ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS : FUNDS FLOW STATEMENT NOTES

The basic financial statements, i.e., the Balance Sheet and Profit and Loss Account or Income Statement of business, reveal the net effect of the various transactions on the operational and financial position of the company. The Balance Sheet gives a summary of the assets and liabilities of an undertaking at a particular point of time. It reveals the financial status of the company. The assets side of a Balance Sheet shows the deployment of resources of an undertaking while the liabilities side indicates its obligations, i.e., the manner in which these resources were obtained. The Profit and Loss Account reflects the results of the business operations for a period of time. It contains a summary of expenses incurred and the revenue realised in an accounting period. Both these statements provide the essential basic information on the financial activities of a business, but their usefulness is limited for analysis and planning purposes. The Balance Sheet gives a static view of the resources (liabilities) of a business and the uses (assets) to which these resources have been put at a certain point of time. It does not disclose the causes for changes in the assets and liabilities between two different points of time. The Profit and Loss Account, in a general way, indicates the sources provided by operations. But there are many transactions that take place in an undertaking and which do not operate through Profit and Loss Account. Thus, another statement has to be prepared to show the change in the assets and liabilities from the end of one period of time to the end of another period of time. The statement is called a Statement of Changes in Financial Position or a Funds Flow Statement.

The Funds Flow Statement is a statement which shows the movement of

funds and is a report of the financial operations of the business undertaking. It indicates various means by which funds were obtained during particular period and the ways in which these funds were employed. In simple words, it is a statement of sources and applications of funds.

  • MEANING OF FUNDS

The term ‘funds’ has been defined in a number of ways :

  • In a narrow sense, it means cash and a Funds Flow Statement prepared on this basis is called a cash flow statement. Such a statement enumerates net effects of the various business transactions on cash and takes into account receipts and disbursements of cash.
  • In a broader sense, the term ‘funds’ refers to money values in whatever form it may exist. Here funds means all financial resources, used in business whether in the form of men, material, money, machinery and others.
  • In a popular sense, the term ‘funds’ means working capital, i.e., the excess of current assets over current liabilities. The working capital concept of funds has emerged due to the fact that total resources of a business are invested partly in fixed assets in the form of fixed capital and partly kept in form of liquid or near liquid form as working capital.

The concept of funds as working capital is the most popular one and in

this lesson we shall refer to ‘funds’ as working capital.

14.3    MEANING OF FLOW OF FUNDS

The term ‘flow’ means movement and includes both ‘inflow’ and ‘outflow’. The term ‘flow of funds’ means transfer of economic values from one asset or equity to another. Flow of funds is said to have taken place when any transaction makes changes in the amount of funds available before happening of the transaction. If the effect of transaction results in the increase of funds, it is called a source of funds and if it results in the decrease of funds, it is known as an application of funds. Further, in case the transaction does not change funds, it is said to have not resulted in the flow of funds. According to the working capital concept of funds, the term ‘flow of funds’ refers to the movement of funds in the working capital. If any transaction results in the increase in working capital, it is said to be a source or inflow of funds and if it results in the decrease of working capital, it is said to be an application or outflow of funds.

Rule of Flow of Funds

The flow of funds occurs when a transaction changes on the one hand a

non-current account and on the other a current account and vice-versa.

When a change in a non-current account e.g., fixed assets, long-term

liabilities, reserves and surplus, fictitious assets, etc., is followed by a change in another non-current account, it does not amount to flow of funds. This is because of the fact that in such cases neither the working capital increases nor decreases. Similar, when a change in one current account results in a change in another current account, it does not affect funds. Funds move from non-current to current transactions or vice-versa only. In simple language funds move when a transaction affects (i) current asset and a fixed asset, or (ii) a fixed and a current liability, or (iii) a current asset and a fixed liability, or (iv) a fixed liability and current liability; and funds do not move when the transaction affects fixed assets and fixed liability or current assets and current liabilities.

