What is Funds flow statement?Objective and importance of funds flow statement

What is Funds flow statement?

What is Funds flow statement?Objective and importance of funds flow statement

Introduction
The balance sheet and income statement are the traditional basis financial statements of a concern. They furnish useful financial information regarding the operation of the concern; however, a serious limitation of these statements is that they fail to provide of time regarding changes in the financial position of a concern during a particular period of time. Funds flow statement, which is known as the statement of charges in financial position, overcomes these limitations of traditional financial statements.

The statement of charges in financial position is a statement of flows of recourses of a concern. The statement of changes in financial position measures the changes that have take place in the financial position of a concern between two balance sheet dates. It summaries that the sources from which funds have been obtained and the uses to which they have been utilized. 
Meaning and concept of funds flow statement
Funds flow statement is the statement of sources and uses of fund. Funds flow statement shows the source from which the funds are receive and the areas to which they obtained funds have been utilized. Funds flow statement indicates various mean by which funds were received during a particular period and the ways in which these funds were applied.

Funds flow statement comprises three words- fund, flow and statement. 'Fund' means the financial resources used by a concern. In the sense of working capital. 'Fund' represents the net working capital. The excess current asset over the current liabilities is called net working capital. Similarly. The term 'flow' means the movement of funds and includes both inflows (receipt) and outflows (payments) of found. Funds from operation, issue of share and debentures, additional long term debt, non operating revenues etc. are considered as the major sources of fund. Increase in working capital, redemption of debenture, repayment of long term loan, payment for non operating expenses etc. are the amine areas of uses of fund. The term 'statement' represents the format or account under which the flows of fund i.e. cash inflows and outflows are recorded. Funds flows statement is known by various names such as statements of sources and uses of founds, summary of financial operations, which got and where goes statement, movement of working capital statement, funds received and disbursement statement etc.

"The funds statement describes the source from which additional funds were derived and the use to which these sources were put."

Thus, funds flows statement is an essential tool for financial analysis. It explains the sources from which additional fund i.e. working has been arrived and the uses to which the funds or working capital has been employed. Found flow statement is prepared on the basis of two balance sheets of subsequence dates and highlights the changes in the financial position of a concern.
Objective and importance of funds flow statement
The main objectives of funds flow statement are as below:
1.    To explain the changes in financial position: the objective of funds flow statement is to disclose the cause of changes in the assets, liabilities and equity capital between two balance sheet dates. It highlights the changes in financial position of a concern and indicates the various means by which funds were obtained during a particular and the ways to where these funds were utilized.
2.    To analyze the operational position: another objective of found flow statement is to analyze the operational position of a concern. Balance sheet gives a static view of the financial position and the profit and loss reported by income statement cannot tell about the actual liquidate position of a firm. Sometimes a firm with high profit may not be able to pay its immediate liabilities due to the shortage of cash. But the objective of funds statement is to explain both the causes of various in different assets, liabilities and capital accounts and their effect on the liquidity position of the concern.
3.    To help in proper allocation of resources. The objective of funds flow statement is to provide information regarding the allocation of limited resources with more efficiently and effectively. It provides the information about the internal and external sources of financing furthermore. It provides data regarding the unbalance fund. On the basis of such information a concern can allocate its funds in and long-term areas more properly.
4.    To evaluate financial position. Internal and external users of financial statements require funds flow statement for the purpose of assessing the strengths and weakness of the concerned firm. Funds flows statement provides information regarding the changes in net information enable various groups of users to assets and evaluate the financial position of the firm.
5.    To act as future guide: funds flow statement acts as a guide for future to management. Funds flow statement provides information about the historical changes in net assets and capital which enable the management to develop a projected funds flow statement. Such projected funds flow statement helps to product need for found and alternative sources of financing.
Procedures of preparing funds flow statement
Funds flow statement is prepared on the basis of balance sheet of two subsequent dates and other information such as net profit or loss reported by income statement, operation and non operating expenses, losses and gains etc. the procedures  of preparing funds flow statement consists of the following three steps:

Net working capital is related with current assets and current liabilities. A fund from operation is determined with the help of net income or loss, non-operating and non-cash items. Similarly, funds flow statement is prepared from the differences of non-current assets, non-current liabilities and non-operating items.
Statement of changes in working capital
 The different between current assets and current liabilities is called net working capital. In other words, working capital is the excess current assets over the current liabilities. Current assets are those assets which can be converted into cash within short time period (generally one year) without any adverse effect in their value. The examples of current assets are cash in hand, bank balance, prepaid expenses, accrued income, bills receivable, marketable securities, debtors, short-term investment, inventories/ stock and other short term assets.
 
