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Management Accounting Notes: Funds Flow Statement Notes | Theory | For B.Com, BBA and MBA


FUNDS FLOW ANALYSIS - MEANING, OBJECTIVES, FORMAT, SOURCES AND APPLICATIONS OF FUNDS

Funds flow statement Meaning:

The financial statement of the business indicates assets, liabilities and capital on a particular date and also the profit or loss during a period. But it is possible that there is enough profit in the business and the financial position is also good and still there may be deficiency of cash or of working capital in business. Financial statements are not helpful in analysing such situation. Therefore, a statement of the sources and applications of funds is prepared which indicates the utilisation of working capital during an accounting period. This statement is called Funds Flow statement.

In popular sense the term ‘fund’ is used to denote excess of current assets over current liabilities.

Define Funds Flow Statement?

According to R.N. Anthony, “Fund Flow is a statement prepared to indicate the increase in cash resources and the utilization of such resources of a business during the accounting period.”

According to Smith Brown, “Fund Flow is prepared in summary form to indicate changes occurring in items of financial condition between two different balance sheet dates.”

From the above discussion, it is clear that the fund flow statement is statement summarising the significant financial change which have occurred between the beginning and the end of a company’s accounting period. Funds flow statement is also know as Statement of sources and applications of funds.

Meaning of Flow of Funds

The term flow means movement and includes both inflow and outflow of fund. The term flow of funds means the transfer of economic values from one asset of equity to another. Flow of funds is said to have taken place when any transaction makes changes in the amount of funds available before happening of the transaction. In effect, transaction results in increase of funds are called inflow of funds and transaction which decreases funds are called outflow of funds. Further if a transaction does not changes the funds , it is said to have no flow of funds. According to working capital concept of fund, the term flow of funds means movement of funds in the working capital. A transaction which increases the working capital is called inflow of funds and which decreases working capital is called outflow of funds.

Rule of flow of funds: The flow of fund occurs when a transaction changes on the one hand a non current account and on the other hand a current account and vice versa It means that a change in non current account followed by a change in another non current account or a change in a current account followed by a change in another current account will not result in the flow of fund.

Current and non current accounts

Current accounts are accounts of current assets and current liabilities. Current assets are those assets which are in the ordinary course of business can be or will be converted into cash within a short period of normally one accounting year E.g. Cash in hand and at bank, Bills receivable, sundry debtors, short term loans and advances inventories, prepaid expenses and accrued incomes Current liabilities are those liabilities which are intended to be paid within the ordinary course of business within a short period of normally one accounting year out of the current assets or the income of the business. It includes sundry creditors, bills payable outstanding expenses bank overdraft etc.

Noncurrent assets are assets other than current assets and include goodwill land, plant and machinery furniture trademarks etc. Noncurrent liabilities are liabilities other than current liabilities and include all other long term liabilities such as equity share capital debentures , long term loans etc.

To know whether a transaction results in flow of funds the following procedure can be applied

1. Analyze the transaction and find out the accounts involved

2. Make journal entry of the transaction

3. Determine whether the accounts involved in the transaction are current or non current

4. If both accounts are current, either current assets or liabilities, it doesn’t result in flow of funds

5. If both accounts are noncurrent, either noncurrent assets or noncurrent liabilities, it doesn’t result in flow of funds.

6. If accounts involved are such that one is a current account while the other is a non current account, it results in flow of funds

E.g.1.cash collected from debtors

Cash A/c……………….Dr

To Debtors A/c

Both cash and debtors a/c are current accounts and hence do not result in flow of funds. The transaction results in increase in cash and at the same time an equal decrease in debtors and thus do not result in change in working capital or funds.

E.g.2.purchase of new machinery in exchange of old machinery. Here also both the accounts involved are non current accounts and do not result in flow of funds

Eg.3.issue of shares for cash

Cash A/c……………….Dr

To share capital

Here one account is current and the other is non current and results in flow of funds. Here cash increases without any increase in current liability and results in increase in working capital and thus results in flow of funds.