Examples

  • Transactions which involve only the current accounts and hence do not result in the flow of funds Cash collected from debtors.
    1. Bills receivables realised.
    2. Cash paid to creditors.
    3. Payment or discharge of bills payable. 5. Issued bills payable to trade creditors.
    4. Received acceptances from customers.
    5. Raising of short-term loans.
    6. Sale of purchased for cash or credit.
    7. Goods purchased for cash or credit.
  • Transactions which involve only non-current accounts and hence do not result in the flow of funds
    1. Purchase of one new machine in exchange of two old machines.
    2. Purchase of building or furniture in exchange of land.
    3. Conversion of debentures into shares.
    4. Redemption of preference shares in exchange of debentures.
    5. Transfers to General Reserves, etc.
    6. Payment of bonus in the form of shares.
    7. Purchase of fixed assets in exchange of shares, debentures, bonds or long-term loans.
    8. Writing off of fictitious assets.
    9. Writing off a accumulated losses or discount on issue of shares, etc.
  • Transactions which involve both current and non-current accounts and hence result in the flow of funds
    1. Issue of shares for cash.
    2. Issue of debentures for cash.
    3. Raising of long-term loans.
    4. Sale of fixed assets on cash or credit.
    5. Sale of trade investments.
    6. Redemption of Preference shares.
    7. Redemption of debentures.
    8. Purchase of fixed assets on cash or credit.
    9. Purchase of long-term/trade investments.
    10. Payment of bonus in cash.
    11. Repayment of long-term loans.
    12. Issue of shares against purchase of stock-in-trade.

14.4   FUNDS FLOW STATEMENT

The Funds Flow Statement is a financial statement which reveals the

methods by which the business has been financed and how it has used its funds between the opening and closing Balance Sheet dates. According to Anthony, “The Funds Flow Statement describe the sources from which additional funds were derived and the uses to which these funds were put”. The analysis of such statements over periods of time clearly shows the sources from which past activities have been financed and brings to highlight the uses to which such funds have been put. The statement is known by various titles, such as, Statement of Sources and Applications of Funds, Statement of Changes in Working Capital, Where Got and Gone Statement and Statement of Resources Provided and Applied.

Objectives of Funds Flow Statement

Generally a business prepares two financial statements i.e., Balance Sheet

and Profit and Loss Account. The former reflects the state of assets and liabilities of a company on a particular date whereas the latter tells about the result of operations of the company over a period of a year. These financial statements have great utility but they do not reveal the movement of funds during the year and their consequent effect on its financial position. For example, a company which has made substantial profits during the year, may discover to its surprise that there are not enough liquid funds to pay dividend and income tax because of profits tied up in other assets, and is always after the bank authorities to get the cash credit or bank overdraft facility. In order to remove this defect, another statement known as Funds Flow Statement is prepared. The main purposes of such statement are :

  • To help to understand the changes in assets and asset sources which are not readily evident in the Income Statement or the financial position statement.
  • To inform as at how the loans to the business have been used, and
  • To point out the financial strengths and weaknesses of the business.

Procedure for Preparing a Funds Flow Statement

Funds flow statement is a method by which we study changes in the

financial position of a business enterprise between beginning and ending  financial statements dates. Hence, the Funds Flow Statement is prepared by comparing two Balance Sheets and with the help of such other information derived from the accounts as may be needed. Broadly speaking, the preparation of a Funds Flow Statement consists of following two parts :

  1. Statement or Schedule of Changes in Working Capital
  2. Statement of Sources and Application of Funds
  3. Statement or Schedule of Changes in Working Capital

Working Capital means the excess of current assets over current liabilities. Statement of changes in working capital is prepared to show the changes in the working capital between the two Balance Sheet dates. This statement is prepared with the help of current assets and current liabilities derived from the two Balance Sheets.

