
1. The asset is being bought or sold.
2. Determine whether cash is involved.
Buying of asset generates a cash outflow or decrease in cash balance and selling of assets lead to cash inflow or increase in cash balance.
It should also be noted that when a company is expanding, it will buy more assets than it sells and this will lead to net cash outflow. In other words for a company which is growing cash flow from investment is negative.
On the other hand, financing activities refers to the process of funding the investments and operation of a business. Following are major sources for long term funding of operations and investing activities:
1. Long Term loans(Debts)(External Sources)
2. Preference Shares (Internal Sources with fixed rate of dividends)
3. Equity Share capital (Internal Sources with dividend rates not fixed).
A. The important fact to be remembered is issue of debts/equity share capital/preference capital leads to cash inflow.
B. On the other hand interests and dividends which are servicing costs associated with these sources of capital lead to cash outflow.
C. Redemption of debentures (Debt) and Equity/Preference leads to outflow of cash.
Here is a format for cash flow statement:
Cash flows from operating activities (CFO)
Profit after taxation
Add:Depreciation
Add:Interest expense
Add:Profit on the sale of property, plant & equipment
Working capital changes:
(Increase) / Decrease in trade and other receivables
(Increase) / (Decrease) in inventories
Increase / (Decrease) in trade payables
Cash Flow from Operating Activities
Cash flows from investing activities (CFI)
Less: Business acquisitions, net of cash acquired (purchases of business leads to cash outflow ; hence negative)
Less:Purchase of property, plant and equipment(PP&E) (purchases of PP&E leads to cash outflow ; hence negative)
Proceeds from sale of equipment (leads to cash inflow ; hence positive)
Less: Acquisition of portfolio investments (leads to cash outflow ; hence negative)
Add: Investment income (leads to cash inflow ; hence positive)
Net cash used in investing activities Cash flows from financing activities (CFF)
Add: Proceeds from issue of share capital (Cash inflow)
Add: Proceeds from long-term borrowings (Cash inflow)
Less: Payment of interest on long term borrowings (Cash Outflow)
Less: Payment of Dividend on preference and Equity share capital (Cash Outflow)
Redemption of shares and debentures (Debts)(Cash Outflow)
Net increase in cash and cash equivalents (CFO+CFI+CFF) Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period (Should match with the cash and cash equivalent in the balance sheet)

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +

Thursday, September 15, 2011

Score Keeper prepares a cash flow from operations statement statement

I believe that at times drawing analogies help in understanding a concept better. A lot of beginners find difficulty in understanding how a cash flow is derived from an income statement. Even though constructing a cash flow by direct method is easier it is not what companies prefer.
Before I start I would like to revisit the Income Statement :
Schedule 1:
Sales
Less: Cost of Goods sold
Gross Profit
Less: Operating Expenses(Excluding Depreciation Expenses)
EBIDTA
Less: Depreciation
EBIT
Less: Interest
Add: Other Income (Profit on sale of investments)
EBT
Less: Tax
Net Income

Following are the points to be noted:
1. We are adding all income - paid in cash or outstanding
2. We are subtracting all expenses - paid in cash or outstanding
3. Expenses also include non cash expenses such as depreciation. They are notional figures which do not really involve cash.
4. All income and expenses are recurring in nature

Here I have drawn a parallel between "book keeping" and "score keeping again".
The game, cash flow has three parts:
Cash flow from operations
Cash Flow from investments
Cash Flow from Financing activities

The results of cash flow from operations is derived from net income statement.

To start with imagine that the results of the game income statement is already available. The result of this game is known as "net profit". Look at Schedule 1 to get a better understanding of the same.

Now if someone asks you to derive cash flow from operations from the results of an income statement the first thing you need to understand is the difference between the two.
1. We do not include income which is not in cash. Example, profit on sales of assets is not in cash hence not included.The same is included in income statement.
2. We do not include expenses not in cash. Depreciation is not in cash hence not included.
3. Outstanding expenses and income due but not received also is included in income statement but need to be removed to get the cash flow from operations.


The facts that we need to know before we start converting the results of one game to another:
1. If we want to annul the impact of a positive number we subtract.
2. If we want to annul the impact of a negative number we add.
3. All income items are positive. Hence to annul it's impact we subtract.
4. All expense items are negative. Hence to annul it's impact we add.
5. We need to annul impact of non cash expenditure such as depreciation. Hence if the net income is given we add back depreciation.
6. We need to annul impact of non cash income such as profit from sale of assets. Hence we subtract the item from net income.
7. Interest is amount paid on financing activities. Hence it has no place in cash flow from operating activities. Thus we add interest paid to net income.
8. There are certain items such as credit sales and credit purchases which cannot be ascertained from income statement. Now we need to take the help of balance sheet.We can find credit sales as the difference between accounts receivable (current year)and accounts receivable (last year). A positive credit sales leads to increase in net income. Hence to annul it's impact the bookkeeper subtracts increase in accounts receivable and adds back decrease in accounts receivable.
9. Following the same principle any increase in non cash current asset needs to be subtracted and any decrease needs to be added.
10. In case of increase in current liabilities we add back as increase in current liabilities denote increase in credit expenses. To remove the effect of unwanted cash we need to add back.

Following is how a cash flow from operations looks:
Profit after taxation
Adjustments for:
Depreciation (Non Cash Expense)(Hence add back)
Interest expense (Non Operating expense)(Hence add back)
Profit on the sale of property, plant & equipment (Increase in profits, not in cash flow)Note: total cash from sales has been recorded as a separate
Working capital changes:
Add Decrease in trade and other receivables
Add Decrease in inventories
Add Increase in trade payable

Cash generated from operations

Hence, here the book keeper has converted the income statement into cash flow from operating statement. Comment awaited.

Author: Abhishek Sinha

Abhishek Sinha has approximately 8 year of experience in equity research, business research and consultancy. He has also had the privilege of managing a small portfolio of INR 3 million. However, his interest lies in teaching and "demystifying concepts." He has taught students right from the age of 3 years at PP1, to 40 years at executive courses and believes teaching is not about knowing the concepts; it is about relating the concepts to the audience. At present he is "gainfully employed" at Vignana Jyothi Institute of Management, Hyderabad; where he loves to teach finance to an enthusiastic bunch of management students. His hobbies include analyzing income statement, balance sheet and cash flow.> Google +