Lesson 3.1: Funds Flow Analysis And Cash Flow Analysis
3.1.1 Introduction
At the end of each accounting period, preparation and presentation
of financial statements are undertaken with an objective of providing as
much information as possible for the public. The balance sheet presents a
snapshot picture of the financial position at a given point of time and the
income statement shows a summary of revenues and expenses during the
accounting period. Though these are significant statements especially in
terms of the principal goals of the enterprise, yet there is a need for one
more statement which will indicate the changes and movement of funds
between two balance sheet dates which are not clearly mirrored in the
balance sheet and income statement. That statement is called as funds flow
statement. The analysis which studies the flow and movement of funds
is called as funds flow analysis. Similarly one more statement has to be
prepared known as cash flow statement. This requires the doing of cash
flow analysis. The focus of cash flow analysis is to study the movement and
flow of cash during the accounting period. This lesson deals at length both
the analyses.
3.1.2
Understand the concept of funds and flow.
Evaluate the changes in working capital in an organization.
Ascertain the sources and uses of funds from a given financial
statement.
Prepare fund flow statement.
Understand the concepts of cash and cash flow.
Understand the cash flow analysis.
Prepare cash flow statement.
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3.1.3 Contents of concepts:
3.3.3.1 Concept Of Funds
3.3.3.2. Flow Of Funds
3.3.3.3 Importance And Utility Of Funds Flow Analysis
3.3.3.4 Preparation Of Funds Flow Statement
3.3.3.5 Illustrations
3.3.3.6 Meaning Of Concepts Of Cash, Cash Flow And Cash Flow
Analysis
3.3.3.7 Cash Flow Statement
3.3.3.8 Calculation Of Cash From Operations
3.3.3.9 Utility Of Cash Flow Analysis
3.3.3.10 Cash Flow Analysis Vs. Funds Flow Analysis
3.3.3.11 Illustrations
3.3.3.12 Summary
3.3.3.13 Key Words
3.3.3.14 Self Assessment Questions
3.3.3.15 Key To Self Assessment Questions
3.3.3.16 Case Analysis
3.3.3.17 Books For Further Reading
3.1.3.1 Concept Of Funds
How are funds defined? Perhaps the most ambiguous aspect of funds
flow statement is understanding what is meant by funds. Unfortunately
there is no general agreement as to precisely how funds should be defined.
To a lay man the concept of funds means `cash’. According to a few, `funds’
means `net current monetary assets’ arrived at by considering current
assets (cash + marketable securities + short term receivables) minus short
term obligations. A third view, which is the most acceptable one, is that
concept of funds means `working capital’ and in this lesson the term
`funds’ is used in the sense of
Working capital.
Working Capital Concept Of Funds
The excess of an enterprise’s total current assets over its total current
liabilities at some point of time may be termed as its net current assets or
working capital. To illustrate this, let us assume that on the balance sheet
date the total current assets of an enterprise are rs.3,00,000 and its total
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current liabilities are rs.2,00,000. Its working capital on that date will be
rs.3,00,000 – rs.2,00,000 = rs.1,00,000. It follows from the above, that any
increase in total current assets or any decrease in total current liabilities
will result in a change in working capital.
3.1.3.2 Flow Of Funds
The term `flow’ means change and therefore, the term `flow of
funds’ means `change in funds’ or `change in working capital’. According
to manmohan and goyal, “the flow of funds” refers to movement of funds
described in terms of the flow in and out of the working capital area. In
short, any increase or decrease in working capital means `flow of funds’.
Many transactions which take place in a business enterprise may increase
its working capital, may decrease it or may not effect any change in it. Let
us consider the following examples.
(i) Purchased Machinery For Rs.3,00,000:
The effect of this transaction is that working capital decreases by
3,00,000 as cash balance is reduced. This change (decrease) in working
capital is called as application of funds. Here the accounts involved are
current assets (cash a/c) and fixed asset (machinery a/c).
(ii) Issue Of Share Capital Of Rs.10,00,000:
This transaction will increase the working capital as cash balance
increases. This change (increase) in working capital is called as source of
funds. Here the two accounts involved are current assets (cash a/c) and
long-term liability (share capital a/c).
(iii) Sold Plant For Rs.3,00,000:
This transaction will have the effect of increasing the working
capital by rs.3,00,000 as the cash balance increases by rs.3,00,000. It is a
source of funds. Here the accounts involved are current assets (cash a/c)
and fixed assets (plant a/c).
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(iv) Redeemed Debentures Worth Rs.1,00,000:
This transaction has the effect of reducing the working capital, as
the redemption of debentures results in reduction in cash balance. Hence
this is an example of application of funds. The two accounts affected by this
transaction are current assets (cash a/c) and long-term liability (debenture
a/c).
(v) Purchased Inventory Worth Rs.10,000:
This transaction results in decrease in cash by rs.10,000 and increase
in stock by rs.10,000 thereby keeping the total current assets at the same
figure. Hence there will be no change in the working capital (there is no
flow of funds in this transaction). Both the accounts affected are current
assets.