The changes in the amount of any current asset or current liability in the

current Balance Sheet as compared to that of the previous Balance Sheet either results in increase or decrease in working capital. The difference is recorded for each individual current asset and current liability. In case a current asset in the current period is more than in the previous period, the effect is an increase in working  capital and it is recorded in the increase column. But if a current liability in the current period is more than in the previous period, the effect is decrease in working capital and it is recorded in the decrease column or vice versa. The total increase and the total decrease are compared and the difference shows the net increase or net decrease in working capital. It is worth noting that schedule of changes in working capital is prepared only from current assets and current liabilities and the other information is not of any use for preparing this statement. A typical form of statement or schedule of changes in working capital is as follows :

Statement or Schedule of Changes in Working Capital

       Effect on
Particulars Previous Year Current Year Working Capital
Increase Decrease
Current Assets :

Cash in hand

Cash at bank

Bills Receivable

Sundry Debtors

Temporary Investments

Stock/Inventories Prepaid Expenses

Accrued Incomes

Total Current Assets Current Liabilities :

Bills Payable

Sundry Creditors

Outstanding Expenses

Bank Overdraft

Short-term advances

Dividends Payable

Proposed dividends*

Provision for taxation*

Total Current Liabilities

Working Capital (CA-CL)

Net Increase or Decrease in

Working Capital

       
   
   
   
   
       

* May or may not be a current liability

Illustration 1. Prepare a Statement of changes in Working Capital from the following Balance Sheets of Manjit and Company Limited.

Statement of Sources and Application of Funds

Funds flow statement is statement which indicates various sources from

which funds (working capital) have been obtained during certain period and the uses or applications to which these funds have been put during that period. Generally, this statement is prepared in two formats :

  • Report Form
  • T Form or An Account Form or Self Balancing Type.

Specimen of  Report Form of Funds Flow Statement

Sources of Funds :

Funds from Operations

Issue of Share Capital

Raising of long-term loans

Receipts from partly paid shares, called up

Sales of non current (fixed) assets

Non-trading receipts, such as dividends received

Sale of Investments (long-term)

Decrease in working capital (as per Schedule of

Changes in Working Capital) Total

Applications or Uses of Funds :

Funds Lost in Operations

Redemption of Preference Share Capital

Redemption of Debentures

Repayment of long-term loans

Purchase of non-current (fixed) assets

Purchase of long-term Investments

Non-trading payments

Payments of dividends*

Payment of tax*

Increase in Working Capital (as per Schedule of

Changes in Working Capital)

Total

Rs.
 
 
 
 

T Form or An Account Form or Self Balancing Type

Funds Flow Statement

Sources Rs. Applications Rs.
Funds from Operations   Funds lost in Operations  
Issue of Share Capital   Redemption of Preference  
Issue of Debentures   Share Capital  
Raising of long-term loans   Redemption of Debentures  
Receipts from partly paid   Repayment of long-term  
shares, called up   loans  
Sale of non-current (fixed)   Purchase of non-current  
assets   Investments  
Sale of long-term Investments

Net Decrease in Working Capital

  Non-trading payments Payment of Dividends

Net Increase in Working Capital

 
 
 
 

* 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 following are the sources from which funds generally flow (come), into the business :

  1. Funds from operation or Trading Profits

Trading profits or the profits from operations of the business are the

most important and major source of funds. Sales are the main source of inflow of funds into the business as they increase current assets (cash, debtors or bills receivable) but at the same time funds flow out of business for expenses and cost of goods sold. Thus, the net effect of operations will be a source of funds if inflow from sales exceeds the outflow for expenses and cost of goods sold and vice-versa. But it must be remembered that funds from operations do not necessarily mean the profit as shown by the Profit and Loss Account of a firm, because there are many non-fund or nonoperating items which may have been either debited or credited to Profit and Loss Account. The examples of such items on the debit side of a Profit and Loss Accounts are  amortization of fictitious and intangible assets such as goodwill, preliminary expenses and discount on issue of shares and debentures written off, appropriation of retained earnings, such as transfers to reserves, etc., depreciation and depletion, loss on sale of fixed assets, payment of dividend, etc. The non-fund items are those which may be operational expenses but they do not affect funds of the business, e.g., in case of depreciation charged to Profit and Loss Account, funds really do not move out of business. Non-operating items are those which although may result in the outflow of funds but are not related to the trading operations of the business, such as loss on sale of machinery or payment of dividends. There are two methods of calculating funds from operations which are as follows :

