‘Flow’ means change. ‘Funds’ is interpreted as’ working capital’ in the context of funds flow statement. Thus, ‘Funds flow’ is ‘change in working capital’. Flow of funds implies any changes in working capital. These changes are a continuous process, day after day, as and when transactions take place. So, the changes in working capital may be called ‘Flow’. It can be ‘Inflow’ or ‘Outflow’ of working capital.
Funds Flow Statement measures and presents in an analytical manner the summarised version of the numerous flows of funds for a specified period.
Working Capital of Funds:
Funds flow statement is based on the working capital concept of funds. However working capital is also a controversial term. ‘Gross working capital’ is the total of current assets. ‘Circulating Capital’ is the amount revolving in the cycle of ‘Cash – Inventories – Receivables and Cash’. ‘Net working Capital’ is the excess of Current Assets over Current liabilities. Funds Flow statement is generally prepared and interpreted on the basis of ‘Net Working Capital’.
Net working capital can be computed as the difference between Current Assets and Current liabilities.
All those assets which are converted into cash in the normal course of business within one year or within the operating cycle are known as ‘Current Assets’.
The intention in acquiring such assets must be to convert them into cash. The conversion has to take place in the normal course of business. The time span for the conversion should not exceed one year or the operating cycle of die business.
The following are the different categories of current assets:
(a) Cash and Near Cash Items – Cash in hand, cash at bank, Govt., bonds, fixed deposits in banks, trade investments, etc.
(b) Accounts Receivable – Trade debtors, non-trade debtors, bills receivable, etc.
(c) Inventories – Stocks of raw materials, Work-in-Progress or semi-finished goods and the finished goods.
(d) Advances Recoverable in Cash – Advances and loans to employees, advances to suppliers, etc.
(e) Prepaid Expenses – Prepaid expenses, etc., like prepaid Insurance.
All those liabilities which are payable in cash in the normal course of business within a period of one year or within the operating cycle are called current liabilities. Here also, the intention of contracting the liability must be to pay it off in the normal course. The period of repayment should not exceed one year or the operating cycle. Thus, the long term loans or debentures, etc., in the year of repayment also should not be treated as current liabilities because they were not intended to be paid off within one year out of current assets.
The following are the different current liabilities:
(a) Accounts Payable – Bills payable, notes payable, trade creditors and non-trade creditors.
(b) Borrowings on Short Term Basis – Temporary bank overdraft, short-term bank loans, private borrowings repayable within one year.
(c) Outstanding Expenses – Expenses for which payment has become due.
(d) Incomes Received in Advance – Money received in advance for service to be rendered or goods to be supplied in future.
(e) Tax Payable and Dividend Payable – When tax is assessed, it becomes a liability. Similarly divided declared is a liability.
Provisions against Current Liabilities and Assets:
‘Provision for doubtful debts’, ‘Provision for discount on creditors’, ‘Provision made against trade investments’ are also current items. They reduce the respective current assets or liabilities.
All assets other than the current assets can be termed as non-current assets.
They include the following:
(a) Fixed assets like land, buildings, machinery, furniture, loose tools, etc.
(b) Intangible assets like goodwill, patents, copyrights, etc.
(c) Long-term investments in shares of other companies, Govt. Bonds, etc.
All those liabilities which are not included under ‘current liabilities’ may be termed as ‘non- current liabilities’. Share capital, Debentures, Public deposits, Reserves, etc., are included in this category.
Transaction Analysis (or) Identification of Transactions which Cause Flow of Funds:
As a prelude to preparation of funds flow statement, it is essential to analyse the numerous business transactions to identify those transactions which result in flow of funds or which cause changes in working capital.
Working capital, in the context of funds flow statement, is understood as the difference between current assets and current liabilities. So, business transactions which cause change in the working capital are deemed to result in flow of funds.
All the business transactions may be classified into-
(1) Those transactions which do not cause any change in funds and
(2) Those transactions which cause change in funds or cause flow of funds or affect funds.
The transactions which affect funds may be again classified into- (a) Those transactions which increase funds and are termed ‘Sources of funds’, (b) Those transactions which decrease funds and are termed as ‘Applications of funds’.
Identification of transactions which increase or decrease funds is essential for “Funds Flow Analysis”. For this purpose, the following broad classification of assets and liabilities and guidelines for identification of transactions are useful.
(1) Current Accounts – Both current assets and current liabilities.
(2) Non-current accounts – Both long term liabilities and fixed assets.