Similarly, current liabilities are those outsiders' obligation which must be repaid within short notice and includes creditors, bills payable, advance incomes, bank overdraft, outstanding expenses, short-term loan and other short term liabilities.

On the basis o current assets and current liabilities reported on two balance sheets, the change in net working capital is determined as bellows:
Net working capital = current assets- current liabilities
 
The changes in the amount of any current asset or current liability in the current year's balance sheet as compared to previous year's balance sheet result either increase or decrease in net working capital. The rule for identifying such increase or decrease is as below:
•    Increase in current asset – increase in working capital.
•    Decrease in current asset – decrease in working capital.
•    Increase in current liability - decrease in working capital.
•    Decrease in current liability – increase in working capital.
 
For the purpose of determining the changes in net working capital, a statement of changes of working capital is prepared with help of the current asset and current liabilities reported in two balance sheets. The format of statement of changes in working capital is as below:
Funds from operation
The amount of working capital provided by a business organization from its day to day business operation is called funds from operation. The profit reported by the income statement (profit and loss account) does not indicate the actual working capital generate from the operation of business due to the following reasons:
•    Profit and loss account contains non-cash operating express such as depreciation which do not involve any movement of fund.
•    Profit and loss account contains non-cash operating expenses and losses such as amortization of intangible assets, loss on sales of fixed assets and investment etc, which do not involve any corresponding movement of fund.
•    Profit and loss account contains non-operating incomes and gains such as dividend received. Gain on sale of fixed assets and investment, premium on premium on repayment of long term debt etc.
 
Fund from operation is determined on the basis of net income, non-cash expenses and non-operating items. The operating and non-operating and non-operating items are stated in the following table.

Funds from operation is determined by making necessary adjustments for above non-operating and non cash item with the profit or loss as reprinted by the profit an loss account. Funds from operation can be determined either through a statement or by preparing an adjustment profit and loss account.
a.    Determination of funds from operation by using statement methods
Under statement method, all the non cash expenses, non operation expenses and non operating losses are added to back with net profit for the purposes of determining funds from operating. Similarly, all the non operation revenues, incomes and gains are sub scripted from the net profit. It is important to note that all the items of profit and loss account which are paid in cash and related with the operation of the business are ignored while determining the funds from operation.
b.    Determination of funds from operation by adjusted profit and loss account
Under this method, an adjusted profit and loss account is prepared by debiting all the non cash expenses, non operation expense and non-operating together with net profit. Similarly, all the non operation expenses and non-oeprating expenses with net profit. Similarly, all the non operation revenues, income and gains are credited to an adjusted profit and loss account. Like statement method, all the items of profit and loss account which are paid in cash and related with the operation of the business are ignored while determining the funds from operation under adjustment profit and loss and loss account method too. The format of an adjusted profit and loss account has been presented as below:
c.    Determination of funds from operation under direct method
This method is just reverse to above two methods. Under this direct method. All the expenses which are required for the operation of business and are paid in cash are sub scripted from the operating revenue whereas all the non cash expenses, non operation income and gains are ignored
 Funds flow statement
Funds flow statement is a statement, which depicts different sources from which funds have been obtained during a certain period and the applications to which these funds have been spent. Before preparing funds flow statement, the concept flow of fund and non flow of fund should be cleared.
Flow of fund
The flow of funds occurs only when a transaction changes on the hand a non current (fixed asset or fixed liability) account and on the other hand a current account (current asset or current liability. In other words, the flow of funds occurs when a transaction affect:
 