  • The first method is to prepaid the Profit and Loss Account afresh by taking into consideration only fund and operational items which involve funds and are related to the normal operations of the business. The balancing figure in this case will be either funds generated from operations or funds lost in operations depending upon whether the income or credit side or Profit and Loss Account exceeds the expense or debit side of Profit and Loss Account or vice-versa.
  • The second method (which is generally used) is to proceed from the figure of net profit or net loss as arrived at from the Profit and Loss Account already prepared.

Funds from operations by this method can be calculate as under :

  • Calculation of Funds from Operation
Closing Balance of Profit and Loss Account (as given in the Balance Sheet)

Add Non-fund and Non-operating items which have been already debited to Profit and Loss Account : (i) Depreciation and Depletion

Rs.
(ii) Amortization of fictitious and Intangible Assets such as : Goodwill/ Patents/Trade marks/Preliminary Expenses/ Discount on Issue of Shares, etc.  
(iii) Appropriation of Retained Earnings, such as :

Transfer to General Reserve/ Dividend Equalisation Fund/ Transfer to Sinking Fund/ Contingency Reserve etc.

 
(iv) Loss on the Sale of any non-current (fixed) assets such as :

Loss on sale of land and building/Loss on sale of machinery/

Loss on sale of furniture/Loss on sale of long-term investments etc.

 
(v) Dividends including :

Interim Dividend/ Proposed Dividend (if it is an appropriation of profits and not taken as current liability)

 
(vi) Provision for Taxation (if it is not taken as Current Liability)  
(vii)

Less

Any other non-fund/non-operating items which have been debited to Profit and Loss Account

Total (A)

Non-fund or Non-operating items which have already been credited to Profit and Loss Account

 
 
 
(i) Profit or Gain from the sale of non-current (fixed) assets such as : Sale of land and building/Sale of plant & machinery/ Sale of long-term investments, etc.  
(ii) Appreciation in the value of fixed assets, such as increase in the value of land if it has been credited to Profit and Loss Account  
(iii) Dividends Received  
(iv) Excess Provision retransferred to Profit and Loss Account or written off  
(v) Any other non-operating item which has been credited to Profit and Loss Account  
(vi) Opening balance of Profit and Loss Account or Retained Earnings

(as given in the Balance Sheet)

Total (B)

Total (A) – Total (B) = Funds generated by operations

 
 
 
  • Funds from operations can also be calculated by preparing Adjusted Profit andLoss Account as follows :

Adjusted Profit and Loss Account

  Rs.   Rs.
To Depreciation & Depletion   By Opening Balance  
  or amortization of fictitious   (of P&L A/c)  
  and intangible assets, such as :   By Transfers from excess  
  Goodwill, Patents, Trade   provisions  
  Marks, Preliminary Expenses   By Appreciation in the  
  etc.   value of fixed assets  
To Appropriation of Retained   By Dividends received  
  Earnings, such as :   By Profit on sale of fixed  
  Transfers to General   or non-current assets  
  Reserve, Dividend Equalisation   By Funds from Operations  
  Fund, Sinking Fund, etc.   (balancing figure in case  
To Loss on Sales of any non-current   debit side exceeds credit  
  or fixed assets   side)  
To Dividends (including interim dividend)      
To Proposed Dividend (if not taken as a current liability)      
To Provision for taxation (if not taken as a current liability)

To Closing balance (of P&L A/c)

To Funds lost in Operations (balancing figure, in case credit side exceeds the debit side)

     
   
   

