Essay on Funds Flow Analysis | Business| Capital | Accounting

Read this essay to learn about:- 1. Meaning of Funds 2. Uses of Funds Flow Analysis 3. Statement Showing Changes in Working Capital 4. Sources and Applications of Funds 5. Determination of Funds Flow by Incremental Analysis 6. Funds Flow Statement 7. Non-Fund Transactions.

Essay # 1. Meaning of Funds:

Funds mean working capital. Working capital consists of current assets and current liabilities.

Current assets are those which are either in the form of cash or can be converted into cash in the short run. Similarly, current liabilities are those which are to be paid in the short run. ‘Short run’ time frame may be taken as higher of one year or the normal operating cycle of the business.

Generally, no provision (including proposed dividend and tax provision) is considered as current liability.

Essay # 2. Uses of Funds Flow Analysis:

Funds flow analysis helps in understanding the level of working capital and its movement. Every increase or decrease of working capital is caused by funds movement from sources and applications thereof. Funds flow analysis helps to identify the various sources and applica­tions.

Balance sheet is a position statement. It simply indicates the level of various assets and liabilities. It does not explain the underlying funds movement. Understanding funds movement helps in working capital management. Funds flow analysis reveals how additional funds are created or how funds have been released.

Indiscriminate release of funds for investments in fixed assets or outside business may affect the normal functioning. On the other hand, unnec­essary increase of funds may cause idle funds. Idle funds carry oppor­tunity cost. Both increase and decrease should be supported by proper funds requirement analysis.

Earlier it was believed that funds flow analysis explains the liquidity position too. A funds flow statement should be an integral part of the financial statements. This should be released to the external users also. However, this notion has now changed. Presently, common perception is that cash flow analysis is a better indicator of liquidity.

Essay # 3. Statement Showing Changes in Working Capital:

Changes in working capital is measured between two balance sheet dates. For internal funds management it should be done on quarterly basis. Often funds flow analysis is made on the basis annual profit and loss account and balance sheets as on the year-end dates.

Identification of current assets:

At this stage we may straight come to current assets, loans and advances and current liabilities and provisions.

a) Advance tax and tax provision are generally considered separately to indicate funds movement arising out taxation transactions. They are not considered as elements of working capital for funds flow analysis.

b) Proposed dividend is simply application of profit. Firstly, it should be considered as funds inflow arising out of trading operations and thereafter, payment of dividend should be considered as funds outflow.

c) Thus advance tax, tax provision and proposed dividend are ex­cluded from current assets and current liabilities. Other provisions are included in the current liabilities.

d) Any short-term loan or advance is also an element of current asset. So are the current investments which are very liquid and held temporarily with a view to parking the funds in the short run. However, illiquid short-term investments are not part of current investments.

e) Long-term investments and long-term loans are not part of current assets.

f) Any portion of secured and unsecured loans which is of the nature of short-term loans payable within a period of twelve months should be considered as current liabilities. Similarly, any portion of secured and unsecured loans which is falling due within a period of twelve months or any instalment along with interest that has fallen due or will fall due within a period of twelve months is considered as current liability.

Let us now see how changes in working capital is calculated.

Illustration:

Given below the balance sheets of X Ltd. as on 31-3-2002 and 31-3-2001. Prepare a Statement showing Changes in Working Capital.

Additional Information:

(1) 10% of secured loans as on 31-3-2002 will fall due within 3 months.

(2) Short-term unsecured loans: As on 31-3-02 Rs.500 lacs and as on 31-3-01 Rs.200 lacs.

(3) Current and liquid investments: As on 31-3-02 Rs.800 lacs, as on 31-3-01 Rs.300 lacs.

Solution:

Thus there is a decrease in working capital by Rs.150 lacs.

Notes:

1. Any increase in current liabilities means decrease in working capital and any decrease in current liabilities means increase in working capital.

2. Any increase in current assets means increase in working capital and any decrease in current assets means decrease in working capital.

Reasons for Change in Working Capital:

Funds mean working capital. It may be compared with a liquid put in a tub. Let us compare the funds as on a day with a water level (see Fig. 6.1). The water level decreases if there is more outflow than inflow. Similarly, funds decrease if funds inflows between two dates are less than funds outflows. On the contrary, funds will increase if the funds inflows between two dates are more than funds outflows.

Essay # 4. Sources and Applications of Funds:

Various sources and applications of funds are given below:

Essay # 5. Determination of Funds Flow by Incremental Analysis:

Funds flow from various sources are computed on incremental basis. For this you have to compare data of two balance sheet dates.

i. Funds Flow from Issue of Shares:

If you have a relook to the data given in Illustration 1, you will find share capital has been increased by Rs. 1000 lacs and share premium balance between increased by Rs.1000 lacs.

Thus there was funds inflow of Rs. 2,000 lacs.

ii. Funds Flow by Raising Loans:

Let us consider data of secured and unsecured loans given in Illustration 1.

Firstly, current liability portion is eliminated from secured and unse­cured loans. Increase in non-current portion is taken as funds inflow.

iii. Trading Operations at a Profit:

This is computed on the basis of increase in various balances of free reserves and profit and loss account. Increase in share premium account balance will not form part of profit from trading operations. This is already included in funds from issue of shares.

Similarly, increase in capital reserve is caused by capital profit. Capital profit arises from sale of fixed assets or long-term investments. Capital reserve may also represent revaluation profit that arises out of revalu­ation of fixed assets. Increase in capital reserve does not also form part of profit out of trading operations.