•    Current assets and fixed assets e.g sale of fixed assets on cash, or credit.
•    Current liabilities and fixed assets e.g. purchase of fixed assets on credit.
•    Current assets and fixed liabilities e.g. purchase of investor by the issue of shares or debenture, or
•    Fixed liabilities and current liabilities e.g. payment to creditor by the issue of debentures etc. 
No flow of fund
The flows of fund doe not occur when a transaction affects fixed assets and fixed liabilities or current assets and current liabilities. Purchase of investor on cash or credit, sales of inventory on cash or credit, payment to creditors, collection from debtors, sales or purchase of marketable securities, exchange of fixed assets, redemption of debenture by the issue of shares, purchase of fixed assets by the issue of shares, conversion of debentures into shares etc.arc the examples of some transactions which do not affect the flow of funds and not recorded in the funds flow statement.
Analysis of non-current assets and liabilities
For the purpose of preparing funds statement, non-current assets and non-current liabilities are taken into consideration. It is because current assets and current liabilities are shown is statement of changes in working capital. The effect of changes in non-current assets in as below:
Format of funds flow statement
The funds flow statement can be prepared either by using horizontal format or by using vertical format.
1.    Horizontal format: horizontal form of funds flow statement is prepared by showing sources of funds in the left hand side and used of funds in the right hand side which is as below:
2.    Vertical format: under this form of fund statement, sources of funds are shown on the upside of the statement and uses of funds (except working capital) are shown just below the source of funds. The difference of sources and uses is called net changes in working capital.
Limitation of funds flow statement
Funds flow statement is a major tool of financial analysis, however, it as the following limitations.
a.    Ignores the non-fund transactions: fund flow statement ignores the non-fund transactions i.e. it does not take into consideration those transactions which do not affect the working capital. For example, funds flow statement does not record the purchase of fixed assets by the issue of share or debentures.
b.    Based on secondary information: funds flow statement is based on secondary data. In other words, funds flow statement is based on income statement and balance sheet.
c.    Historical in nature: funds flow statement is historical in nature because it is prepared on the basis of historical financial statement i.e. balance sheet and income statement.
Adjustments
To identify whether there is an inflow or outflow of funds on account of non-current items, the accounts of all non-current items should be prepared after taking into consideration the following:
i.    Opening balance (given in opening balance sheet)
ii.    Closing balance  (given in closing balance sheet)
iii.    Relevant additional information (if any given)
1.    Adjustments related to tangible fixed assets
Tangible fixed assets accounts are prepared as below:
•    Start entering the opening balance in the debit side.
•    Enter the closing balance in the credit side.
•    If the amount of debit side is less than the amount of credit side, the balancing figure represents the purchase of assets.
•    If the amount of credit side is less than the amount of debit side, the balancing figure represents the either sales of assets or depreciation of fixed assets.
•    The format of tangible fixed assets account is as below:
a.    Purchase and sales of fixed assets on cash: fixed assets account on which no depreciation has been charged is prepared as  below:
i.    Opening balance of fixed assets is debited and closing balance is credited.
ii.    The balance figure of credit side represents the sales of fixed during the year and is treated as sources of funds. In the absence of any information, the decrease in the cost price of assets is assumed as the sales of assets.
iii.    The debit balance represents the purchase of fixed assets during the year and is treated as uses of fund. In the absence of any information, the increase in the cost price of assets is assumed as purchase made during the year.
iv.    The loss on sale is transferred to adjusted profit and loss account and is appears in the credit side of assets account. If there is gain on the sale of asset, it will appear in the debit side of account. In the absence of any information, it is assumed that there is no profit or loss and no accumulated depreciation on the part of asset which has been sold.
b.    Depreciation of fixed assets: depreciation is the gradual in the value of fixed assets due to their continuous and permanent use. Depreciation is treated as an expense and debited in the value of fixed assets due to wear, age, or obsolesces as well as a source of fund. The effect of depreciation is show in the balance sheet in the following ways.
i.    Net cost method: under net cost method, assets are recorded at book value or net cost i.e. depreciation is deducted from the cost of assets in the assets side of balance sheet. Under this method a separate depreciation account is not shown in the balance sheet. The depreciation charged during the year is debited in the profit and loss account. While preparing funds flow attempt, the depreciation charged on fixed assets is credited to related assets account and debited in the adjusted profit & loss assets is credited to fixed asset account is as below:
ii.    Gross cost method: Under gross cost method, assets are recorded at original cost and accumulated depreciation is not deducted from the cost of asset. Under this method, a separate depreciation is not deducted from the cost of assets. Under this method, the assets side in the form of deduction.
iii.    Accumulated depreciation is given in additional information: if the opening balance and closing balance of accumulated depreciation account is given in additional information is stead of  balance sheet, it is treated as below:
•    Assets account is prepared by adding opening balance and closing balance of accumulated depreciation with opening balance and closing balance of assets. This is similar to gross cost method.
•    Accumulated depreciation is prepared under which accumulated depreciation of sold part is debited and depreciation for the year is credited. 

