The Purpose of Financial Statements for Different Businesses — practice questions

The Statement of Cash Flows is crucial for directors as it provides vital information about the company's liquidity and solvency that is not always apparent from the Statement of Profit or Loss, which is based on accrual accounting. Here's how it aids their decision-making:

1. Assessing Liquidity: The statement shows the actual cash generated from operations. Directors can use this to assess whether the company has enough cash to meet its short-term obligations, such as paying suppliers, employees, and interest. A profitable company can still face a liquidity crisis if it cannot convert its profits into cash.
2. Evaluating Investment Decisions: The 'Cash flows from investing activities' section shows how much cash has been spent on non-current assets (like machinery or property) and how much has been received from their disposal. Directors can evaluate whether past investments are generating sufficient cash returns and plan for future capital expenditure.
3. Making Financing Decisions: The 'Cash flows from financing activities' section details cash received from issuing shares or taking out loans, and cash paid for loan repayments and dividends. This helps directors decide on the best way to raise new finance and manage existing debt.
4. Formulating Dividend Policy: A company can only pay dividends out of cash. The Statement of Cash Flows helps directors determine if there is sufficient cash available to pay dividends to shareholders after meeting all other obligations. It helps ensure that dividend payments are sustainable and do not jeopardise the company's financial stability.

1. Calculate Capital Employed Capital Employed is the total capital invested in the business. It can be calculated as Total Assets - Current Liabilities. $\text{Capital Employed} = \text{\textdollar}900,000 - \text{\textdollar}250,000 = \text{\textdollar}650,000$

2. Calculate Return on Capital Employed (ROCE) ROCE measures how efficiently a company is using its capital to generate profits. The formula is: $\text{ROCE} = \frac{\text{Profit from Operations}}{\text{Capital Employed}} \times 100\%$ $\text{ROCE} = \frac{\text{\textdollar}150,000}{\text{\textdollar}650,000} \times 100\% = 23.08\%$

3. Calculate the Current Ratio The Current Ratio assesses the company's ability to meet its short-term liabilities with its short-term assets. The formula is: $\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$ $\text{Current Ratio} = \frac{\text{\textdollar}400,000}{\text{\textdollar}250,000} = 1.6$ This is expressed as a ratio of 1.6 : 1.

4. Advice to the Bank

• Profitability (ROCE): The ROCE of 23.08% is a strong result. It indicates that for every $100 of capital invested, the company generates $23.08 in profit before interest and tax. This high level of profitability suggests Alpha Ltd can comfortably cover the interest payments on a new loan.
• Liquidity (Current Ratio): The current ratio of 1.6 : 1 is also healthy. A ratio between 1.5:1 and 2:1 is generally considered ideal. It shows that the company has $1.60 of current assets available to cover every $1 of current liabilities, indicating a low risk of short-term cash flow problems.

Conclusion: Based on the strong profitability and healthy liquidity position demonstrated by these ratios, the bank should view Alpha Ltd's loan application favourably. Further analysis of the Statement of Cash Flows would provide additional assurance about the company's ability to generate cash to service the debt.