Guidelines for Transaction Analysis:
(a) Any Transaction between a Current Account and Another Current Account does not Affect Funds:
1. A transaction involving two current assets does not affect funds.
2. A transaction involving two current liabilities does not affect funds.
3. A transaction involving a current asset and a current liability does not affect funds.
(b) Any Transaction between a Noncurrent Account and Another Noncurrent Account does not Affect Funds:
1. A transaction involving two noncurrent or fixed assets does not affect funds.
2 A transaction involving two long term liabilities does not affect funds.
3. A transaction involving a noncurrent asset and a long term liability also does not affect funds.
(c) Any Transaction between a Current Account and a Noncurrent Account Affects Funds:
1. A transaction involving a long term liability and a current asset affects funds;
2. A transaction involving a long term liability and a current liability affects funds;
3. A transaction involving a noncurrent asset and a current asset affects funds;
4. A transaction involving a noncurrent asset and a current liability affects funds.
(a) 1. When debtors are collected, debtors decrease but cash increases by the same amount. Total current assets remain unaffected. Working capital does not change.
2. When bills payable are issued to creditors, bills payable increase but creditors decrease by the same amount. Total current liabilities remain the same. Working capital does not change.
3. When cash is paid to creditors, creditors decrease, but cash also decreases. Thus the decrease in the current liabilities is equal to the decrease in current Assets. Working capital is not at all affected.
(b) 1. When Land is given to a building Promoter in return for some flats, Land which is a fixed asset decreases but ‘Flats’ another fixed asset increases. No current asset or current liability is involved in the transaction and working capital is not at all affected.
2. When Debentures are converted into shares, Debentures which is a long term liability decreases but share capital which is also a long term liability increases. No current asset or current liability is involved and thus working capital (or) Funds is not at all affected.
3. When Machinery is acquired by issue of shares, Machinery which is a fixed asset increases. Share capital which is a long term liability also increases. However, no current assets or current liabilities are affected and working capital does not change.
(c) 1. When shares are issued for cash both share capital and cash increase. The increase in cash increases total current assets and the working capital increases to that extent. Thus, this transaction is an example for source of funds.
2. Creditors may be settled by issue of debentures to them. Here ‘debentures’ which is a long term liability increases and ‘creditors’ which is a current liability decreases. The decrease in creditors decreases the total current liabilities and the working capital increases to that extent. This transaction is an example for source of funds without involving cash.
3. When building is sold for cash, ‘buildings’, a fixed asset decrease and ‘cash’ a current asset, increases. Total current assets go up and the working capital also increases. This transaction is also an example for ‘sources of funds’.
4. When furniture is purchased by accepting a two months bill, fixed assets increase and also the current liabilities go up. The increase in current liabilities, decreases the working capital. This transaction is an example for application of funds without involving cash.
The above discussion leads to the following conclusions:
Transactions between two current items or two long term items do not-effect funds or working capital.
‘Cross transactions’ or Transactions between current and long term assets or liabilities affect the working capital and funds.
Importance or Uses or Benefits of Funds Flow Statement:
Funds flow statement is an important tool in the armoury of the finance manager. It helps in the planning, deployment and controlling of funds year after year.
The following are the benefits or uses of funds flow statement:
1. It provides a detailed analysis and understanding of changes in the distribution of financial resources between two balance sheet dates.
2. It shows how the funds were obtained and used during a period.
3. The sources from which funds were obtained are useful in computation of cost of capital of the business.
4. A detailed analysis of sources of funds in the past acts as a guide for obtaining funds for future requirements.
5. A study of the applications of funds provides an understanding about the utilisation of resources in the past. It can form the basis for selection of investment proposals or future capital expenditure decisions.
6. It gives indication of any weakness or strength in the general financial position of a firm.
7. It throws light on the financial consequences of business operations.
8. It can be compared with the relevant budgets to assess the usage of funds as per plans.
9. Rearrangement of capital structure, formulating long term financial plans and policies, etc., are facilitated by funds flow analysis.
10. Working capital and the causes for changes in working capital are highlighted. This can help in the formulation of sound policy for liquidity and short term solvency of the firm.
Limitations of Funds Flow Statement:
1. It is historical in nature. It shows what happened in the past. So, necessarily, its value is limited from the point of view of future operations.
2. It is nothing but ‘secondary data’. The information in financial accounts is rearranged and presented. So, its accuracy and reliability depend on the accounting department.
3. It is a summarised presentation of figures and cannot provide information about changes on a continuous basis.
4. The effect of transactions between current assets and liabilities is not shown in the statement.
5. It also ignores transactions between long term assets and liabilities.
6. It is not generally considered as a sophisticated technique of financial analysis.
In spite of these limitations, funds flow statement provides a ‘Birds eye view’ of the financial history of a firm between two balance sheet dates.