Proposed dividend is part of profit. Profit is first earned and thereafter appropriated as proposed dividend.

Provision for taxation is also part of pre-tax profit. If funds from operations are intended to be determined on pre-tax basis, profit should be considered before making provision for taxation. Payment of tax is shown as an application.

Depreciation is a non-cash expenditure item. It is charged in the profit and loss account, merely as a book entry. Similarly, there are amortisations of goodwill, other intangible assets and preliminary expenses. These depreciation and amortisation charges do not involve any funds out­flow. So they are added to profit to arrive at funds flow from trading operations.

Now let us turn to data given in Illustration 1. Let us add one assump­tion that fixed assets were revalued by Rs.500 lacs and revaluation profit of Rs.500 lacs had been added to capital reserve. By this capital reserve was increased from Rs.500 lacs as on 31-3-01 to Rs.1,000 lacs on 31-3-02.

Thus funds from trading operations at profit is Rs.3,850 lacs.

iv. Funds Outflow for Purchase of Fixed Assets:

Purchase of fixed assets can be identified by comparing the gross block figures of two dates. However, the gross block data should be adjusted for increase/decrease by revaluation and sale.

Now let us compare the data given in Illustration:

Thus funds outflow for purchase of fixed assets was Rs.1500 lacs and investment in incomplete capital asset was Rs 3000 lacs.

Funds outflow for purchase of long-term investments and loans:

To arrive at the funds outflow it is necessary to adjust the current investments and short-term loans. Adjusted figures of two dates may be compared to arrive at funds outflow.

Let us consider the data given in Illustration:

Thus funds outflow for purchase of long-term investments and giving loans were Rs.1, 500 lacs.

Essay # 6. Funds Flow Statement:

Let us now enter the final stage of funds flow analysis. It is preparation of a funds flow statement. Funds flow statement is a statement that shows various sources and applications together.

Funds flow statement of X Ltd. would appear as follows:

Funds flow statement for the year 2001-02:

Now you may see that applications were more than sources by Rs.150 lacs. Exactly by the same amount working capital balance got reduced. So by this we have learnt how to prepare funds flow statement.

Essay # 7. Non-Fund Transactions:

While analysing funds flow, you will encounter a large number of non-fund transactions. These transactions although neither represent source nor application, but it is necessary to adjust these transactions for proper appreciation of funds movement.

Some non-fund transactions are discussed below:

(i) Depreciation, amortisation and write off:

Physical fixed assets like plant and machinery, building and furniture are depreciated over the life of the assets. Intangibles like goodwill, patent rights, copyrights, etc. are amortised over the period in which they are effective in generating revenue. Similarly preliminary expenses are written off over a period of 5-10 years. That apart there may be a permanent decline in the value of long-term investments and there may arise profit/loss in sale of invest­ments, which were written off against profit.

These depreciation, amortisation and write off are charged against profit. On the other hand, profit on sale of fixed assets and investments are credit to profit and loss account. These transactions do not involve any fund movement. They are merely book entry. Funds from trading operations are determined by adjusting these non-fund transactions.

Trading operations at profit increases for non-fund charge like deprecia­tion, amortisation and write off. It is decreased for credit to profit and loss account for sale of fixed assets/investments.

(ii) Issue of bonus share:

Share capital increases by issue of bonus share and reserves and surplus decrease correspondingly. Let us take an example. Equity Share Capital of a company as on 31-3-01 was Rs. 5,00,000 and its General Reserve as on that date was Rs. 12,00,000. The company issued 1:1 bonus during the year 2001-02. As on 31-3-02 its Equity Share Capital balance was Rs.10, 00,000 and General Reserve balance was Rs. 8,00,000.

The post-bonus data on 31-3-02 should be carefully scrutinised. Increase in share capital by Rs. 5,00,000 does not reflect source of funds. It is simply non-fund adjustment arising out of bonus issue. Similarly, decrease in general reserve does not reflect trading operations at loss.

Rather there is trading operations at profit:

Increase in general reserve after adjustment of transfer for bonus issue and opening balance is for current profit.

(iii) Revaluation of fixed assets:

Fixed assets are revalued periodically to represent current value of such assets in the balance sheet. By this process net asset value per equity share is correctly reflected. Revalua­tion profit is transferred to capital reserve and revaluation loss is adjusted against general reserve. These adjustment does not involve any fund movement.

Let us take an example. Balances of Gross Block of a company as on 31-3-2001 and 31-3-2002 were Rs. 400 lacs and Rs. 600 lacs respectively. Balance of capital reserve stood at Rs. 100 lacs as on 31-3-2002. The company revalued the fixed assets by Rs. 100 lacs and the revaluation profit was transferred to capital reserve account. This represents non- fund transaction. Increase in capital reserve should not be treated as trading operations at profit. On the other hand, purchase of new fixed assets should be taken at Rs. 100 lacs – increase of gross block by another Rs. 100 lacs represents simply revaluation profit.

There is no application of fund for increase in value of fixed assets to the extent it represents revaluation profit and increase in reserve does not represent source of fund to the extent it reflects revaluation profit.

(iv) Purchase of assets supported by deferred credit or issue of shares or debentures:

Often plant and machinery are purchased through defer credit agreement. Other popular financing arrangement is issuance of equity or preference shares or debentures to cover the purchase consi­deration.

One view is that these composite transactions increase the value of business. So they should be indicated as source as well as application of funds. However, the better approach should be indication of these transactions by way of note to the funds flow statement.