Funds Flow Statement

Meaning of Funds Flow Statement

Funds : According to Accounting Standard No.7, the term ‘Fund’
generally refers to cash and cash equivalents, or to working
capital.
Working Capital: There are two concepts of working capital :
gross concept and net concept. Gross working capital refers
to the firms investment in current assets, while net working
capital means excess of current assets over current
liabilities. ‘Funds’ is generally used to mean net working
capital.
Current Assets: Assets which are reasonably expected to be
realized in cash or sold or consumed during the normal
operating cycle of the business ex. Cash, accounts
receivable, inventory, advances recoverable, prepaid
expenses etc.
Current Liabilities: All obligations that will require within the
coming year or operating cycle, whichever is longer, i) the
use of existing current assets or ii) the creation of other
current liabilities ex. accounts payable, outstanding
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 Meaning of Funds Flow Statement ( Contd)
expenses, bank overdrafts, short term loans, advance payments
received, current maturities of long-term loans etc.
Non Current Assets: All Assets other than current assets ex.
goodwill, land, building, machinery, furniture, debit balance in
P & L account etc.
Non Current Liabilities: All liabilities other than current
liabilities ex. share capital, long term loans, debentures, share
premium, credit balance in P & L account.
Flow of Funds: Any increase or decrease in working capital
means flow of funds. Flow of funds will not occur for
transactions involving only Non Current assets or liabilities or
only Current assets or liabilities. ‘Cross’ transactions
involving a fixed asset or liability and a current asset or
liability will result in a flow of funds.

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 Preparation of the Funds Flow Statement
Sources of Funds
Internal Sources: Following adjustments need to be made to the
figure of Net Profit to calculate the funds from operations: Add
the following items that do not involve funds outflow:
i. Depreciation
ii. Preliminary expenses or goodwill etc. written off.
iii. Contribution to debenture redemption fund, transfer to general
reserve etc.
iv. Provision for taxation and proposed dividend
v. Loss on sale of Fixed Asset
Deduct the following as no funds inflow is involved :
i. Profit on sale of fixed Asset
ii. Profit on revaluation of Fixed Assets

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 Preparation of the Funds Flow Statement
(Contd)
External Sources:
i. Funds from long term loans : e.g debentures, borrowings
from financial institutions etc.
ii. Sale of fixed assets : Sale of land, building, long-term
investments will result in generation of funds.
iii. Funds from increase in share capital : Issue of shares for
cash or any other current asset results in increase in working
capital and hence there will be flow of funds.
Application of funds:
i. Purchase of Fixed Assets: Results in decrease of current
assets without decrease in current liabilities. In case shares
or debentures are issued for acquisition of fixed assets, there
will be no flow of funds.
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 Preparation of the Funds Flow Statement
(Contd)
ii. Payment of dividend
iii. Payment of fixed liabilities e.g redemption of debentures or
redeemable preference shares.
iv. Payment of tax liability
Schedule for changes in Working Capital: Funds flow statement
depicts changes in working capital, hence it is advisable to
prepare a schedule for changes in working capital, which can
be done by comparing current assets and current liabilities for
two periods.
Rules:
i. Increase in current assets results in increase in working
capital and vice versa
ii. Increase in current liabilities results in decrease in current
liabilities and vice versa 6
 Preparation of the Funds Flow Statement
(Contd)
Format for Schedule of changes in Working Capital
Item as on as on Change
--- --- Increase Decrease
Current Assets:
Cash
Bank Balance
Accounts receivable
Stock in trade
Prepaid expenses
Current Liabilities:
Bank Overdraft
Outstanding Expenses
Accounts payable
Net Increase/ Decrease in working capital
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 Preparation of the Funds Flow Statement
(Contd)
Funds Flow Statement: While preparing this statement, current
assets and liabilities are to be ignored. Attention is to be given
to changes in fixed assets and fixed liabilities:
A. Sources of funds:
Issue of shares
Issue of debentures
Long term borrowings
Sale of fixed Assets
Operating Profit
B. Application of funds:
Redemption of redeemable preference shares
Redemption of debentures
Payment of other long term loans
Purchase of fixed Assets
Operating loss
Payment of dividends, tax etc.
Net Increase/ decrease in Working Capital ( A-B) 8
 Preparation of the Funds Flow Statement
(Contd)
The change in working capital disclosed by ‘the schedule of
changes in working capital’ will tally with the change in
working capital disclosed by ‘funds flow statement’.

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 Treatment of Provision for Taxation
Provision for Taxation : There are two options available:
i. Treated as a current liability: When provision for taxation is
made, it involves P & L appropriation account, which is a
fixed liability and Provision for taxation account, which is a
current liability, resulting in a decrease in working capital. On
payment of tax, there will be no change in working capital as
it involves one current liability ( Provision for Tax) and one
current asset ( Bank or cash ).
ii. It may be taken only as an appropriation of profits: There will
be no change in working capital when the provision is made
as two fixed liabilities are involved i.e P & L appropriation
account and Provision for taxation account. However, when
taxes are paid, there is an application of funds as it involves
one fixed liability ( Provision for Tax ) and one current asset (
Bank or Cash ). 10
 Treatment of Proposed Dividends
Proposed Dividends: Can be dealt with in the similar two ways :
i. May be treated as current liability : It will appear as one of
the items decreasing working capital in the schedule for
changes in working capital. It will not be shown as
application of funds when dividend is paid later on.
ii. May be treated as an appropriation of profits : In this case,
proposed dividend for the current year will be added back to
current year’s profits in order to find out funds from
operations, if such amount of dividend has already been
charged to profits. Payment of dividends will be shown as
an ‘application of funds’.
In case no specific directions are given with regard to the
treatment of these two items, it is advised that assumptions
are clearly stated.
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 Funds Flow Vs. Income Statement
 Deals with financial  Discloses the result of
resources required for business activities i.e how
running the business. much has been earned and
Explains how funds were how it has been spent..
obtained & used.
 Matches funds raised and  Matches incomes of a period
funds applied during a with the expenditure of that
particular period. The period, both of which are
sources and applications of revenue in nature.
funds may be capital or
revenue in nature.  An income statement which
 Sources of funds are many, discloses the results of
besides operations such as operations cannot even
share capital, debentures, accurately tell about the funds
sale of fixed assets etc. from operations alone because
of non-fund items like
depreciation, being included
therein.
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 Uses Of Funds Flow Statement
i. Explains the Financial consequences of business operations:
Helps the financial analyst in advising his employer / client
regarding directing of funds to those channels which will be
most profitable for the business.
ii. Acts as an instrument for allocation of resources: The funds
should be managed in such a way that the business is in a
position to make payment of interest and loan installments
as per the agreed schedule.
iii. It is a test as to the effective or otherwise use of capital: The
adequacy or inadequacy of working capital will tell the
financial analyst about the possible steps that the
management should take for effective use of surplus
working capital or make arrangements in case of
inadequacy of working capital.
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Cash Flow Statement
 Meaning of Cash Flow Statement
 A Cash Flow Statement is a statement depicting change in
cash position from one period to another. The term ‘Cash’
here stands for cash and bank balances.
 The cash flow statement explains the reason for inflow or
outflow of cash, as the case may be and also helps
management in making plans for the immediate future.
 A proper planning of cash resources will enable the
management to have cash available whenever needed and
put it to some productive use in case there is surplus
available.

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 Preparation of Cash Flow Statement
Prepared on the same pattern as the Funds Flow Statement.
The change in cash position is computed by taking into
account the ‘sources’ and ‘applications’ of cash.
Sources Of Cash
Internal Sources
Cash from Operations is the main internal source. The Net
profit from the P & L account will be adjusted for the
following non-cash items to arrive at the cash from
operations:
i. Depreciation : Does not result in cash outflow, hence
added back to net profit.
ii. Amortization of intangible assets: Goodwill, preliminary
expenses etc. when written off, have to be added back to
the net profit.
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Preparation of Cash Flow Statement ( Contd)
iii.Loss on sale of fixed assets :Added back to the net profit
iv. Gain on sale of fixed assets : Deducted from net profit.
v. Creation of reserves: If profit for the year has been arrived
at after charging transfers to reserves, the same should be
added back to the net profit.
Computation of cash from operations can be studied using two
different situations:
i. When all transactions are cash transactions: In this case
Cash from operations = Net Profit
ii. When all transactions are not cash transactions: In this
case, cash from operations is calculated in two stages:
a) Computation of funds from operations as explained earlier.
b) Adjustment of funds so calculated for changes in current
assets ( excluding cash ) & current liabilities.
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Preparation of Cash Flow Statement ( Contd )
Adjustments for changes in Current Assets & Current Liabilities
i. Effect of credit sales : Cash from operations can be
calculated as per the following equation if there are debtors
outstanding at the end as in the beginning of the accounting
year :
Cash from Operations = Net Profit + Decrease in Debtors
or - Increase in Debtors
ii. Effect of credit purchases :
Cash from operations = Net Profit + Increase in Creditors
or - Decrease in Creditors.
iii. Effect of opening and closing stocks: The amount of
opening stock is charged to the debit side of the P& L
account. It thus reduces net profit without reducing cash
from operations. Similarly, closing stock which appears
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Preparation of Cash Flow Statement ( Contd )
On the credit side of the P& L Account increases net profit
without increasing cash from operations. The following
adjustment is made :
Cash from Operations = Net Profit + Decrease in Stock
or - Increase in Stock
iv. Effect of Outstanding expenses, income received in
advance etc. : Net profit is calculated after charging all
expenses, whether paid or outstanding and income received
in advance is not considered. Hence an increase in
outstanding expenses and income received in advance will
increase the cash from operations and vice versa. The
following adjustment is made:

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Preparation of Cash Flow Statement ( Contd )
Cash from operations =
Net Profit + increase in Outstanding Expenses
+ Increase in income received in advance
- Decrease in Outstanding Expenses
- Decrease in income received in advance
v. Effect of Prepaid Expenses and outstanding Income : The
effect on cash from operations is exactly opposite to the
effect of outstanding expenses and income received in
advance . The following adjustment is made :
Cash from Operations =
Net Profit + Decrease in Prepaid expenses / Accrued Income
- Increase in Prepaid expenses/ Accrued Income.

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Preparation of Cash Flow Statement ( Contd )
The above adjustments may be summarized as :
 Increase in Current Asset / Decrease in Current Liability
results in Decrease in Cash
 Decrease in Current Asset/ Increase in Current Liability
results in Increase in Cash.
External Sources of Cash :
i. Issue of New Shares
ii. Raising of long term loans
iii. Purchase of Plant & Machinery on deferred payment : This
should be shown as a separate source of cash to the extent of
the deferred credit. However, the cost of machinery purchased
will be shown as an application of cash.
iv. Short term borrowings – cash credit from banks
v. Sale of fixed Assets , Investments etc.
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Preparation of Cash Flow Statement ( Contd )
Applications of Cash:
i. Purchase of Fixed Assets
ii. Payment of Long-term loans
iii. Decrease in deferred payment liabilities
iv. Loss on account of operations
v. Payment of tax
vi. Payment of Dividend
vii. Decrease in Unsecured loans , deposits etc.

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Preparation of Cash Flow Statement ( Contd )
Format for the Cash Flow Statement:
Cash Flow Statement for the yr ending..
Bal. as on Jan 1..
Cash Balance
Bank Balance
Add: Sources of Cash
Add/ Less: Adjustments for Non- Cash Items
Add: Increase in Current Liabilities
Decrease in Current Assets
Less: Increase in Current Assets
Decrease in Current Liabilities
Total Cash Available (1)
Less: Applications of Cash (2)
Closing Balance ( 1-2)
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 Cash Flow Vs. Funds Flow Analysis
 Cash flow analysis is concerned with the change in cash
position, while funds flow analysis is concerned with
change in working capital between two balance sheet dates.
 Cash flow statement is merely a record of cash receipts and
disbursements. While studying short term solvency of a
business, one is interested not only in cash balance but also
assets which can be easily converted to cash.
 Cash flow analysis is more useful as a tool for financial
analysis in short periods as compared to funds flow
analysis.
 Cash is part of working capital , hence inflow of cash
results in inflow of funds but reverse is not true.

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 Utility of Cash Flow Analysis
 Helps in efficient Cash Management : The management can
know how much cash is needed, from which source it will
be obtained, how much can be generated internally and how
much could be obtained from outside.
 Helps in Internal Financial Management: Provides
information about funds which will be available from
operations. This helps the management in determining
policies regarding internal financial management e.g
dividend policy, possibility of repayment of long term debts.
 Discloses the movements of cash
 Discloses the success / failure of cash planning : This is
determined by comparing projected with actual cash flow
statement.

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 Limitations of Cash Flow Analysis
 Cash flow statement cannot be equated with the income
statement. Income statement takes into account both cash
and non- cash items and hence, net cash does not necessarily
mean the net income of the business.
 The cash balance as per the cash flow statement may not
represent the real liquid position of the business since it can
be easily influenced by postponing purchases and other
payments.
 Cash flow statement can not replace income statement or
funds flow statement. Each of them has a separate function
to perform.

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