c.    Purchases of assets by the issue of shares or debentures: sometimes companies issue shares of debenture to purchase current and non-current assets. There is no flow of fund it non-current assets are purchase by the issue of non-current liabilities such as shares and debentures. However, there is flow of funds if current assets are purchase through fixed liabilities such as by the issue of share or debenture. The nature of assets and liabilities and their impact on the flow of fund has been presented in the following exhibit.
2.    Adjustment relate to intangible assets
Goodwill patent, copyright and trademarks are the example of intangible assets. In the absence of any information, the increase in intangible assets is treated as the purchase and decrease in these assets is considered as written off. The increased value of increased value of intangible assets is recorded as use of fund and written off value is debited into adjusted profit & loss account.
•    Start entering the opening balance in the debit side.
•    Enter the closing balance in the credit side.
•    If the amount of debit side is less than the amount of credit side, the balancing figure represents the purchase, in the absence of any information.
•    If the amount of credit side is less than the amount of debit side, the balancing figure or credit side reprents written off or amortization of intangible assets which is trading to profit and loss account.
3.    Adjustment related to miscellaneous expenditures
Discount on issue of shares and debentures, underwriting commission, preliminary expenses advertisement development account etc. are the example of miscellaneous expenditures and losses. Such accounts nacre prepared as below:
•    Start entering the opening balance in the debit side.
•    Enter the closing balance in the credit side.
•    Generally, there is no debit balance of fictitious assets account. If the amount of credit side is less than the amount of debit side, the balancing figures of credit side represents written off or amortization of fictitious assets which is transfer to profit and loss account.
a.    Decrease in miscellaneous expenses: any decrease in miscellanea expenses account is considered as written off. Like entailed assets the written off value of miscellaneous expenses account is debited into profit and loss account.
b.    Increase in value of miscellaneous expenses: generally, the values of miscellaneous expenses do not increase, however, in special case, the value may increase and the increased values to which miscellaneous expenses are increased. In the absence of any information, the increase value is considered as payment and recorded in the uses side of funds flow statement.
4.    Adjustments related to non-current liabilities accounts
Non-current liabilities accounts are prepared as below:
•    Enter the opening balance in the credit side.
•    Enter the opening balance in the debit side.
•    In case of share capital, share premium, debenture and other long-term debt, the balancing figure of credit side represented sources of funds i.e. issue of share/debentures, additional loan received, etc. the balancing debit side represented the redemption of debentures or payment of loan etc. in case of provision, the different is generally transferred to profit and loss account in the absence of information.
a.    Adjustments related to ordinary and preference shares: shares capital is a non-current liability. The increase in the both types of shares capital account is an indication of additional issue of shares capital and is regarded as a source of funds. Shares are  issued on the following conditions:
i.    Issue of shares at par: if shares are issued at par, the net increase in the shares capital account is treated as the source of fund.
ii.    Issue of shares at premium: if shares are issued at premium, the actual amount received would be more than the net increase in share capital account. In the case of premium the source of founds includes increase in par value of shares plus increase in shares premium account.
iii.    Issue of shares at discount: in case of discount, the source of funds includes increase in par value of shares minus increase in discount on issue of shares account.
5.    Adjustment related to provision for taxation
Provision for taxation is treated as below:
a.    Current liabilities: in the absence of any information, provision for taxation is treated as current liabilities and included in the statement of changes in working capital.
b.    Non-current liabilities: provision for taxation may be treated as non-current liabilities. In such condition. The actual amount paid is recorded as the use of fund balance is treated as provision made during the year which is debited into adjusted profit & loss account.
6.    Adjustment related to dividend
a.    Provision for dividend: like provision for taxation, provision for dividend is treated has current liabilities and included in the statement of changes in working capital.
i.    Non-current liabilities: generally, provision for dividend is treated as non-current liabilities. In such condition, the actual amount paid is recorded as the use of fund and the balance is treated as provision made during the year. The procedure of adjusting dividend has been presented in the following exhibit.
j.    Current liability: in the absence of any information, provision for dividend is treated as current liabilities and included in the statement of changes in working capital.
b.    Interim dividend: interim dividend paid by the company is debited into adjusted profit & loss account and show in the uses side of funds flow statement.
c.    Cash dividend: cash dividend is paid from in distributed profit. Retained earnings account or reserve & surplus account represent the balance of undistributed profit. In the absence of any information, cash dividend paid is ascertained by preparing retaining earning/ reserve & surplus account in the following manner:
d.    Stock dividend: sometimes companies distribute additional shares to shareholders as dividend. Such dividend is called stock dividend or bonus shares. The balance of undistributed profit decrease and shares capital increase due the stock dividend. However, cash balance is unaffected by the stock dividend. Therefore, stock dividend is not treated as use of fund and not shown in the funds statement. The effect of stock dividend on different accounts is as below:
 
i.    First method: under this method, retained earning account is prepared to determine the amount of net profit or dividend which is not given. Thereafter, adjusted profit & loss account is prepared to determine the funds from operation.
ii.    Second method: under this method, stock dividend is shown in the debit side of adjusted profit and loss account prepared on the basis of retained earning account as below.