(A) What are the objectives of 'ratios'?
(B) State the various sources of cash inflows from operating activities.
(B) State the various sources of cash inflows from operating activities.
A) Objectives of Ratio AnalysisInterpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfills.
1.Measure of profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
2. Evaluation of operational efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3.Ensure suitable liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
4.Overall financial strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.
5.Comparision
The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.
B ) In thestatement of cash flow, cash flowinformation is reported within three separate classifications, one of which is operating activities. Operating activities are an entity’s primary revenue-producing activities, so cash flows are generally associated with revenues and expenses.
Examples of cash inflows from operating activities are:
- Cash receipts from the sale of goods and services
- Cash receipts from the collection of receivable
- Cash receipts from lawsuit settlements
- Cash receipts from the settlement of insurance claims
- Cash receipts from supplier refunds
- Cash receipts from licensees
Examples of cash outflows for operating activities are:
- Cash payments to employees
- Cash payments to suppliers
- Cash payments of fines
- Cash payments to settle lawsuits
- Cash payments of taxes
- Cash refunds to customers
- Cash payments to settle assets retirement obligations
- Cash payments of interest to creditors
- Cash payments of contributions
The other two classifications used in the statement of cash flows are Investing activities and Financing activities. The operating activities classification is the default classification, so if a cash flow does not belong in either of the other classifications, it is placed in operating activities.
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfills.
1.Measure of profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense ratio etc provide a measure of profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
2. Evaluation of operational efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3.Ensure suitable liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
4.Overall financial strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios etc.
5.Comparision
The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.
Examples of cash inflows from operating activities are:
- Cash receipts from the sale of goods and services
- Cash receipts from the collection of receivable
- Cash receipts from lawsuit settlements
- Cash receipts from the settlement of insurance claims
- Cash receipts from supplier refunds
- Cash receipts from licensees
Examples of cash outflows for operating activities are:
- Cash payments to employees
- Cash payments to suppliers
- Cash payments of fines
- Cash payments to settle lawsuits
- Cash payments of taxes
- Cash refunds to customers
- Cash payments to settle assets retirement obligations
- Cash payments of interest to creditors
- Cash payments of contributions
The other two classifications used in the statement of cash flows are Investing activities and Financing activities. The operating activities classification is the default classification, so if a cash flow does not belong in either of the other classifications, it is placed in operating activities.
