Sunday, September 29, 2013

Funds Flow and Cash Flow Statements

Meaning of funds flow statement:
The financial statement of the business indicates assets, liabilities and capital on a particular date and also the profit or loss during a period. But it is possible that there is enough profit in the business and the financial position is also good and still there may be deficiency of cash or of working capital in business. Financial statements are not helpful in analysing such situation. Therefore, a statement of the sources and applications of funds is prepared which indicates the utilisation of working capital during an accounting period. This statement is called Funds Flow statement.
In popular sense the term ‘fund’ is used to denote excess of current assets over current liabilities.
According to R.N. Anthony, “Fund Flow is a statement prepared to indicate the increase in cash resources and the utilization of such resources of a business during the accounting period.”
According to Smith Brown, “Fund Flow is prepared in summary form to indicate changes occurring in items of financial condition between two different balance sheet dates.”
From the above discussion, it is clear that the fund flow statement is statement summarising the significant financial change which have occurred between the beginning and the end of a company’s accounting period.

Meaning of Flow of Funds (Most important question for Nov’ 2013 Exam)
The term ‘flow’ means movement and includes both ‘inflow’ and ‘outflow’. The term ‘flow of funds’ means transfer of economic values from one asset of 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 out-flow of funds Rule. 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. Similarly, 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: (Refer Explanation in Management accounting of JAIN AND NARANG Page no. 16)
Ø  a current asset and a Non-current asset,
Ø  a current asset and a Non-current liability, or
Ø  a Non-current and a current liability, or
Ø  a fixed liability and current liability; and
Funds do not move when the transaction affects:
Ø  a current asset and a current liabilities, or
Ø  a Non-current asset and a Non-current liability, or
Ø  only noncurrent liabilities
Importance of Funds Flow Statement
The Balance sheet and Profit and loss account failed to provide the information which is provided by Funds flow statement i.e., Changes in financial position of an enterprise. It indicates the changes which have taken place between two accounting dates. It generally serves the following purposes:-
(1) Analysis of Financial Position: Funds flow statement is useful for long term financial analysis. Such analysis is of great help to management, shareholders, creditors, brokers etc. It helps in answering the following questions:
(i) Where have the profits gone?
(ii)  How was it possible to distribute dividends in absence of or in excess of current income for the period?
(iii) How was the sale proceeds of plant and machinery used?
(iv) How was the sale proceeds of plant and machinery used?
(v) How were the debts retired?
(vi) What became to the proceeds of share issue or debenture issue?
(vii) How was the increase in working capital financed?
(viii) Where did the profits go?
Though it is not easy to find the definite answers to such questions because funds derived from a particular source are rarely used for a particular purpose. However, certain useful assumptions can often be made and reasonable conclusions are usually not difficult to arrive at.

(2) Evaluation of the Firm's Financing: One of the important use of this statement is that it evaluates the firm' financing capacity. The analysis of sources of funds reveals how the firm's financed its development projects in the past i.e., from internal sources or from external sources. It also reveals the rate of growth of the firm.

(3) Test of Adequacy: The funds flow statement analysis helps the management to test whether the working capital has been effectively used on not and whether the working capital level is adequate or inadequate for the requirement of business.

(4) An Instrument for Allocation of Resources: In modern large scale business, available funds are always short for expansion programmes and there is always a problem of allocation of resources. Funds flow statement helps management to take policy decisions and to decide about the financing policies and capital expenditure programmes for future.

(5) Guide for investors: The funds flow statement analysis helps the investors to decide whether the company has managed funds properly or not. It indicates the financial soundness of a company which helps the investor to decide whether to invest money in the company or not.

(6) A tool for Measuring credit worthiness: Funds flow statement indicates the credit worthiness of a company which helps the lenders to decide whether to lend money to the company or not.

(7) Future Guide: A projected funds flow statement can be prepared and resources can be properly allocated after an analysis of the present state of affairs. The optimal utilisation of available funds is necessary for the overall growth of the enterprise. A projected funds flow statement gives a clear cut direction to the management in this regard.

Limitation of Funds Flow Statement:
1)      Historical : It relates to past only and thus it tells that the changes in funds have taken place in the past. It will be of limited use for making predictions for the future.
2)      Static: It is static in nature. This statement fails to reveal the continuous changes.
3)      Incomplete statement : This statement does not show the changes in working capital. It only presents the changes in working capital.
4)      Non original statement:  It is not an original statement but simply re-arrangement of financial data.
5)      Not a substitute: It is not a substitute of income statement or a balance sheet. It is only a supplement to them.

Cash Flow Statement:
A Cash Flow Statement is similar to the Funds Flow Statement, but while preparing funds flow statement all the current assets and current liabilities are taken into consideration. But in a cash flow statement only sources and applications of cash are taken into consideration, even liquid asset like Debtors and Bills Receivables are ignored.
A Cash Flow Statement is a statement, which summarises the resources of cash available to finance the activities of a business enterprise and the uses for which such resources have been used during a particular period of time. Any transaction, which increases the amount of cash, is a source of cash and any transaction, which decreases the amount of cash, is an application of cash.
Simply, Cash Flow is a statement which analyses the reasons for changes in balance of cash in hand and at bank between two accounting period. It shows the inflows and outflows of cash.