(vi) Notes Payable Drawn By Creditors Accepted For Rs.30,000:
The effect of this transaction on working capital is nil as it results
in increase in notes payable (a current liability) and decreases the creditors
(another current liability). Since there is no change in total current
liabilities there is no flow of funds.
(vii) Building Purchased For Rs.30,00,000 And Payment Is Made By
Shares:
This transaction will not have any impact on working capital as it
does not result in any change either in the current asset or in the current
liability. Hence there is no flow of funds. The two accounts affected are
fixed assets (building a/c) and long term liabilities (capital a/c).
From the above series of examples, we arrive at the following rules on flow
of funds:
I. There Will Be Flow Of Funds Only When There Is A Cross-Transaction
I.E., Only When The Transaction Involves:
Ֆ Current Assets And Fixed Assets E.G., Purchase Of Machinery
For Cash (Application Of Funds) Or Sale Of Plant For A Cash
(Source Of Funds).
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Ֆ Current Assets And Capital, E.G., Issue Of Shares (Source Of
Funds).
Ֆ Current Assets And Long Term Liabilities, E.G., Redemption Of
Debentures In Cash (Application Of Funds).
Ֆ Current Liabilities And Long-Term Liabilities, E.G., Creditors
Paid Off In Debentures Or Shares (Source Of Funds).
Ֆ Current Liabilities And Fixed Assets, E.G., Building Transferred
To Creditors In Satisfaction Of Their Claims (Source Of Funds).
Ii. There Will Be No Flow Of Funds When There Is No Cross Transaction
I.E., When The Transaction Involves:
Ֆ Current Assets And Current Assets, E.G., Inventory Purchased
For Cash.
Ֆ Current Liabilities And Current Liabilities, E.G., Notes Payable
Issued To Creditors.
Ֆ Current Assets And Current Liabilities, E.G., Payments Made To
Creditors.
Ֆ Fixed Assets And Long Term Liabilities, E.G., Building Purchased
And Payment Made In Shares Or Debentures.
(a) Sources And Application Of Funds: the following are the main sources
of funds:
(i) Funds From Operations: the operations of the business generate
revenue and entail expenses. Revenues augment working capital and
expenses other than depreciation and other amortizations. The following
adjustments will be required in the figures of net profit for finding out the
real funds from operations:
Funds From Operations
Net profit for the year
x
x
x
Add*: depreciation of fixed assets
x
x
x
Preliminary expenses, goodwill, etc.
Written
off
x
x
x
Loss on sale of fixed assets
x
x
x
Transfers to reserve
x
x
x
Less: profit on sale or revaluation
x
x
x
Dividends received, etc.
X
x
x
Funds from operations
x
x
x
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* these items are added as they do not result in outflow of funds. In case of
`net loss’ for the year these items will be deducted.
(ii) Issue Of Share Capita l: an issue of share capital results in an
inflow of funds.
(iii) Long-Term Borrowings: when a long-term loan is taken, there
is an increase in working capital because of cash inflow. A short term loan,
however, does not increase the working capital because a short-term loan
increases the current assets (cash) and the current liability (short term
loan) by the same amount, leaving the size of working capital unchanged.
(iv) Sale Of Non-Current Assets: when a fixed asset or a long-term
investment or any other non-current asset is sold, there will be inflow
represented by cash or short-term receivables.
(b) Uses Of Funds: the following are the main uses of funds:
(i) Payment Of Dividend: the transaction results in decrease in
working capital owing to outflow of cash.
(ii) Repayment Of Long-Term Liability:
The repayment of long-term loan involves cash outflow and
hence it is used for working capital. The repayment of a current liability
does not affect the amount of working capital because it entails an equal
reduction in current liabilities and current assets.
(iii) Purchase Of Non-Current Assets:
when a firm purchases fixed assets or other non-current assets, and
if it pays cash or incurs a short-term debt, its working capital decreases.
Hence it is a use of funds.
3.1.3.3 Importance And Utility Of Funds Flow Analysis
Funds flow analysis provides an insight into the movement of funds and
helps in understanding the change in the structure of assets, liabilities and
owners’ equity. This analysis helps financial managers to find answers to
questions like:
(i) how far capital investment has been supported by long term
financing?
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(ii) how far short-term sources of financing have been used to
support capital investment?
(iii) how much funds have been generated from the operations of a
business?
(iv) to what extent the enterprise has relied on external sources of
financing?
(v) what major commitments of funds have been made during the
year?
(vi) where did profits go?
(vii) why were dividends not larger?
(viii) how was it possible to distribute dividends in excess of current
earnings or in the presence of a net loss during the current period?
(ix) why are the current assets down although the income is up?
(x) has the liquidity position of the firm improved?
(xi) what accounted for an increase in net current assets despite a
net loss for the period?
(xii) how was the increase in working capital financed?
3.1.3.4 Preparation Of Funds Flow Statement
Two statements are involved in funds flow analysis.
