Funds Flow Statement: Meaning and Preparation

In this article we will discuss about:- 1. Meaning of Funds Flow Statement 2. Preparation of Funds Flow Statement 3. Benefits and Drawbacks.

Meaning of Funds Flow Statement:

The profit and loss account and balance sheet statements are the common important accounting statements of a business organization. The profit and loss account provides financial information relating to only a limited range of financial transactions entered into during an accounting period and its impact on the profits to be reported.

The balance sheet contains information relating to capital or debt raised or assets purchased. But both the above two statements do not contain sufficiently wide range of information to make assessment of organization by the end user of the information.

In view of recognized importance of capital inflows and outflows, which often involve large amounts of money should be reported to the stakeholders, the funds flow statement is devised.

In a funds flow analysis, the details of financial resources availed and the ways in which such resources are used during a particular accounting period, are given in a statement form called ‘Funds flow statement’. The sources of funds also include the funds generated from operations internally.

The funds flow statement can explain the reasons for liquidity problems of the firm even though it is earning profits. It helps the efficient working capital management and indicates the ability of the firm in servicing its long-term debt obligations. The changes in working capital position can also be tracked by observing the surplus/deficit of funds during a particular accounting period.

This statement is also called ‘statement of sources and application of funds ‘and ‘statement of changes in financial position’. While preparation of funds flow statement, non-fund transactions are ignored. A funds flow statement is based on the accrual accounting system, and does not provide explanation as to transactions affecting the cash or cash equivalents. Funds flow is a broader concept than ‘cashflow’.

A funds flow statement fails to give reasons for excess or shortage of cash and cash equivalents. The funds flow statement contains all the details of the financial resources which have become available during an accounting period and the ways in which those resources have been used up.

This statement discloses the amounts raised from various sources of finance during a period and then explains how that finance has been used in the business. This statement is valuable in interpretation of the accounts. It is a very useful tool in analysis of financial statements which analyses the changes taking place between two balance sheet dates.

The statement analyses the changes between the opening and closing balance sheets for the period. A balance sheet sets out the financial position at a point of time, setting liabilities from which funds have been raised against assets acquired by the use of those funds.

A funds flow statement analyses the changes which have taken place in the assets and liabilities during certain period as disclosed by a comparison of the opening and closing balance sheets.

Meaning of ‘Fund’ and ‘Flow’:

For preparation of a funds flow statement, the whole items of the balance sheet are classified into the following four categories as shown below:

The excess of current assets over current liabilities is called ‘working capital’. The excess of funds generated over funds outgo from non-current assets and non-current liabilities will lead to increase or decrease in working capital.

This can further be analyzed into increase or decrease in respective current assets and current liabilities. The term ‘fund’ has been defined and interpreted differently by different experts. Broadly, the term ‘fund’ refers to all the financial resources of the company.

On the other extreme, ‘fund’ has been understood as ‘cash’ only. However, the most acceptable meaning of the ‘fund’ is ‘working capital’. Working Capital is the excess of current assets over current liabilities.

In funds flow analysis, we shall also abide by the popular definition of funds, meaning working capital. The ‘flow’ of funds refer to transfer of economic values from one asset equity to another. When ‘fund ‘mean working capital, flow of funds refers to movement of funds which cause a change in working capital of the organization.

Identification of Flow of Funds:

A ‘flow’ of funds takes place only if a current account is involved. To identify a flow, journalize the transaction, identify the two accounts involved as ‘current’ and ‘non-current’ and apply the general rule.

(a) Transactions which involve only current accounts do not result in a flow.

(b) Transactions which involve only non-current accounts do not result in a flow.

(c) Transactions which involve one current account and one non-current account results in a flow of funds.

Preparation of Funds Flow Statement:

Sources and Application of Funds:

The relationship between sources and application of funds and its impact on working capital is explained in the format of statement of sources and application of funds as given below:

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 of Funds:

The funds inflow into the organization will come from the following sources:

Funds Generated from Operations – During the course of trading activity, a company generates revenue mainly in the form of sale proceeds and paid out for costs. The difference between these two items will be the amount of funds generated by the trading operations.

The funds generated from business operations are arrived at after making the following adjustments:

Notes:

(a) Depreciation on fixed assets or amortization of intangible assets like preliminary expenses, patents, goodwill, etc., written off is charged against profit to reflect the use of fixed assets or written-off of intangible asset. In these transactions there is no corresponding cash outlay occurs and hence, add back the amount charged against profit, to arrive at the total funds generated from business operations.

(b) The profit or loss on sale of non-current assets (fixed assets and long-term investments) is adjusted to arrive at the true funds from operations.

(c) The provision for tax made in the profit and loss account is to be added back to the reported profit. The actual amount paid as tax is to be shown as the application of funds in the funds flow statement. The provision for tax, if it is shown in the balance sheet, need not be considered for calculation of funds generated from operations.

(d) Any amount appropriated in the profit and loss account towards transfer to reserves or proposed dividend is to be added back to arrive at the funds generated from operation. The actual amount paid as dividend is to be shown as application of funds in the funds flow statement. The dividend proposed but awaiting payment is a current liability in the balance sheet. If this amount increases, from one year end to the next, the extra liability appears as a source of funds.

Funds Raised from Shares, Debentures and Long-Term Loans:

The long-term funds injected into the business during the year by issue of new shares or debentures and by raising long-term loans, and any premium collected on such issues.