Issue of Share Capital and Debentures

If during the year there is any increase in the share capital, whether

preference or equity, it means capital has been raised during the year. Issue of shares/ debentures is a source of funds as it constitutes inflow of funds. Even the calls received from partly paid shares/debentures constitutes an inflow of funds. It should also be remembered that it is the net proceeds from the issue of share capital which amounts to a source of funds and hence in case shares are issued at premium, even the amount of premium collected shall become a source of funds. The same is true when shares are issued at discount; it will not be the nominal value of shares but the actual realisation after deducting discount that shall amount to inflow of funds. But sometimes shares are issued otherwise than in cash, the following rules must be followed :

  • Issue of shares or making of partly paid shares as fully paid out of accumulated profits in the form of bonus shares is not a source of funds.
  • Issues of shares for consideration other than current assets such as against purchase of land, machines, etc. does not amount to inflow of funds.
  • Conversion of debentures or loans into shares also does not amount to inflow of funds.

In all the three cases mentioned above, both the accounts involved are

non-current and do not involve any current assets or funds.

  1. Sale of Fixed (non-current assets) and Long-term or Trade investments

When any fixed or non-current asset like land, building, plant and

machinery, furniture, long-term investments, etc. are sold it generates funds and becomes a source of funds. However, it must be remembered that if one fixed asset is exchanged for another fixed asset, it does not constitute an inflow of funds because no current assets are involved.

  1. Non-Trading Receipts

Any non-trading receipt like dividend received, refund of tax, rent

received, etc. also increases funds and is treated as a sources of funds because such an income is not included in the funds from operations.

  1. Decrease in Working Capital

If the working capital decreases during the current period as compared

to the previous period, it means that there has been a release of funds from working capital and it constitutes a source of funds.

Application or Uses of Funds

  1. Funds lost in operations

Sometimes the result of trading in a certain year is a loss and some funds

are lost during that period in trading operations. Such loss of funds in trading amounts to an outflow of funds and is treated as an application of funds.

  1. Purchase of fixed assets

Purchase of fixed assets such as land, building, plant, machinery, long-

term investments, etc., results in decrease of current assets without any decrease in current liabilities. Hence, there will be a flow of fund. But in case shares or debentures are issued for acquisition of fixed assets, there will be no flow of funds.

  1. Payment of dividend

Payment of dividend results in decrease of a fixed liability and, therefore,

it affects funds. Generally, recommendation of directors regarding declaration of dividend (i.e., proposed dividends) is simply taken as an appropriation of profits and not as an item affecting the working capital.

  1. Payment of fixed liabilities

Payment of a long-term liability, such as redemption of debentures or

redemption of redeemable preference shares, results in reduction of working capital and hence it is taken as an application of funds.

  1. Payment of tax liability

Provision for taxation is generally taken as an appropriation of profits

and not as application of funds. But if the tax has been paid, it will be taken as an application of funds.

14.5   HIDDEN TRANSACTIONS

While preparing a Funds Flow Statement, one has to analyse the given

balance sheets. Items relating to current accounts, i.e., current assets and current liabilities have to be shown in the Schedule of Changes in Working Capital. But the non-current assets and non-current liabilities have to be further analysed to find out the hidden information with regard to sale or purchase of non-current assets, issue or redemption of share capital, raising or repayment of long-term loans, transfer to reserve and provisions, etc. The following items require special care while preparing a Funds Flow Statement :

  1. Fixed Assets

Sometimes there are certain adjustments or transactions of sale and

purchase of fixed assets which are given after two Balance Sheets. Under such circumstances, it is desirable to prepare accounts relating to such fixed assets and provisions or reserve for depreciation. The working of these accounts will be as follows:

Fixed Asset Account

Particulars Rs. Particulars  
Rs.