(I) Statement Or Schedule Of Changes In Working Capital
(II) Statement Of Funds Flow
(a) Statement Of Changes In Working Capital:
This statement when prepared shows whether the working capital
has increased or decreased during two balance sheet dates. But this does
not give the reasons for increase or decrease in working capital. This
statement is prepared by comparing the current assets and the current
liabilities of two periods. It may be shown in the following form:
Schedule Of Changes In Working Capital (Proforma)
Items
As on As on Change
Current Assets Increase Decrease
Cash Balances
Bank Balances
Marketable Securities
Stock In Trade
Pre-Paid Expenses
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Current Liabilities
Bank Overdraft
Outstanding Expenses
Accounts Payable
Provision For Tax
Dividend
Increase / Decrease In
Working Capital
Any increase in current assets will result in increase in working
capital and any decrease in current assets will result in decrease in working
capital. Any increase in current liability will result in decrease in working
capital and any decrease in current liability will result in increase in
working capital.
(b) Funds Flow Statement:
Funds flow statement is also called as statement of changes in
financial position or statement of sources and applications of funds or
where got, where gone statement. The purpose of the funds flow statement
is to provide information about the enterprise’s investing and financing
activities. The activities that the funds flow statement describes can be
classified into two categories:
(i) activities that generate funds, called sources, and
(ii) activities that involve spending of funds, called uses.
When the funds generated are more than funds used, we get an
increase in working capital and when funds generated are lesser than the
funds used, we get decrease in working capital. The increase or decrease
in working capital disclosed by the schedule of changes in working capital
should tally with the increase or decrease disclosed by the funds flow
statement.
The funds flow statement may be prepared either in the form of a
statement or in `t’ shape form. When prepared in the form of statement it
would appear as follows:
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Funds Flow Statement
Sources Of Funds
Issues
of
shares
x x x
Issue
of
debentures
x x x
Long term borrowings
x
x
x
Sale of fixed assets
x
x
x
*operating profit
(funds from operations)
x
x
x
Total
sources
x
x
x
Application Of Funds
Redemption of redeemable
Preference
shares
x x
x
Redemption of debentures
x
x
x
Payments for other long-term loans
x
x
x
Purchase of fixed assets
x
x
x
* operation loss (funds lost from
x
x
x
Operations)
-------------------------
Total uses
x
x
x
--------------------------
Net increase / decrease in working capital
(total sources – total uses)
When prepared in `t’ shape form, the funds flow statement would
Appear as follows:
Funds Flow Statement
Sources Of Funds
Application Of Funds
* Funds From Operation x x x *Funds Lost In Operations xx x
Issue Of Shares
x x x Redemption Of
Preference Shares x x x
Issue Of Debentures x x x Redemption Of Debentures x x x
Long-Term Borrowings x x x Payment Of Other Long-Term
Loans
x x x
Sale Of Fixed Assets x x x Purchase Of Fixed Assets x x x
* Decrease In Working
Payment Of Dividend, Tax,
Capital
x x x Etc.
x x x
Increase In Working Capital
x x x
---------------------------------------------------------------------------------
*Only One Figure Will Be There.
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It may be seen from the proforma that in the funds flow statement
preparation, current assets and current liabilities are ignored. Attention is
given only to change in fixed assets and fixed liabilities.
In this connection an important point about provision for
taxation and proposed dividend is worth mentioning. These two may
either be treated as current liability or long-term liability. When treated
as current liabilities they will be taken tòschedule of changes in working
capital’ and thereafter no adjustment is required anywhere. If they are
treated as long-term liabilities there is no place for them in the schedule
of changes in working capital. The amount of tax provided and dividend
proposed during the current year will be added to net profits to find the
funds from operations. The amount of actual tax and dividend paid will be
shown as application of funds in the funds flow statement. In this lesson,
we have taken them as current liabilities.
3.1.3.5 Illustrations
Illustration 1: the mechanism of preparation of funds flow statement is
proposed to be explained with the help of annual reports for the years
2010-11 and 2011-12 pertaining to arasu limited.
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Arasu limited
Balance sheet as at 31st march
Rs.2000
2011-12
2010-11
Source of
funds
1. Share capital
1,40,00
1,40,00
2. Reserves and
surplus
2,77,84
2,30,62
--------- -
--------
4,17,84
3,70,62
----------
---------
Ii. Application
of funds
1. Fixed assets
4,83,15
4,61,23
Less: dep.
Provision
2. Investments
2,57,85 2,25,30 2,27,36 2,33,87
--------- ---------
20,25 20,30
3. Current Assets, Loans
And Advances
Inventories 1,52,83 1,92,54
Debtors 51,41 64,29
Cash And Bank 1,40,80 18,46
Loans & Advances 17,82 14,73
--------- ---------
3,62,86 2,90,02
--------- ---------
Less: Current Liabilities
& Provisions
Liabilities 89,81 76,70
Provisions 100,76 96,87
--------- ---------
1,90,57 1,73,57
--------- ---------
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Net Current Assets 1,72,29 1,16,45
--------- ---------
(Working Capital) 4,17,84 3,70,62
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Profit And Los