In simple language funds move when a transaction affects:

Ø  a current asset and a Non-current asset,

Ø  a current asset and a Non-current liability, or

Ø  a Non-current and a current liability, or

Ø  a fixed liability and current liability; and

Funds do not move when the transaction affects:

Ø  a current asset and a current liabilities, or

Ø  a Non-current asset and a Non-current liability, or

Ø  only noncurrent liabilities

Procedure for preparation of Funds Flow Statement / Funds Flow Statement Format

Funds Flow statement is a method by which we study changes in the financial position of a business enterprise between beginning and ending financial statements dates. Hence, the funds flow statement is prepared by comparing two balance sheets and with the help of such other information derived from the accounts as may be needed. Broadly speaking, Funds Flow Statement Format consists of two parts:

1.    Statement or Schedule of Charges in Working Capital.

2.    Statement of Sources and Application of Funds.

1. Statement or Schedule of Changes in Working Capital: Working Capital means the excess of current assets over current liabilities. Statement of changes in working capital is prepared to show the changes in the working capital between the two balance sheet dates. This statement is prepared with the help of current assets and current liabilities derived from the two balance sheets.  As, Working Capital = Current Assets – Current Liabilities.

The change in the amount of any current asset or current liability in the current balance sheet is compared to that of the previous balance sheet either results in increase or decrease in working capital. The difference is recorded for each individual current asset and current liability. In case a current asset in the current period is more than in the previous period, the effects is an increase in working capital and it is recorded in the increase column. But if a current liability in the current period is more than in the previous period, the effect is decrease in working capital and it is recorded in the decrease column or vice versa. A typical form of statement or schedule of changes in working capital is as follows:

Statement of Schedule of Changes in Working Capital

 

Particulars

 

Previous Year

 

Current Year

Effects on Working Capital

Amount

Amount

Current Assets (CA):

Cash in hand

Cash at bank

Bills Receivable

Sundry Debtors

Temporary Investments

Stock/Inventories

Prepaid expenses

Accrued Incomes

 

 

 

 

Total Current Assets

 

 

 

 

Current Liabilities (CL):

Bills Payable

Sundry Creditors

Outstanding Expenses

Bank Overdraft

Stock-term advances

Dividends Payable

Proposed dividends

Provision for taxation

 

 

 

 

Total Current Liabilities

 

 

 

 

Working Capital (CA-CL)

 

 

 

 

Net Increase or Decrease in W.C.

 

 

 

 

2. Statement of Sources and Application of Funds: Funds flow statement is a statement which indicates various sources from which funds (working capital) have been obtained during a certain period and the use or applications to which these funds have been put during that period. Format of Funds Flow Statement are given below:

Funds flow statement

(For the year ended…….)

Sources

Amount

Applications

Amount

Funds from Operations

Issue of Share Capital

Issue of Debentures

Raising of long-term loans

Receipts from partly paid shares, called up

Sale of non-current (fixed) assets

Non-trading receipts such as dividends

Sale of long-term Investments

Net Decrease in Working Capital

 

Funds lost in Operations

Redemption of Preference Share Capital

Redemption of Debentures

Repayment of long-term loans

Purchase of non-current (fixed) assets

Purchase of long-term investments

Non-trading payments

Payment of Dividends

Payment of tax

Net Increase in Working Capital

 

 

++++++

 

++++++

Note. Payment of dividend and tax will appear as an application of funds only when these items are appropriations of profits and not current liabilities.

Sources and Applications of funds / Working Capital


Sources of funds

The following are the sources from which funds generally flow (come), into the business:

1.          Funds From Operations or Trading Profits: Trading profits or the profits from operations of the business are the most important and major source of funds. Sales are the main source of inflow of funds into the business as they increase current assets (cash, debtors or bills receivable) but at the same time funds flow out of business for expenses and cost of goods sold. Thus, the net effect of operations will be a source of funds if inflow from sales exceeds the outflow for expenses and cost of goods sold and vice-versa. But it must be remembered that funds from operations do not necessarily mean the profit as shown by the profit and loss account of a firm, because there are many non-fund or non-operating items which may have been either debited or credited to profit and loss account. The examples of such items on the debit side of a profit and loss account are: Amortization of fictitious and intangible assets such as goodwill, Preliminary expenses and Discount on issue of shares and debentures written off; Appropriation of Retained Earnings, such as Transfers to Reserves, etc., Depreciation and depletion; Loss on sale of fixed assets; Payment of dividend, etc. The non-fund items are those which may be operational expenses but they do not affect funds of the business, e.g. for depreciation charged to profit and loss account, funds really do not move out of business. Non-operating items are those which although may result in the outflow of funds but are not related to the trading operations of the business, such as loss on sale of machinery or payment of dividends. The methods of calculating funds from operations have been discussed in the following pages.

