Introduction
Financial statements
are most necessary to report the financial performance of an organization. The
balance sheet, part of the traditional financial statements package, contains
the position of the business in terms of development in assets and liabilities
over the accounting period. The income statement shows the operating
performance of the enterprise, which shows the periods and productive and
commercial activities and its ultimate effect in a change in owners' equity.
Although these financial statements are of high importance and show the change
in assets and liabilities compared between the beginning and ending of the
period at a single snap-shot, it fails to portray those activities which made
changes or causes change in these financial items.
These additional
statements of change in financial position are prepared in two different ways:
i) Working capital basis
as funds flow statement.
ii) Cash basis as cash
flow statements.
MEANING AND DEFINITION
The funds flow
statement is prepared to show the changes in financial position between two
balance sheet dates so that decision-makers and analysts use it more
purposefully. The word funds flow statement consists of two different words
‘funds’ and ‘flow’. The funds have a different meaning in their places like
cash or working capital or all the other financial resources. Flow means
changes occurred in the fund from one specific date to another date under
review. Flow may be inflows and outflows. Thus it can be said that statement
prepared to show the flow of funds on a working capital basis is known as a funds
flow statement. It shows the different sources of funds and the application of
funds in the business.
According to Roy
Fouke, “A statement of sources and application of funds is a technical
device designed to analyze the changes in the financial position of a business
enterprise between two dates.”
IMPORTANCE
Funds flow statement
is an important financial tool, which is required to analyze the changes in the
financial position of a firm showing the sources and applications of its funds.
It provides valuable information about the firms operating, financing, and
investing activities during a particular period. The importance of funds flow
statement is;
· To show the
relationship of net profit to the changes in the fund from the business
operation.
· To show the firms
ability to generate long term financial to satisfy the investment.
· To predict future
funds flow it reports about past fund flow as an aid.
· To identify the change
in the level of current assets investment and current liabilities financing.
· To analyze the changes
in the working capital level of a firm.
· To show the
relationship of net income to the changes in funds from the business operation.
· To determine the firm's
liability to pay interest and dividends, and pay a debt when they become due.
· To show the relationship
of net profit to the changes in the fund from the business operation.
· To show the firms
ability to generate long term financial to satisfy the investment.
CONCEPT OF FUNDS, FLOW
AND STATEMENTS
FUNDS
The word funds refer
to the cash, i.e., all financial resources in the business. The term “funds”
has more than one meaning. In the funds flow statement, however, cash is not
used as a basis, because it concentrates only on changes in a single asset,
cash. Instead, the term funds are used in the broader sense of working capital,
as it focuses on changes in the broader category of working capital.
However, there are two
concepts of working capital, i.e gross concept, and net concept. The gross
concept of working capital means the form’s total investment in its current
assets. In its net concept, working capital is the difference between a firm’s
current assets and current liabilities, such that:
Net working capital =
Current Assets – Current Liabilities
The net working
capital is thought of as a pool of funds to be used in the smooth operation of
the business.
FLOW
Here the word “Flow”
refers to movement or change of funds in terms of net working capital. It means
inflow or increase and outflow or decrease of funds, i.e net working capital,
as a result of certain financial transactions that have taken place in the firm
during the specific period. All financial transactions finally affect the
balance sheet, but they all do not affect the net working capital of the firm.
The financial transaction which increases current assets or decreases current
liabilities with a corresponding decrease in fixed assets or increases in
liabilities and capital creates inflow or increase in funds or net working
capital. On the other hand, the transactions which decrease current assets or
increase current liabilities with a corresponding increase in fixed assets or
decrease in long-term liabilities and capital cause outflow or decrease in
funds or net working capital.
There are the following
types of transactions that change(increase and decrease) of funds:
1.Transactions
involving current liabilities and non-current liabilities: Inflow or
outflow of funds there involves the result of transactions of current
liabilities and non-current liabilities and equity. For instance, the issue of
debentures and shares for the payment of sundry creditors will cause an inflow
of funds, while drawing bills of exchange for the redemption of debenture and
preference shares will cause an outflow of funds.
