UNIT 4

Fund flow statement:, Concept of gross and Net Working Capital, Preparation of schedule of changes in working capital, Preparation of fund flow statement, Cash Flow Statement, Flow of cash, Preparation of cash flow statement,

Funds flow statement


Funds flow statement is a statement which discloses the analytical information about the different sources of a fund and the application of the same in an accounting cycle. It deals with the transactions which change either the amount of current assets and current liabilities (in the form of decrease or increase in working capital) or fixed assets, long-term loans including ownership fund.
It gives a clear picture about the movement of funds between the opening and closing dates of the Balance Sheet. It is also called the Statement of Sources and Applications of Funds, Movement of Funds Statement; Where Got—Where Gone Statement: Inflow and Outflow of Fund Statement, etc. No doubt, Funds Flow Statement is an important indicator of financial analysis and control. It is valuable and also helps to determine how the funds are financed. The financial analyst can evaluate the future flows of a firm on the basis of past data.

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This statement supplies an efficient method for the financial manager in order to assess the:
(a) Growth of the firm,
(b) Its resulting financial needs, and
(c) To determine the best way to finance those needs.

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In particular, funds flow statements are very useful in planning intermediate and long-term financing.
Objective of Preparing a Fund Flow Statement:
The main purpose of preparing a Funds Flow Statement is that it reveals clearly the important items relating to sources and applications of funds of fixed assets, long-term loans including capital. It also informs how far the assets derived from normal activities of business are being utilized properly with adequate consideration.
Secondly, it also reveals how much out of the total funds is being collected by disposing of fixed assets, how much from issuing shares or debentures, how much from long-term or short-term loans, and how much from normal operational activities of the business.
Thirdly, it also provides the information about the specific utilization of such funds, i.e. how much has been applied for acquiring fixed assets, how much for repayment of long-term or short-term loans as well as for payment of tax and dividend etc.
Lastly, it helps the management to prepare budgets and formulate the policies that will be adopted for future operational activities.
Significance and Importance of Funds Flow Statement:
Since traditional reports (i.e. Income Statement/Profit and Loss Account, and Balance Sheet) are not very informative, a financial analyst has to depend on some other report—Funds Flow Statement. In other words, along with the traditional sources of information, some other sources of information are absolutely required in order to take the challenge offered by modern business.
Funds Flow Statement, no doubt, caters to the needs of management. This is because a Funds Flow Statement not only presents the Balance Sheet values for consecutive two years, it also ascertains the changes of working capital—which is a very important indicator.
It not only reveals the source from which additional working capital has been financed but also, at the same time, the use of such funds. Moreover, from a projected funds flow statement the management can easily ascertain the adequacy or inadequacy of working capital, i.e., it helps in decision-making in a number of ways.
The significance and importance of Funds Flow Statements may be summarized as:
(a) Analysis of Financial Statement:
The traditional financial statements, viz. Profit and Loss Account and Balance Sheet, exhibit the result of the operation and financial position of a firm. Balance Sheet presents a static view about the resources and how the said resources have been utilized at a particular date with recording the changes in financial activities. But Funds Flow Statement can do so, i.e., it explains the causes of changes so made and effect of such change in the firm accordingly.
(b) Highlighting Answers to Various Perplexing Questions:
Funds Flow Statement highlights answers of the following questions:
(i) Causes of changes in Working Capital;
(ii) Whether the firm sells any Non-Current Asset; if sold, how were the proceeds utilized?
(iii) Why smaller amount of dividend is paid in spite of sufficient profit?
(iv) Where did the net profit go?
(v) Was it possible to pay more dividend than the present one?
(vi) Did the firm pay-off its scheduled debts? If so, how, and from what sources?
(vii) Sources of increased Working Capital, etc.
(c) Realistic Dividend Policy:
Sometimes it may so happen that a firm, instead of having sufficient profit, cannot pay dividend due to lack of liquid sources, viz. cash. In such a circumstance, Funds Flow Statement helps the firm to take decision about a sound dividend policy which is very helpful to the management.
(d) Proper Allocation of Resources:
Resources are always limited. So, it is the duty of the management to make its proper use. A projected Funds Flow Statement helps the management to take proper decision about the proper allocation of business resources in a best possible manner since it highlights the future.
(e) As a Future Guide:
A projected Funds Flow Statement acts as a business guide. It helps the management to make provision for the future for the necessary funds to be required on the basis of the problem faced. In other words, the future needs of the fund for various purposes can be known well in advance which is a very helpful guide to the management. In short, a firm may arrange funds on the basis of this statement in order to avoid the financial problem that may arise in future.
(f) Appraising of the Working Capital:
A projected Funds Flow Statement, no doubt, helps the management to know about how the working capital has been efficiently used and, at the same time, also suggests how to improve the working capital position for the future on the basis of the present problem faced by it, if any.

Concept of gross and Net Working Capital

There are two concepts or senses used for working capital.
These are:
1. Gross Working Capital
2. Net working Capital
Let us explain what these two concepts mean.