Calculating funds from operations:

Adjusted Profit and Loss Account

 

Rs.

 

Rs.

To Depreciation & Depletion or amortization of fictitious and intangible assets, such as: Goodwill, Patents, Trade Marks, Preliminary Expenses etc.

To Appropriation of Retained Earnings, such as: Transfer to General Reserve, Dividend Equalization Fund, Sinking Fund, etc.

To Loss on sales of any non-current or fixed assets

To Dividends (including interim dividend)

To Proposed Dividend (if not taken as a current liability)

To Provision for taxation (if not taken as a current liability)

To Closing balance (of P & L A/c)

To Funds lost in Operations (balancing figure, in case credit side exceeds the debit side)

 

By Opening Balance (of P & L A/c).

By Transfers from excess provisions

By Appreciation in the value of fixed assets

By Dividends received

By Profit on sale of fixed or non-current assets

By Funds from Operations (balancing figure in case debit side exceeds credit side)

 

 

 

 

 

2.          Issue of Share Capital. If during the year there is any increase in the share capital, whether preference or equity, it means capital has been raised during the year. Issue of shares is a source of funds as it constitutes inflow of funds. Even the calls received from partly paid shares and securities premium realised on issue of shares constitute an inflow of funds. But issue of bonus shares, issue of shares for consideration other than cash and conversion of shares into debentures or vice-versa does results into inflow of funds.

3.          Issue of Debentures and Raising of Loans: Issue of debentures or raising of loans (long-term) whether secured or unsecured results in the flow of funds into the business. The inflow of funds is the actual proceeds from the issue of such debentures or raising of loans, i.e., including the amount of premium or excluding discount, if any. However, loans raised for consideration other than a current asset, such as for purchase of building, will not constitute inflow or funds because in that case the accounts involved are only fixed or non-current.

4.          Sale of Fixed (non-current) Assets and Long-term or Trade investments. When any fixed or non-current assets like land, building, plant and machinery, furniture, long-term investments, etc. are sold it generates funds and becomes a source of funds. However, it must be remembered that if one fixed assets is exchanged for another fixed asset, it does not constitute an inflow of funds because no current assets are involved.

5.          Non-Trading Receipts. Any non-trading receipt like dividend received, refund of tax, rent received, etc. also increases funds and is treated as a sources of funds because such an income is not included in the funds from operations.

6.          Decrease in Working Capital. If the working capital decreases during the current period as compared to the previous period, it means that there has been a release of funds from working capital and it constitutes a source of funds.

Applications of Funds

1)         Funds lost in operations. Sometimes the result of trading in a certain year is a loss and some funds are lost during that period in trading operations. Such loss of funds is trading amounts to be outflow of funds and is treated as an application of funds.

2)         Redemption of preference share capital. If during the year any preference shares are redeemed, it will result in the outflow of funds and is taken as an application of funds. When the shares are redeemed at premium or discount, it is the net amount paid (including premium or excluding discount, as the case may be). However, if shares are redeemed in exchange of some other type of shares or debentures, it does not constitute an outflow of funds as no current account is involved in that case.

3)         Repayment of loans or redemption of debentures, etc. In the same way as redemption of preference share capital, redemption of debentures or repayment of loans also constitutes an application of funds.

4)         Purchase of any non-current or fixed asset: When any fixed or non-current asset like land, building, plant and machinery, furniture, long-term investments, etc. are purchased, funds outflow from the business. However, if fixed assets are purchased for a consideration of issue of shares or debentures or if same fixed asset is exchanged for another, it does not involve any funds and hence not an application of funds.

5)         Payment of dividends and tax. Payment of dividends and tare are also applications of funds. It is the actual payment of dividend (may be interim dividend) and tax which should be taken as an outflow of funds and not the mere declaration of dividend or creating of a provision for taxation.