To Opening Balance b/d

  By Adjusted Profit & Loss  
To Bank (Purchase of an   (Dep.)  
Asset : Bal. fig.)   By Bank (Sale of an Asset)  
To Adjusted Profit & Loss A/c

(Profit on Sale)

  By Adjusted Profit & Loss A/c

(Loss on Sale)

 
   

By Balance c/d

Depreciation Account

Particulars Rs. Particulars Rs.
To Fixed Asset A/c   By Opening Balance b/d  
(Accumulated depreciation relating   By Adjusted Profit & Loss A/c  
to asset transferred or sold)

To Closing Balance c/d

  (New provision or reserve)  
   
  1. Proposed Dividend : It can be treated as an item of current liability or noncurrent liability but preferably it should be treated as non-current liability. For knowing hidden transactions relating to dividend, it is desirable to prepare proposed dividend account as follows (in case treated as non-current liability) :

Proposed Dividend Account

  Rs.   Rs.
To Bank (Payment of dividend of   By Opening Balance b/d  
last year)   By Adjusted Profit & Loss A/c  
To Closing Balance c/d   (Provision made for the current year)

(Bal. fig.)

 
   

If dividend paid during the year is not given, then it is assumed that last

year balance must have been paid during the year and provision made during the year must be equal to the closing balance. Interim dividend has nothing to do with proposed dividend account. If interim dividend is paid it will be shown on the debit side of Adjusted Profit and Loss Account and on the application side of Funds Flow Statement. If treated as current liability it will be shown in Schedule of Changes in Working Capital and dividend paid will be shown on the debit side of Profit and Loss Account and as an application in the Funds Flow Statement.

  1. Provision for Income tax. Like proposed dividend it can be treated as current liabilities or non-current Liability. But preferably it should be treated as non-current liability. If income tax paid during the year is not given, then it is assumed that last year balance must have been paid during the year and will be shown as an application in the Funds Flow Statement. Provision made during the year must be the closing balance of such account and will be shown on the debit side of Adjusted Profit and Loss A/c. Income Tax payable is a current liability. The provision for income tax account is prepared as under (if treated as non-current liability) :

Provision for Taxation Account

  Rs.   Rs.
To Bank (Tax paid)   By Opening Balance c/d  
To Closing Balance c/d   By Profit & Loss A/c

(Provision made) (Bal. fig.)

 
   

If treated as a current liability, it will be shown in the Schedule of Changes

in Working Capital and tax paid will be shown as an application in the Funds Flow Statement and on the debit side of Profit and Loss Account.

  1. Fictitious Assets : If there are certain fictitious assets shown in the Balance Sheet such as discount on issue of shares or debentures, preliminary expenses, underwriting commission, etc., then the balance to be written off to the Adjusted Profit and Loss Account can be calculated by preparing the fictitious asset account. It will be prepared as follows :

Fictitious Asset Account

  Rs.   Rs.
To Opening Balance c/d   By Adjusted Profit & Loss A/c

(Bal. fig.) (written off)

By Balance c/d

 
   
  1. Undistributed Reserves and Funds : If there are any undistributed profits in the form of reserves and funds the difference of these reserves and funds will be shown on the debit or credit side of Adjusted Profit and Loss Account. If it increases, it will be shown on the debit side, if it decreases, will be shown on the credit side. The account is shown as under :

Reserve Account

  Rs.   Rs.
To Adjusted Profit & Loss A/c   By Balance c/d  
(reserve utilised)   By Adjusted Profit and Loss A/c  
To Balance c/d   (new reserve)  
   

 

Net Profit or  Drawings. Sometimes in case of sole trader or partnership concerns, capital of the proprietor or partners is given but figures of drawings or net profit may be missing.

  1. Intangible Assets. Intangible assets as goodwill, patents, copyrights, licences are also written off from the Adjusted Profit and Loss Account. Till these assets are completely written off their balances will be shown in the Balance Sheet. Sometimes additions are also made to these assets. Balance to be written off will be the balancing figure. Such assets accounts are prepared as follows :

Intangible Asset Account

  Rs.   Rs.
To Balance b/d   By Adjusted Profit & Loss A/c  
To Bank Share Capital A/c   (written off)  
(purchase for cash or issue of share capital   By Balance c/d  
   
  1. Redemption of Debentures : When debentures are to be redeemed during a specified period, it must be seen whether the total payment to be made is more or less than the face value of debentures. If it is more than the face value, the excess will be charged to Adjusted Profit and Loss Account as loss on redemption and if less than the face value, the difference will be profit on redemption and will be shown on the credit side of Adjusted Profit and Loss Account. Actual amount paid will be shown an application in the Funds Flow Statement. The account will be prepared as under :

Debentures Account

  Rs.   Rs.
To Bank (Actual amount paid)   By Opening Balance  
To Adjusted Profit and Loss A/c   By Adjusted Profit and Loss A/c  
(Bal. Fig.)   (loss on redemption)  
(Profit on redemption)   (Bal. Fig.)  
   
