MANAGEMENT ACCOUNTING THEORY (301)

7. WHAT IS CASH FROM OPERATING ACTIVITIES?

ANS: Cash flow from operating activities (CFO) indicates the amount of money a company brings
in from its ongoing, regular business activities, such as manufacturing and selling goods or
providing a service to customers. It is the first section depicted on a company's cash flow
statement.

Cash flow from operating activities does not include long-term capital expenditures or investment
revenue and expense. CFO focuses only on the core business, and is also known as operating cash
flow (OCF) or net cash from operating activities.

Cash flow forms one of the most important parts of business operations and accounts for the total
amount of money being transferred into and out of a business. Since it affects the
company's liquidity, it has significance for multiple reasons. It allows business owners and
operators check where the money is coming from and going to, it helps them take steps to generate
and maintain sufficient cash necessary for operational efficiency and other necessary needs, and it
helps in making key and efficient financing decisions.

The details about the cash flow of a company are available in its cash flow statement, which is part
of a company's quarterly and annual reports. The cash flow from operating activities depicts the
cash-generating abilities of a company's core business activities. It typically includes net
income from the income statement and adjustments to modify net income from an accrual
accounting basis to a cash accounting basis.

Cash availability allows a business the option to expand, build and launch new products, buy
back shares to affirm their strong financial position, pay out dividends to reward and bolster
shareholder confidence, or reduce debt to save on interest payments. Investors attempt to look for
companies whose share prices are lower and cash flow from operations is showing an upward trend
over recent quarters. The disparity indicates that the company has increasing levels of cash flow
which, if better utilized, can lead to higher share prices in near future.

Positive (and increasing) cash flow from operating activities indicates that the core business
activities of the company are thriving. It provides as additional measure/indicator of profitability
potential of a company, in addition to the traditional ones like net income or EBITDA.

Cash Flow Statement

The cash flow statement is one of the three main financial statements required in standard financial
reporting- in addition to the income statement and balance sheet. The cash flow statement is
divided into three sections—cash flow from operating activities, cash flow from investing
activities, and cash flow from financing activities. Collectively, all three sections provide a picture
of where the company's cash comes from, how it is spent, and the net change in cash resulting
from the firm's activities during a given accounting period.
The cash flow from investing section shows the cash used to purchase fixed and long-term assets,
such as plant, property, and equipment (PPE), as well as any proceeds from the sale of these assets.
The cash flow from financing section shows the source of a company's financing and capital as
well as its servicing and payments on the loans. For example, proceeds from the issuance
of stocks and bonds, dividend payments, and interest payments will be included under financing
activities.

Investors examine a company’s cash flow from operating activities, within the cash flow statement,
to determine where a company is getting its money from. In contrast to investing and financing
activities which may be one-time or sporadic revenue, the operating activities are core to the
business and are recurring in nature.

Types of Cash Flow from Operating Activities

i. Indirect Method- The first option is the indirect method, where the company begins with
net income on an accrual accounting basis and works backwards to achieve a cash basis
figure for the period. Under the accrual method of accounting, revenue is recognized when
earned, not necessarily when cash is received.

ii. Direct Method- The second option is the direct method, in which a company records all
transactions on a cash basis and displays the information on the cash flow statement using
actual cash inflows and outflows during the accounting period.

8. BRIEFLY DESCRIBE THE LIMITATIONS OF RELEVANT COSTING.

ANS: Limitation of relevant costing:

If the correct and accurate results are to be obtained, then proper thought has to be given to the
matter. Each cost item apparent or hidden needs proper attention before assumption are built in the
solution. It is not proper to proceed on the assumption in the context of relevant costing. The cost
so indicated on the relevant cost statement is valid only at a given level of activity. Experts stated
that in relevant costing, period of comparison is often incomplete or incomparable. Timing of cost
and benefit is not important in the technique of relevant costing. On the contrary, the financial
analyst considers the cash flow along with the timing of it. The consideration of time factors allows
the discontinuation in the cash flow in financial management theories. Relevant costing suffers the
limitation on this count but serves the practical objective of profit. Another issue in relevant costing
is handling the opportunity cost. The difficulty of estimating opportunity cost can be temporarily
overcome by extending relevant costing solution into the calculation of accounting rate of return.
It is also termed as average rate of return. A return as a percentage of investment is calculated
(Allied Publishers, 1997).
To summarize, decision making is an integral part of any business of human life. But business life
presupposes the conscious level of decision making instead of rash decision. Before taking the
decision, managers must identify the variables that may have bearing on the decision and try to
get information about those variables. Relevant cost, in managerial accounting, denotes to the
incremental and unnecessary cost of implementing a business decision. Relevant cost analysis is a
cost accounting based evaluation technique. It is just an improved application of basic principles
to business decisions. The major factor in relevant costing is the capacity to clean what is and is
not pertinent to a business choice. This technique is applicable to all special or non-routine
situations.
i. You can’t always predict the future accurately
ii. It’s tough to consider everything that a decision could impact
iii. Relevant costs don’t take non financial info into account

19. WHAT SIGNIFICANT INFERENCES ARE BROUGHT OUT BY THE STATEMENT

OF CASH FLOW?