6)         Any other non-trading payment. Any payment or expenses not related to the trading operations of the business amounts to outflow of funds and is taken as an application of funds. The examples could be drawings in case of sole trader or partnership firms, loss of cash, etc.

Importance / Purpose / Advantages / Uses and Objectives of Fund Flow Statement

A funds flow statement is an essential tool for the financial analysis and is of primary importance to the financial management. The basic purpose of funds flow statement is to reveal the changes in the working capital on two balance sheet dates. It also describes the source from which additional working capital has been financed and the uses to which working capital has been applied. By making use of projected funds flow statement the management can come to know the adequacy or inadequacy of working capital even in advance. One can plan the intermediate and long term financing of the firm, repayment of long term debts, expansion of the business, allocation of resources etc. The significance of funds flow statement are explained as follows:

(1) Analysis of Financial Position: Funds flow statement is useful for long term financial analysis. Such analysis is of great help to management, shareholders, creditors, brokers etc. It helps in answering the following questions:

(i) Where have the profits gone?

(ii)  How was it possible to distribute dividends in absence of or in excess of current income for the period?

(iii) How was the sale proceeds of plant and machinery used?

(iv) How was the sale proceeds of plant and machinery used?

(v) How were the debts retired?

(vi) What became to the proceeds of share issue or debenture issue?

(vii) How was the increase in working capital financed?

(viii) Where did the profits go?

Though it is not easy to find the definite answers to such questions because funds derived from a particular source are rarely used for a particular purpose. However, certain useful assumptions can often be made and reasonable conclusions are usually not difficult to arrive at.

(2) Evaluation of the Firm's Financing: One of the important use of this statement is that it evaluates the firm' financing capacity. The analysis of sources of funds reveals how the firm's financed its development projects in the past i.e., from internal sources or from external sources. It also reveals the rate of growth of the firm.

(3) Test of Adequacy: The funds flow statement analysis helps the management to test whether the working capital has been effectively used on not and whether the working capital level is adequate or inadequate for the requirement of business.

(4) An Instrument for Allocation of Resources: In modern large scale business, available funds are always short for expansion programmes and there is always a problem of allocation of resources. Funds flow statement helps management to take policy decisions and to decide about the financing policies and capital expenditure programmes for future.

(5) Guide for investors: The funds flow statement analysis helps the investors to decide whether the company has managed funds properly or not. It indicates the financial soundness of a company which helps the investor to decide whether to invest money in the company or not.

(6) A tool for Measuring credit worthiness: Funds flow statement indicates the credit worthiness of a company which helps the lenders to decide whether to lend money to the company or not.

(7) Future Guide: A projected funds flow statement can be prepared and resources can be properly allocated after an analysis of the present state of affairs. The optimal utilisation of available funds is necessary for the overall growth of the enterprise. A projected funds flow statement gives a clear cut direction to the management in this regard.

(8) It helps in lending or borrowing operations and policies: Lending institution, such as Banks, IFS, IDBI etc. also requires the funds flow statement besides the financial statements in order to know the credit worthiness of the concern and also its ability to convert assets into cash for making the payments at the scheduled time.

Limitations of Funds Flow Statement

In spite of various uses of funds flow statement, it has the following limitations

1)      Historical: This statement only shows how the company has performed in the previous year and does not give much clarity of current and future costs of the company. Hence, realistic comparison of the profit position of the company is not shown. Also, projected fund flow statement is also not very accurate.

2)      Static: A fund flow statement takes into consideration two particular time periods for the purpose of analysis of working capital. Hence, it cannot depict continuous changes. Also, it does not take into consideration noncash items in the company which, in actual accounting, play an important role in many companies.

3)      Incomplete statement: This statement does not show the reasons behind changes in working capital. It only presents the changes in working capital in the form of statement.

4)      Non original statement:  It is not an original statement but simply re-arrangement of financial data over two accounting periods. It is due to this reason many companies avoid preparation of funds flow statement.

5)      Not a substitute: Since this statement only gives an idea of changes in working capital of the company, it cannot be used as a substitute of income statement or a balance sheet. It is only a supplement to them.

6)      Cash flow statement is preferred over funds flow statement: Cash Flow Statement, i.e. changes in cash position, is more important or more informative than the changes in working capital which is presented by a Funds Flow Statement.