  1. Redemption of reference Share : Like redeemable debentures, the redeemable preference shares can be redeemed by the company either at premium or at discount. Excess amount of premium paid alongwith the face value of the shares will be a charge to Adjusted Profit and Loss Account while discount gained on redemption will be credited to Adjusted Profit and Loss Account. The account of redeemable shares will be prepared as under :

Redeemable Preference Share Capital Account

  Rs.   Rs.
To Bank   By Opening Balance b/d  
To Profit and Loss A/c (Gain on Redemption)   By Profit and Loss A/c (Premium on Redemption)  
   
  1. Bonus Shares : Bonus shares are those shares which are issued to the existing shareholders in certain proportion without receiving anything in cash from them. Such shares are issued from existing balances of various accounts such as capital redemption reserve, shares premium, general reserve or Profit and Loss Account. If indication to this respect is given, then that account is prepared in order to see the net effect of the account to be taken to Adjusted Profit and Loss Account.

Is depreciation a source of funds?

Depreciation means decrease in the value of an asset due to wear and

tear, lapse of time, obsolescence, exhaustion and accident. Depreciation is taken as an operating expense while calculating funds from operations. The accounting entries are

:

(i) Depreciation A/c

To Fixed Asset A/c

Dr.
(ii) Profit and Loss A/c Dr.

To Depreciation A/c

Thus, effectively the Profit and Loss Account is debited while the Fixed Asset Account is credited with the amount of depreciation. Since, both Profit and Loss Account and the Fixed Asset Account are non-current accounts, depreciation is a nonfund item. It is neither a source nor an application of funds. It is added back to Operating Profit to find out funds from operations since it has already been charged to profit but it does not decrease funds from operations. Depreciation should not, therefore, be taken as a ‘Source of Funds’. If depreciation were really a source of funds by itself, any enterprise could have improved its funds position at will by merely increasing the periodical depreciation charge.

However, depreciation can be taken as a source of funds in a limited

sense because of three reasons :

  • In case of manufacturing concern, when current assets include closing inventory is and the value of closing inventories includes the depreciation on fixed assets as an element of cost, depreciation acts as a source of funds in such a case.
  • Depreciation does not generate funds but it definitely save funds. For example, if the business had taken the fixed assets on hire, it would have been required to pay rent for them. Since it owns fixed assets, it saves outflow of funds which would have otherwise gone out in the form of rent.

DIFFERENCE BETWEEN FUNDS FLOW STATEMENT AND INCOME STATEMENT

A Funds Flow Statement differs from an Income Statement (i.e., Profit

and Loss Account) in several respects :

  • A Funds Flow Statement deals with the financial resources required for running the business activities. It explains how were the funds obtained and how were they used. Whereas an Income Statement discloses the results of the business activities, i.e., how much has been earned and how it has been spent.
  • A Funds Flow Statement matches the funds raised and funds applied during a particular period. The sources and applications of funds may be of capital as well as of revenue nature. An Income Statement matches the incomes of a period with the expenditure of that period which are both of a revenue nature. For example, when shares are issued for cash, it becomes a source of funds while preparing a Funds Flow Statement but it is not an item of income for an Income Statement.
  • Sources of funds are many besides operations such as share capital, debentures, sale of fixed assets, etc. An Incomes Statement which discloses the results of operations cannot even accurately tell about the funds from operations alone because of non-fund items (such as depreciation, writing off of fictitious assets etc.) being included therein.