ANS: The Cash Flow Statement – also referred to as statement of cash flows or funds flow
statement is one of the three financial statements commonly used to gauge a company’s
performance and overall health. The other two financial statements Balance Sheet and Income
Statement have been addressed in previous articles.
As the name implies, the Cash Flow Statement provides information about an organization’s cash
inflows and outflows over a specified time period. Simply put, it reveals how a company spends
its money (cash outflows) and where that money comes from (cash inflows).
The Cash Flow Statement is the best resource for testing a company’s liquidity because it shows
changes over time, rather than absolute dollar amounts at a specific point in time. It's also useful
in determining the short-term viability of a company.
It's important to note that the Cash Flow Statement reflects a firm’s liquidity. It does not
show profitability –the Income Statement does that.
There are two methods of preparing the Cash Flow Statement: direct and indirect.
i. The direct method utilizes actual cash flow information from the company’s operations. It
presents major classes of gross cash receipts and payments. The direct method would most
likely be used by small firms doing their accounting on a cash rather than an accrual basis.
ii. The indirect method derives the data from the Income Statement and from changes on the
Balance Sheet from one period to the next. Both the Income Statement and the Balance
Sheet are based on accrual accounting.
i. Operating Activities

This represents the key source of an organization’s cash generation. It's considered by many to be
the most important information on the Cash Flow Statement. This section of the Cash Flow
Statement shows how much cash is generated from a company’s core products or services. A
strong, positive cash flow from operations (especially over time) is a good sign of a healthy
company. Operating Activities starts with the Net Income number from the Income Statement. If
all of a company’s operating revenues and expenses were in cash, then Net Cash Provided by
Operating Activities (Cash Flow Statement) would equal Net Income (Income Statement).
However, this is rarely the case. Typically, the Net Income must be adjusted on the Cash Flow
Statement based on an increase or decrease in cash calculated from changes on the Balance Sheet
from one period to the next. Most of these adjustment items can either result in an increase or
decrease in cash from operating activities. Exceptions would be adjustments for depreciation and
amortization, which are always an increase to Net Income on the Cash Flow Statement. Look for
consistent levels of cash flow from Operating Activities over time, indicating the company will
probably continue to be able to fund its operations.
ii. Investing Activities
This section records changes in equipment, assets or investments. Cash changes from investing
are generally considered “cash outflows” because cash is used to purchase equipment, buildings,
or short-term assets. When a company divests an asset, the transaction is considered a “cash
inflow”. A healthy company generally invests continually in plant, equipment, land and other fixed
assets
iii. Financing Activities
Changes in debt, loans or stock options, long-term borrowings, etc. are accounted for under
Financing Activities. When capital is raised, it is considered “cash in”; when dividends are paid or
debt is reduced, “cash out”. The Financing Activities section shows how borrowing affects the
company’s cash flow.
“Bottom Line”
The bottom line on the Cash Flow Statement is the Net Increase (Decrease) in Cash and Cash
Equivalents. It's determined by calculating the total cash inflows and outflows for each of the three
sections in the Cash Flow Statement. The 2018 Net Increase (Decrease) in Cash and Cash
Equivalents on the Cash Flow Statement should equal the difference between the 2018 and
2017 Cash and Cash Equivalents figures on the Balance Sheet.

20. WHAT ARE THE CATAGORIES UNDER WHIACH THE VARIOUS RATIOS ARE
GROUPED IN RATIO ANALYSIS?
ANS: Financial ratios are measurements of a business' financial performance. Ratios help an
owner or other interested parties develop an understand the overall financial health of the company.
Financial ratios are used by businesses and analysts to determine how a company is financed.
Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability
to pay off short term debts, and solvency is the ability to pay off long term debts.

Commonly used financial ratios can be divided into the following five categories.

i. Liquidity and Solvency Ratios- Liquidity ratios focus on a firm's ability to pay its short-
term debt obligations. The information you need to calculate these ratios can be found on
your balance sheet, which shows your assets, liabilities, and shareholder's equity. Common
liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is
an indicator of your company's ability to pay its short term liabilities (debts). The quick
ratio (sometimes called the acid-test) is similar to the current ratio. The difference between
 the two is that in the quick ratio, inventory is subtracted from current assets. Since
inventory is sold and restocked continuously, subtracting it from your assets results in a
more precise visual than the current ratio. The cash ratio is different from both the quick
and current ratios in that it only takes into account assets that are the easiest to convert into
cash. These assets are cash and cash equivalents, such as marketable securities, money
orders, or money in a checking account. The solvency ratio represents the ability of a
company to pay it's long term obligations. This ratio compares your company's non-cash
expenses and net income after taxes to your total liabilities (short term and long term).