7)      Not a forecast: Fund flow statement does not forecast a firm’s future performance. Its indication is related to the performance of the previous year.

8)      Does not show constant change: It cannot show any constant changes. The reason revolves around the fact that only two specific years can be taken for the purpose of analysis.

Difference Between:

(a) Difference between Funds flow statement and Balance sheet:

(i) Balance sheet is a statement showing the financial position of the concern on a particular date. It shows all assets and liabilities whether current or fixed, tangible or intangible etc., while Funds Flow Statement shows the changes in current assets an current liabilities during a particular period of time.
(ii) Balance Sheet shows the total financial position on a particular date and its utility is very limited for the management. On the other hand, Funds Flow Statement is a comparative statement of assets and liabilities and depicts the changes in working capital during the period of two Balance sheets.
(iii) Funds Flow Statement is an analysis and control device for the management. It is a modern technique of knowing the inflows and outflows of funds during a particular period. Balance Sheet represents the balance of various assets and liabilities and does not present analysis of any kind.
(iv) There are two views of the financial position of the firm-long term and short-term. Short-term financial position means the solvency of the firm in the near future while on the other hand, long-term financial position means future financial structure of the firm. Both are inter-relate but there is a differences in their analysis. The short-term view of the financial position of the firm cannot be had from the Balance Sheet.

(b) Difference between Funds Flow Statement and Cash Flow Statement

Basis of Difference
Funds Flow Statement
Cash Flow Statement
Basis of Analysis
Funds flow statement is based on broader concept i.e. working capital.
Cash flow statement is based on narrow concept i.e. cash, which is only one of the elements of working capital.
Objective
The object funds flow statement is to disclose the magnitude, direction and causes of changes in working capital.
The object of cash flow is to disclose the magnitude, direction and causes of changes in cash and cash equivalents.
Source
Funds flow statement tells about the various sources from where the funds generated with various uses to which they are put.
Cash flow statement starts with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses.
Usefulness
Funds flow statement is more useful in assessing the long-term financial position.
Cash flow statement is more useful in assessing the short-term financial position of the business.
Schedule of Changes in Working Capital
In funds flow statement changes in current assets and current liabilities are shown through the schedule of changes in working capital.
In cash flow statement changes in current assets and current liabilities are shown in the cash flow statement.
Causes
Funds flow statement shows the causes of changes in net working capital.
Cash flow statement shows the causes of changes in cash.
Principal of Accounting
Funds flow statement is based on the accrual basis of accounting.
In cash flow statement, data are obtained on accrual basis which are converted into cash basis.
Compulsion
There is no prescribed form for preparation of Funds flow statement.
Cash flow statement is compulsory to be prepared in prescribed proforma as given in AS – 3.
Relationship
Funds flow statement can be prepared from the cash flow statement under indirect method.
But a cash flow statement cannot be prepared from funds flow statement.
Financial Health
Sound fund position does not necessarily mean sound cash position.
But sound cash position is always followed by sound fund position.

(c) Difference between Income Statement and Funds Flow Statement

Basis
Income Statement
Funds Flow Statement
Meaning
Income statement is a summary of total income and total expenses and losses of a particular period.
Funds flow statement is the statement of changes in financial position.
Objectives
Income statement is prepared to ascertain the profit earn or loss suffered by a firm.
Funds Flow Statement is prepared to identify how the profit has been utilized.
Preparation
Income statement is prepared on the basis of nominal accounts.
Funds flow statement is prepared on the basis of balance sheet.
Measurement
Income statement is helpful in measuring the profitability of a firm.
Funds flow statement is helpful in determining the net changes in working capital.
Period
It is usually prepared after six months or a year.
It is usually prepared every month.
Matching
This matches the cost of goods sold with the revenue in order to know the profit or loss.
This statement matches the funds raised with funds applied without making any distinction between capital and revenue items.
Scope
It presents the result of all financial transactions of the business during a specified period.
It presents information only relating to working capital and thus its scope is limited.
Reliability
It is not very reliable as items shown in profit or loss account can be easily manipulated by the management.
It is more reliable as items shown in this statement cannot be easily manipulated by the management.

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