2.Transactions
involving current liabilities and non-current assets: Changes in funds are
also affected by those transactions involving in current liabilities such as
bills payable, sundry creditors, dividends payable, and bank overdraft and non-current
assets also effect.
3.Transactions
involving current assets and non-current assets: Those transactions, which
involve current assets such as cash, receivables, and inventory and non-current
assets such as fixed assets, intangible assets, and investment results in the
flow of funds.
4.Transactions
involving current assets and non-current liabilities and owner’s equity:
The transactions, which involver current assets and non-current liabilities
such as along-term loans and owners equity will cause the flow of funds.
5.Transactions
involving non-operating receipts and non-operating loss: The transactions,
which involve non-operating receipts and loss results or decrease of funds. All
non-operating receipts increase funds, while non-operating payments decrease
funds.
STATEMENT
Simply “ statement” is
a written record that presents some kind of information and facts about some
events in a systematic manner. The funds flow statement is, therefore, a
written record of the sources of funds in terms of net working capital and its
application on different heads during a particular period of time. It is also
called a statement of sources and application of funds or how funds come and
where funds have gone statement.
Horizontal form
The funds flow
statement can be prepared by using the horizontal form. In this form, sources
of funds are shown on the left-hand side and use or applications of funds on
the right-hand side of the statement as shown below:
|
Sources of funds |
Amount |
Application of funds |
Amount |
|
Funds from operations…… Net decrease in working …… Issue of common shares… Issue of preference shares…. Issue of bonds and debentures…. Borrowing of long-term loans….. Sales of fixed assets …… Sales of investments……… Non-operating receipts Rent…………………………….……… Dividends……………………………… Interest on investments……… Refund of tax…………………………. |
|
Loss from operations …………… Net increase in working
capital………. Redemption of preference shares…. Redemption of bonds and
debentures… Repayment of long-term loans…………. Purchase of fixed assets………….. Purchase of investments………… Fixed deposits…………………… Non-operating payments Payments made due to legal
action…. Payment of interim & final
dividends… Payment of tax……………………………. |
|
|
|
|
|
|
Vertical form
Alternatively, the
funds flow statement can be prepared by using the vertical form. In this form
sources of funds are shown on the up-side and uses or applications of funds on
the down-side of the statements.
PREPARATION OF FUNDS
FLOW STATEMENT
Funds flow statement
is prepared mainly with the help of the balance sheet of any two successive
dates. It is prepared by comparing the balance sheets of the two dates and
using the income statement of the year for which the statement is being
prepared. The following are the steps of funds flows statement:
Step 1:
In the preparation of
funds flow statement, the first step is to find out the net amount of increase
or decrease of working capital, as an increase in net working capital is a use
of funds, and a decrease in net working capital is a source. Since net working
capital is excess of current assets over current liabilities, the increase or
decrease in the net working can be found out by comparing the current assets
and current liabilities contained in the balance sheets of the two following
dates. For this purpose, a statement is prepared which is called a statement or
schedule of changes in net working capital.
The following points
are taken into account:
Increase in current
assets, increase in net working capital
(↑NWC= ↑CA-CL)
Decrease in a current
assets, decrease in net working capital
(↓NWC =↓CA-CL)
Increase in current
liabilities, decrease in net working capital
(↓NWC=↑CA-CL)
Decrease in current
liabilities, decrease in net working capital
(↑NWC=CA-↓CL)
Using only current
account
The statement or
schedule of changes in working capital can be prepared by using the only
current account, viz. account of current assets and current liabilities. While
preparing the statement, the current assets and current liabilities of the
previous year are compared with those of the current year, and the changes
(increase or decrease) therein are determined. If the total increase is more
than that of a decrease, there is an increase in net working capital or vice
versa.
Using both current and
non-current accounts
The statement or
schedule of changes in net working capital can also be prepared by using both
current as well as non-current accounts. Current account is the account of
current assets and current liabilities, and a non-current account is the
account of non-current assets and non-current liabilities and owners equity.
Increase in an item of current assets or decrease in an item of current
liabilities or decrease in an item of current assets is credited to current account.
