Financial Management: ECM 105 Assignment on Cash Flow and Ratios

This document provides a comprehensive solution to a financial management assignment, addressing key concepts such as the direct and indirect methods of presenting cash flow from operating activities. It explains the segregation of cash flows into operating, investing, and financing activities, detailing each category. The assignment further explores financial ratios, including liquidity, long-term borrowing capacity, and profitability, along with their respective user groups. It also discusses the order of current assets and the implications and limitations of the Capital Asset Pricing Model (CAPM), with a brief mention of alternative models. The solution offers clear explanations and definitions of the financial terms and concepts, providing valuable insights into financial statement analysis and investment evaluation.

Course Name/Code: ECM 105 Financial Management
Assignment Question:
A) There are two principal methods of presenting cash flow from operating activities,
the direct method and the indirect method. Describe these two methods in detail.
B) Into which three categories are cash flows segregated on the statement of cash
flows? Explain each in detail.
C) What does each of the following categories of ratios attempts to measure? i)
Liquidity ii) Long-term borrowing capacity iii) Profitability. List a group of users who
might be interested in each category and why?
D) Usually, current assets are listed in a specific order, starting with cash, what is the
objective of this order listing?
E) What are some of the implications and limitations of capital asset pricing model
(CAPM)? Is there another model that can overcome some of the shortcomings of the
CAPM?
Attempt Count: 2

A) There are two principal methods of presenting cash flow from operating activities,
the direct method and the indirect method. Describe these two methods in detail.
Cash flows from operating activities consisting of amounts such as cash paid to suppliers and
cash from customers, under the direct method. Cash flows available or used from operating
activities are shown and the net effect of these flows on cash and cash equivalent items over
the period. Contrary to the direct method, under the indirect method, net income is shown
followed by changes required to convert the total net income of the cash amount from
operating activities. (Broome,2004) The net income from the statement of income is adjusted
so that it is reconciled with the net cash flow from operating activities. It is presented as
follows:
Net income + Depreciation – Change in assets + Change in liabilities. (Hackel &
Livnat ,1992)
The direct method should also provide a reconciliation of net income to cash generated from
operating activities. This is done automatically under the indirect method. Several companies
prepare a cash flow statement using the indirect method.
B) Into which three categories are cash flows segregated on the statement of cash flows?
Explain each in detail.
On the statement of cash flows, cash flows are separated into Operating activities, financing
activities and Investing activities. Each of these three classifications is described as follows.
Operating activities are the normal day-to-day activities required to manage the project, such
as the sale of goods and services, collection of accounts receivable, purchase of inventory and
payment to suppliers, employees, taxes and other expenses and income in the statement of
income because of operations. (Broome, 2004) These activities of the revenue generating
entity which are considered as an important indicator of the extent to which the entity can
generate cash flows from its core operations sufficient to repay its loans and to maintain
operational capabilities.
Investing activities are activities related to the granting, collection and sale of loans and the
purchase of fixed assets and intangible assets (Schmidgall, Geller & Ilvento, 1993) such as lands,
buildings, equipment, cars etc.., and the sale or purchase of investments classified as cash

equivalent or trading securities which also includes the granting of loans to third parties and
their collection. Changes in cash that investing activities causes are often cash outflows for
the acquisition of fixed assets such as real estate, equipment, etc., therefore when the
company trades assets, this process denotes cash included in cash inflows. Schmidgall, Geller &
Ilvento, 1993)
Financial activities are activities related to the cash resource collected from owners of capital,
cash dividends paid, cash and short-term and long-term borrowings, as well as payments
made to repay the loans. Changes in cash that are caused by financing activities are in cash
when the company issues share or bonds to the public or long-term notes payable, (Broome,
2004) so the company receives cash from the financing thus cash inflows are sources of
money.
C) What does each of the following categories of ratios attempts to measure? i)
Liquidity ii) Long-term borrowing capacity iii) Profitability. List a group of users who
might be interested in each category and why?
Liquidity ratios are used to measure a company’s capacity to fulfill its short-term
requirements to creditors as they come due. (Barnes, 1987) Liquidity indicates how rapidly
an asset can be converted to the amount of cash it is worth at present – the more swiftly it can
turn to cash the more liquid it is said to be.
Long-term borrowing capacity ratio measures the part of a company’s total assets that is
attained with borrowed funds. This comprises long-term debt, short-term debt, and long-term
duties such as leases. A high ratio shows a more aggressive method of financing and is an
indication of high-risk. (Van Horne, 1986) A low ratio shows a more conventional method to
financing.
Probability ratios are used to measure the capability of a firm to turn sales into profits and to
make profits on assets dedicated. Furthermore, profitability ratios allow some understanding
of the general efficiency of the management side.
D) Usually, current assets are listed in a specific order, starting with cash, what is the
objective of this order listing?
Current assets are listed in a specific order of liquidity so that the order of assets which are
simply convertible into cash can easily be known. Therefore, cash is always presented

first, succeeded by marketable securities, which is followed by accounts receivable,
then inventory, and then fixed assets with goodwill being listed last.
E) What are some of the implications and limitations of capital asset pricing model
(CAPM)? Is there another model that can overcome some of the shortcomings of the
CAPM?
Some of the implications of CAPM are that an investor can use CAPM for investment
evaluation as opposed to other rates it suggests greater discount rates and this model can also
visibly relate among required return and systematic risk. (Fama & French, 2004) Hence, the
emphasis is on systematic risk as investors have expanded their portfolios, in this
circumstance unsystematic risk has efficiently been eradicated.
Some of the limitations of CAPM are that it is founded mainly on assumptions and queries
have been raised about the realism of the model and whether it is effective. Additionally,
suggested by investment evaluation is a long-lasting insight on investment return whereas
CAPM is based on a short, single-period time where it is recognized as an investment return
as its assumed tenacious over a longer time; however, this is not the case and is a limitation
of CAPM.