ii. Financial Leverage Ratios- The financial leverage or debt ratios focus on a firm's ability
to meet its long-term debt obligations. They use the firm's long-term liabilities on the
balance sheet such as payable bonds, long-term loans, or pension funds. Common
financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers
to the amount of money and retained earnings invested in the company. The debt ratio
indicates how much debt the firm is using to purchase assets. In other words, it shows if
the company uses debt or equity financing.

iii. Turnover Ratios- Sometimes called asset efficiency ratios; turnover ratios measure how
efficiently a business is using its assets. This ratio uses the information found on both the
income statement and the balance sheet. The turnover ratios used most commonly are
accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts
receivable turnover indicate how effective your company is at collecting credit debt.
Accounts payable turnover expresses your efficiency at paying your accounts, and
inventory turnover is a measurement of the amount of time it takes to consume and restock
your inventory. When used together, turnover ratios describe how well the business is being
managed. They can indicate how fast the company's products are selling, how long
customers take to pay, or how long capital is tied up in inventory.

iv. Profitability Ratios- These are ratios that measure if a business' activities are profitable.
Frequently used ratios are the net profit ratio and the contribution margin ratio. The
contribution margin ratio indicates if your products or services are generating a profit after
variable expenses. The net profit ratio expresses profits after taxes to net sales. This ratio
illustrates the percentage of profits remaining after taxes and all costs have been accounted
for.

v. Market Value Ratios- There is many market value ratios, but the most commonly used
are price per earnings (P/E) and dividend yield. The P/E ratio is used by investors to
determine if a share of a company's stock is over or underpriced. The dividend yield is an
important ratio for investors as it illustrates the return on their investment.
21. DISTINGUISH BETWEEN ABSORPTION COSTING AND MARGINAL COSTING

ANS: Marginal Costing, also known as Variable Costing, is a costing method whereby decisions
can be taken regarding the ascertainment of total cost or the determination of fixed and variable
cost to find out the best process and product for production, etc. It identifies the Marginal Cost of
production and shows its impact on profit for the change in the output units. Marginal cost refers
to the movement in the total cost, due to the production of an additional unit of output. In marginal
costing, all the variable costs are regarded as product related costs while fixed costs are assumed
as period costs. Therefore, fixed cost of production is posted to the Profit & Loss Account.
Moreover, fixed cost is also not given relevance while determining the selling price of the product
or at the time of valuation of closing stock.

Absorption Costing is a method for inventory valuation whereby all the manufacturing expenses
are allocated to the cost centers to recognize the total cost of production. These manufacturing
expenses include all fixed as well as variable costs. It is the traditional method for cost
ascertainment, also known by the name Full Absorption Costing. In an absorption costing system,
both the fixed and variable costs are regarded as product related cost. In this method, the objective
of the assignment of the total cost to cost centre is to recover it from the selling price of the product.

BASIS FOR
MARGINAL COSTING ABSORPTION COSTING
COMPARISON

Meaning A decision making technique for Apportionment of total costs to the cost
ascertaining the total cost of center in order to determine the total
production is known as cost of production is known as
Marginal Costing. Absorption Costing.

Cost Recognition The variable cost is considered Both fixed and variable cost is
as product cost while fixed cost considered as product cost.
is considered as period costs.

Classification of Fixed and Variable Production, Administration and Selling

Overheads & Distribution

Profitability Profitability is measured by Due to the inclusion of fixed cost,

Profit Volume Ratio. profitability gets affected.
 BASIS FOR
MARGINAL COSTING ABSORPTION COSTING
COMPARISON

Cost per unit Variances in the opening and Variances in the opening and closing
closing stock do not influence stock affect the cost per unit.
the cost per unit of output.

Highlights Contribution per unit Net Profit per unit

Cost data Presented to outline total Presented in conventional way.

contribution of each product.

22. STATE THE LIMITATIONS OF MARGINAL COSTING.

ANS: Marginal costing is “The ascertainment, by differentiating between fixed cost and variable

cost, of marginal cost and of the effect on profit of changes in volume or type of output”.
Under this technique all costs are classified into fixed costs and variable costs.

Limitations of Marginal Costing:

i. Segregation of costs into fixed and variable elements involves considerable technical
difficulty.

ii. The linear relationship between output and variable costs may not be true at different levels
of activity. In reality, neither the fixed costs remain constant nor do the variable costs vary
in proportion to the level of activity.

iii. The value of stock cannot be accepted by taxation authorities since it deflates profit.

iv. This technique cannot be applied in the case of contract costing where the value of work-
in-progress will always be high.
 v. This technique also cannot be used in the case of cost plus contracts unless fixed costs and
profits are considered.

vi. Pricing decisions cannot be based on contribution alone.

vii. The elimination of fixed costs renders cost comparison of jobs difficult.

viii. The distinction between fixed and variable costs holds good only in the short run. In the
long run, however, all costs are variable.