On the other hand, an increase in an item of non-current assets or decrease in
an item of non-current liabilities from the previous year to the year is
debited, while increase in an item of non-current liabilities and owners equity
and decrease in an item of non-current assets are credited to non-current
account. The rules for debiting and crediting current and non-current accounts
are ;
Current account
Debit the account, if
an item of current asset increases or an item of current liabilities decreases
from that year to this year.
Credit the account, if
an item of current liabilities increases or an item of current assets decreases
from that year to this year.
Non-current accounts
Debit the account, if
an item of non-current assets increases or an item of non-current liabilities
decreases from that year to this year.
Credit the account, if
an item of non-current liabilities increases or an item of non-current assets
decreases from that year to this year.
Step 2:
Statement of funds
from operation
The second step is the
statement of funds from operation to determine the amount of funds from
business operations. It refers to the funds or loss, which is generated or
suffered in the business as a result of its regular operations during the
period. The funds from operations are an important source of funds, while loss
from operations is one of the important applications of funds. The funds or
loss from operations is determined by adjusting the firm’s net income in a
statement called the statement of funds from operations.
Non-cash expenses such
as depreciation and amortization of intangible assets do not result in actual
cash outflow. Non-operating expense is those which are not treated as regular
expenses of the business.
Non-operating and
Non-cash Expenses
Depreciation for the
year
Amortization of goodwill, copyright, patents, trademarks, preliminary expenses.
Discount on issue of shares and debentures written off.
Loss on sales of fixed assets or investment.
Loss on revaluation of fixed assets.
Premium on redemption of debentures and preference shares.
Provision for tax during the year
Provision for dividend during the year
Transfer to reserves and funds
Interim dividend paid.
Incomes and gains which are not earned from the normal business operations are
called non-operating incomes. These incomes are included while ascertaining the
business income but are excluded while determining the funds from operations.
The following are the expenses of non-operating incomes.
Non-operating incomes
Gain on sales of fixed
assets and investment
Gain on revaluation of
fixed assets.
Discount on the redemption
of debentures and preference shares.
Compensation received
Interest received
Refund of tax
Transfer fees received
Appreciation on fixed
assets
Preparation of statement
of funds from operations
Funds from operations
can be determined by using one of the two following methods:
1.Add back method
Under this method, net
profit is taken as the base. All non-operating and non-cash expenses are added
to net profit and non-operating incomes are deducted.
2.Profit and Loss
adjustment account method
Alternatively, funds
from operations can also be determined by preparing an account called profit
and loss adjustment account. The profit and loss adjustment account begins with
the opening balance of profit on its credit side and the closing balance on the
debit side. Instead of opening and closing balance of profit and loss account,
only the amount of net profit for the year can also be brought down to the
debit side of this account. Then the items of non-operating expenses and
non-cash expenses are adjusted to the debit side and then items of
non-operating incomes are adjusted to the credit side to determine the amount
of funds form operations. It is also called profit and loss adjustment
account because it needs the adjustment for non-operating and non-cash items
for the purpose of calculating funds from operations.
Step 3:
Funds flow statement
After ascertaining the
increase or decrease in net working capital and funds or loss from operations,
the next step is to prepare the funds flow statement. The purpose of preparing
the funds flow statement is to know about the funds obtained and used by the
fir. The funds flow statement has two sides. On the left-hand side, the sources
of funds are shown and on the right-hand side, the uses or applications of
funds are shown.
|
Sources |
Amount |
Application |
Amount |
|
Funds from operation………………………. Decrease in working
capital……………………. Issue of shares…………………………… Issue of debentures…………………….. Increases in long-term
liabilities………. Sale of fixed assets…………………………. Sale of long term investment…………. Non trading receipts like
dividend, tax refund, rent etc…………………… |
|
Increase in working capital………………… Loss from operation…………………………. Redemption of preference shares……… Redemption of debentures ………………… Repayment of long-term
liabilities………. Purchase of fixed assets……………………… Investment made……………………………… Non trading payment like
dividend………. |
|
Reviewed by Bijay Munikar
on
March 15, 2021
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