1. Gross Working Capital:

The concept of gross working capital refers to the total value of current assets. In other words, gross working capital is the total amount available for financing of current assets. However, it does not reveal the true financial position of an enterprise. How? A borrowing will increase current assets and, thus, will increase gross working capital but, at the same time, it will increase current liabilities also.
As a result, the net working capital will remain the same. This concept is usually supported by the business community as it raises their assets (current) and is in their advantage to borrow the funds from external sources such as banks and the financial institutions.
In this sense, the working capital is a financial concept. As per this concept:
Gross Working Capital = Total Current Assets

2. Net Working Capital:

The net working capital is an accounting concept which represents the excess of current assets over current liabilities. Current assets consist of items such as cash, bank balance, stock, debtors, bills receivables, etc. and current liabilities include items such as bills payables, creditors, etc. Excess of current assets over current liabilities, thus, indicates the liquid position of an enterprise.
The ratio of 2:1 between current assets and current liabilities is considered as optimum or sound. What this ratio implies is that the firm/ enterprise have sufficient liquidity to meet operating expenses and current liabilities. It is important to mention that net working capital will not increase with every increase in gross working capital. Importantly, net working capital will increase only when there is increase in current assets without corresponding increase in current liabilities.
Thus, in the form of a simple formula:
Net Working Capital = Current Assets-Current Liabilities
After subtracting current liabilities from current assets what is left over is net working capital.
This process functions much like the following:
  • Current Assets
  • Current Liabilities

    Working Capital

    Working capital normally refers to net working capital. The banks and financial institutions do also adopt the net working capital concept as it helps assess the requirement of the borrower. Yes, if in any particular case, the current assets are less than the current liabilities, then the difference between the two will be called ‘Working Capital Deficit.’
    What this deficit in working capital indicates is that the funds from current sources, i.e., current liabilities have been diverted for acquiring fixed assets. In such case, the enterprise cannot survive for a long period because current liabilities are to be paid out of the realisation made through current assets which are insufficient. Let us understand the two concepts of Gross Working Capital and Net Working Capital.


    Preparation of schedule of changes in working capital

    Preparing the schedule/statement of changes in working capital requires us to present the information relating to the current area of the balance sheets pertaining to the two periods in the format given below and deriving and presenting the changes within them.

    Preparing Funds Flow Statement

    Steps for Preparing Funds Flow Statement: The steps involved in preparing the statement are as follows:
    1. Determine the change (increase or decrease) in working capital.
    3. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital.
    4. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.
    General Rules for Preparing Funds Flow Statement: The following general rules should be observed while preparing funds flow statement:
    1. Increase in a current asset means increase (plus) in working capital.
    2. Decrease in a current asset means decrease (minus) in working capital.
    3. Increase in a current liability means decrease (minus) in working capital.
    4. Decrease in a current liability means increase (plus) in working capital.
    5. Increase in current asset and increase in current liability does not affect working capital.
    6. Decrease in current asset and decrease in current liability does not affect working capital.
    7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital.

    Schedule of Changes in Working Capital: Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).
    This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.

    Cash flow statement

    In financial accounting, a cash flow statement, also known as statement of cash flows,[1] is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet.[1] As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7 (IAS 7), is the International Accounting Standard that deals with cash flow statements.
    People and groups interested in cash flow statements include:
  • Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses.
  • Potential lenders or creditors, who want a clear picture of a company's ability to repay.
  • Potential investors, who need to judge whether the company is financially sound.
  • Potential employees or contractors, who need to know whether the company will be able to afford compensation.
  • Shareholders of the business.

    Cash flow

    Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, pay expenses and provide a buffer against future financial challenges. Negative cash flow indicates that a company's liquid assets are decreasing. Net cash flow is distinguished from net income, which includes accounts receivable and other items for which payment has not actually been received. Cash flow is used to assess the quality of a company's income, that is, how liquid it is, which can indicate whether the company is positioned to remain solvent.

    Often called the "statement of cash flows," the cash flow statement indicates whether a company's income is languishing in the form of IOUs – not a sustainable situation in the long term – or is translating into cash flow. Even very profitable companies, as measured by their net incomes, can become insolvent if they do not have the cash and cash-equivalents to settle short-term liabilities. If a company's profit is tied up in accounts receivable, prepaid expenses and inventory, it may not have the liquidity to survive a downturn in its business or a lawsuit. Cash flow determines the quality of a company's income; if net cash flow is less than net income, that could be a cause for concern.

    Cash flow statements are divided into three categories: operating cash flow, investing cash flow and financing cash flow. Operating cash flows are those related to a company's operations, that is, its day-to-day business. Investing cash flows relate to its investments in businesses through acquisition; in long-term assets, such as towers for a telecom provider; and in securities. Financing cash flows relate to a company's investors and creditors: dividends paid to stockholders would be recorded here, as would cash proceeds from issuing bonds.

    Free cash flow is defined as a company's operating cash flow minus capital expenditures. This is the money that can be used to pay dividends, buy back stock, pay off debt and expand the business.

    Preparation of cash flow statement

    A statement of cash flows contains information about the flows of cash into and out of a company, and the uses to which the cash is put. The statement is comprised of three sections, in which are presented the cash flows that occurred during the reporting period relating to the following:
  • Cash flows from operating activities
  • Cash flows from investing activities
  • Cash flows from financing activities The statement of cash flows is part of the financial statements, and as such is heavily reviewed by the users of the financial statements.
    The most commonly used format for the statement of cash flows is called the indirect method. The general layout of an indirect method statement of cash flows is shown below, along with an explanation of the source of the information in the statement. The sources of information appearing in the table can be used to prepare a cash flow statement.