Thus, both Income Statement and Funds Flow Statement have different

functions to perform. Modern management needs both. One cannot be a substitute for the other rather they are complementary to each other.

14.7   USES OF FUNDS FLOW STATEMENT

The various uses of Funds Flow Statement are summarised as under :

  • As a tool of historical analysis, it provides an answer to some of the important financial questions such as :
    • How was it possible to distribute dividend in excess of current earnings or in the presence of a net loss for the period? (i.e. the firm might have raised funds from other sources also in addition to funds from operations).
    • Why has the net working capital decreased although the net income for the period has gone up? (i.e. the firm might have applied the funds more than the sources of funds).
    • Why has the net working capital increased even though there has been a net loss for the period? (i.e., the firm might have raised the funds more than the application of funds).
    • What happened to the proceeds of the sale of plant and equipment? (e.g., the firm might have purchased some fixed assets or it might have redeemed the redeemable debentures or preference shares)
    • Why did the firm resort to long-term borrowings inspite of large profits? (vi) Why did the firm issue new equity or preference shares?

(vii) How was the retirement of long-term debts or redemption of redeemable preference shares accomplished? (e.g. the firm might have issued new shares).

  • As a tool of planning, the Projected Fund Flow Statement enables the management to plan its future investments, operating and financial activities such as the repayment of long-term loans and interest thereon, modernisation or expansion of plant, payment of cash dividend etc.
  • Alongwith a Schedule of Changes in Working Capital, the Funds Flow Statement helps in managing and utilizing the working capital. The management can know

the adequacy or otherwise of the working capital and can plan for the effective use of surplus working capital or can make arrangement in case of inadequacy of working capital. Besides this, the management can identify the magnitude and directions of changes in various components of working capital and if there is any undesired situation such as heavy inventory accumulations, heavy funds locked up in receivables than normally required, the necessary action may be taken so as to achieve the desired level thereof.

14.8  LIMITATIONS OF FUNDS FLOW STATEMENT

The major limitations of Funds Flow Statement are summarised below :

  • It ignores the non-fund transactions. In other words, it does not take into consideration those transactions which do not affect the working capital e.g., issue of shares against the purchase of fixed assets, conversion of debentures into equity shares.
  • It is a secondary data based statement. It merely rearranges the primary data already appearing in other statements viz. Income Statement and Balance Sheet.
  • It is basically historical in nature, unless Projected Funds Flow Statements are prepared to plan for the future.

14.9   SUMMARY

A funds flow statement is an essential tool for the financial analysis and

is of primary importance to the financial management. Now-a-days, it is being widely used by the financial analysts, credit granting institutions and financial managers. The basic purpose of a funds flow statement is to reveal the changes in the working capital on the two balance sheet dates. It also describes the sources from which additional working capital has been financed and the uses to which working capital has been applied.

Such a statement is particularly useful in assessing the growth of the firm, its resulting financial needs and in determining the best way of financing these needs. By making use of projected funds flow statements, the management can come to know the adequacy or inadequacy of working capital even in advance. One can plan the intermediate and long-term financing of the firm, repayment of long-term debts, expansion of the business, allocation of resources, etc.

  • KEYWORDS

Fund: It refers to all financial resources or purchasing power or economic value possessed by a firm at a point of time.

Fund flow statement: It is a technical device designed to analyse the changes in the financial condition of a business enterprise between two dates.

Flow of funds: The flow of fund refers to the changes in the existing financial position of a business caused by inflow of resources owing to receipts and payments.

  • SELF ASSESSMENT QUESTIONS
  1. Explain the terms ‘Funds’ and ‘Flow in Funds’ in respect of Funds Flow Statement.
  2. What is a ‘Funds Flow Statement’? How is it prepared? What are the various sources and uses of funds ?
  3. What do you mean by ‘funds from operation’? How will you determine it ?
  4. Discuss the importance or significance of Funds Flow Statement. How do you determine whether a particular change is in the nature of a source or of an application of funds ?
  5. Is depreciation a source of funds? Justify your answer.
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