Sale of Fixed Assets and Long-Term Investments:

Any amount generated from sale of fixed assets or long-term investments is a source of funds. While preparation of the funds flow statement the gross sale proceeds from sale is taken as source of funds. This activity does not produce fresh funds, but it releases funds used to finance the assets. Any profit or loss arising from such sale is adjusted in the funds generated from operations.

Application of Funds:

The use of funds in an organization takes place in the following forms:

i. Repayment of Preference Capital or Debentures or Long-Term Debt:

This represents the application of organization’s funds released from business through redemption of preference shares or debentures, repayment of long-term loans previously made by the organization. Any reduction in equity capital is also taken as application of funds.

ii. Purchase of Fixed Assets or Long-Term Investments:

The funds used to purchase long-term assets are usually the most significant application of funds during the year. This group includes capital expenditures on land, buildings, plant and machinery, furniture and fittings, vehicles and long- term investments outside the business.

iii. Distribution of Dividends and Payment of Taxes:

The dividends distributed to the shareholders and tax paid during the year is the application of funds for the firm.

iv. Loss from Operations:

Losses made in the trading activities use up the funds. If costs exceed revenue, a cash outflow will be experienced.

Changes in Working Capital Position:

This statement follows the statement of sources and application of funds. The primary purpose of the statement is to explain the net change in working capital, as arrived in the funds flow statement. In this statement, all current assets and current liabilities are individually listed.

Against each account, the figure pertaining to that account at the beginning and at the end of the accounting period is shown. The net change in its position is also shown. The changes taking place with respect to each account should add up to equal the net change in working capital, as shown by the funds flow statement.

i. Increase in Current Assets and Decrease in Current Liabilities:

The acquisition of current assets and repayment of current liabilities will result in funds outflow. The funds may be applied to finance an increase in stock, debtors etc. or to reduce trade creditors, bank overdraft, bills payable etc.

ii. Decrease in Current Assets and Increase in Current Liabilities:

The reduction in current assets e.g., stock or debtors balances will result in release of funds to be applied elsewhere. Short-term funds raised during the period by any increase in the current liabilities like trade creditors, bank overdraft and tax dues, means that these sources have lent more at the end of the year than at the beginning.

The basic rules in preparation of the funds flow statement is as follows:

(a) An increase in an asset over the year is an application of fund.

(b) A decrease in an asset over the year is a source of fund.

(c) A decrease in a liability over the year is an application of fund.

(d) An increase in a liability over the year is a source of fund.

Benefits and Drawbacks of Funds Flow Analysis:

Benefits:

To determine financial consequences of operations – Funds flow analysis determines the financial consequences of business operations.

In the following cases, funds flow analysis helps the management to understand the movement of funds and in effective funds management:

1. Many a time, a company in spite of earning large profits may have unsatisfactory liquidity position.

2. The company may be incurring losses but its liquidity position is sound or the firm will be investing in fixed assets despite losses.

3. The firm may declare dividend in spite of losses or low profits.

4. The profit earned by the firm from different sources is not easily understood by the management.

5. There may be sufficient cash in the business. But how such high liquidity is existing, is not known.

i. To Fill Financial Blind Spots:

The funds flow statement is designed to fill financial blind spots of the operating statement. It translates the economic consequences of operations into financial information as a basis for action.

ii. Working Capital Utilization:

The funds flow statement helps the management in assessing the activity of working capital and whether the working capital has been effectively used to the maximum extent in business operations or not.

The statement also depicts the surplus or deficit in working capital than required. This helps the management to use the surplus working capital profitably or to locate the sources of additional working capital in case of scarcity.

iii. To Aid in Securing New Finances:

A statement of changes in financial position is useful for the creditor in considering the company’s request for new term loan.

iv. Helps in Allocation of Financial Resources:

It helps the management in taking decisions regarding allocation of limited financial resources among different projects on priority basis.

v. Helps in Deciding the Urgency of a Problem:

Funds flow analysis helps to relate the time factor to financial planning. This enables the management to identify critical points throughout the passage of time. The management as also the outsiders concern themselves with the informa­tion system geared up towards strategic planning and control of the firm.

This places emphasis on the importance of the statement of changes in financial position as the behaviour of funds flow figures relates to the criteria upon which management strategy is based.

vi. Helps in Evaluation of Operational Issues:

The statement of changes functions as an analytical guide for evaluating operational issues. The statement enables the management to ascertain in which the study of trends of success or failure of operations and available resources.

Drawbacks:

a. Historical Nature:

The funds flow statement is historical in nature like any other financial statement. It does not estimate the sources and application of funds for the near future.

b. Structural Changes are not Disclosed:

The funds flow statement does not disclose the structural changes in financial relationship in a firm nor it discloses the major policy changes with regard to investment in current assets and short-term financing. Significant additions to inventories financed by short-term creditors are not furnished in the statement as they are offset by each other while computing net changes in working capital.

c .New Items are not Disclosed:

The funds flow statement does not disclose any new or original items which affect the financial position of the business. The funds flow statement simply rearranges the data given in conventional financial statements and schedules.

d. Not Relevant:

A study of changes in cash is more relevant than a study of changes in funds for the purpose of managerial decision making.

e. Not Foolproof:

The funds flow statement is prepared from the data provided in the balance sheet and profit and loss account. Hence, the defects in financial statements will be carried over to funds flow statement also.

Illustration:

You are required to prepare funds flow statement for the year ended 31st March, 2009.

Solution: