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Dr. F. Husain

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 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.

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

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Dr. F. Husain

Deduct the following as no funds inflow is involved :

i. Profit on sale of fixed Asset

ii. Profit on revaluation of Fixed Assets

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.

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

Format for Schedule of changes in Working Capital

Item as on as on Change

--- --- Increase Decrease

Current Assets:

Cash

Bank Balance
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Accounts receivable

Stock in trade

Prepaid expenses

Current Liabilities:

Bank Overdraft

Outstanding Expenses

Accounts payable

Net Increase/ Decrease in working capital

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)

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 ).

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.

Funds Flow Vs. Income Statement

Funds Flow

 Deals with financial resources required for running the business. Explains how funds
were obtained & used.

 Matches funds raised and funds applied during a particular period. The sources and
applications of funds may be capital or revenue in nature.

 Sources of funds are many, besides operations such as share capital, debentures, sale of
fixed assets etc.
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Income Statement

 Discloses the result of business activities i.e how much has been earned and how it has
been spent..

 Matches incomes of a period with the expenditure of that period, both of which are
revenue in nature.

 An income statement which discloses the results of operations cannot even accurately tell
about the funds from operations alone because of non-fund items like depreciation, being
included therein.

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.

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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Dr. F. Husain

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.

i. Loss on sale of fixed assets :Added back to the net profit

ii. Gain on sale of fixed assets : Deducted from net profit.

iii. 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:

iii. Computation of funds from operations as explained earlier.

iv. Adjustment of funds so calculated for changes in current assets ( excluding cash )
& current liabilities.

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 :

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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

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:
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.

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

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Dr. F. Husain

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.

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.

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.

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.

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.