Objectives of Cash Flow Statement
The Cash Flow Statement is prepared because of number of merits, which are offered by it. Such merits are also termed as its objectives. The important objectives are as follows:
Ø  To Help the Management in Making Future Financial Policies: Cash Flow statement is very helpful to the management. The management can make its future financial policies and is in a position to know about surplus or deficit of cash.
Ø  Helpful in Declaring Dividends etc.: Cash Flow Statement is very helpful in declaring dividends etc. This statement can supply necessary information to understand the liquidity.
Ø  Cash Flow Statement is Different than Cash Budget: Cash budget is prepared with the help of inflow and outflow of cash. If there is any variation, the same can be corrected.
Ø  Helpful in devising the cash requirement:  Cash flow statement is helpful in devising the cash requirement for repayment of liabilities and replacement of fixed assets.
Ø  Helpful in finding reasons for the difference:  Cash Flow Statement is also helpful in finding reasons for the difference between profits/losses earned during the period and the availability of cash whether cash is in surplus or deficit.
Ø  Helpful in predicting sickness of the business:  Cash flow is helpful in predicting sickness of the business. A sound cash position is a true indicator of sound financial position.

Importance of Cash Flow statement:
(i) Short-term financial Planning: Cash flow statement provides useful information which helps the management in taking short-term investment decisions.

(ii) Helpful in preparing Cash Budget: A Cash Budget is an estimate of cash receipts and disbursement for a future period of time. Cash Flow Statement provides help to the management to prepare Cash Budget. A comparison of cash budget and cash flow statement reveals the extent to which the sources of the business were generated and used as per the plans of the business.

(iii) Measurement of Liquidity:  Liquidity means ability of a business enterprise to pay off its liabilities when due. Cash Flow Statement helps to know about the sources where from the cash will be available to pay off the liabilities.

(iv) Dividend Decisions: The Capacity of the firm to pay dividends to shareholders depends on the generation of cash flows. Cash flow statement helps the management to know about the sources of cash to pay off dividend.

(v) Prediction of sickness:  With the help of preparing cash from operation a business enterprise may come to know about cash losses in operation. It helps to predict this type of sickness.

(vi) Future Guide: Most of the users are interested to assess the ability of the firm in generating future cash flows, its timing and certainty. These questions can be answered by analysing the cash flow statement.

(vii) The use of cash in investing and financing Transaction: Information in cash flow statement would be useful to find out as to how cash has been obtained from investing and financing activities and how cash has been used to invest and repay borrowings etc. The statement would be useful to users to ascertain the following:
a)      The change in the net assets of the business.
b)      The change in the financial structure.
c)       The financing of expansion.
d)      The utilisation of finance obtained by the enterprise.
e)      The impact of investing and financing activities on the cash balance of the enterprise.

Limitations of Cash Flow Statement:
Though the Cash Flow Statement is a very useful tool of financial analysis, it has its limitations which must be kept in mind at the time of its use. These limitations are:
(i)      Non-cash Transactions are ignored: The Cash Flow Statement shows only inflows and outflows of cash. It does not show non-cash transactions like the purchase of buildings by the issue of shares or debentures to the vendors or issue of bonus shares.

(ii)    Not a substitute for an Income Statement:  An income statement shows both cash and non-cash items. The income statement shows the net income of the firm whereas the Cash Flow Statement shows only the net cash inflows or outflows which do not represent the net profits or losses of the enterprise.

(iii)   Historical in Nature:  It rearranges the existing information available in the income statement and the balance sheet. It will become more useful if it is accompanied by the projected Cash Flow Statement.

(iv)  Ignorance:  It ignores basic accounting concept, i.e., accrual concept.

(v)    What is Cash: It is difficult to precisely define the term ‘cash’. There are controversies over a number of items like cheques, stamps, postal orders, etc. to be included in cash.

(vi)  Does not reveal true liquidity position: A Cash flow statement reveals the inflow and outflow of cash but the exclusion of near cash items from cash obscures the true reporting of the firm’s liquidity position.

(vii) Working Capital ignored: Working Capital being a wider concept of funds, a funds flow statement presents a more complete picture than cash flow statement.

Distinguish between:
(a) Funds flow statement and Balance sheet
(b) Funds flow statement and cash flow statement
(c) Funds flow statement and Income statement
(d) Cash Flow Statement and Cash Budget

(a) Difference between Funds flow statement and Balance sheet:
(i) Balance sheet is a statement showing the financial position of the concern on a particular date. It shows all assets and liabilities whether current or fixed, tangible or intangible etc., while Funds Flow Statement shows the changes in current assets an current liabilities during a particular period of time.

(ii) Balance Sheet shows the total financial position on a particular date and its utility is very limited for the management. On the other hand, Funds Flow Statement is a comparative statement of assets and liabilities and depicts the changes in working capital during the period of two Balance sheets.

(iii) Funds Flow Statement is an analysis and control device for the management. It is a modern technique of knowing the inflows and outflows of funds during a particular period. Balance Sheet represents the balance of various assets and liabilities and does not present analysis of any kind.

(iv) There are two views of the financial position of the firm-long term and short-term. Short-term financial position means the solvency of the firm in the near future while on the other hand, long-term financial position means future financial structure of the firm. Both are inter-relate but there is a differences in their analysis. The short-term view of the financial position of the firm cannot be had from the Balance Sheet.

(b) Difference between Funds Flow Statement and Cash Flow Statement
Basis of Difference
Funds Flow Statement
Cash Flow Statement
Basis of Analysis
Funds flow statement is based on broader concept i.e. working capital.
Cash flow statement is based on narrow concept i.e. cash, which is only one of the elements of working capital.
The object funds flow statement is to disclose the magnitude, direction and causes of changes in working capital.
The object of cash flow is to disclose the magnitude, direction and causes of changes in cash and cash equivalents.
Funds flow statement tells about the various sources from where the funds generated with various uses to which they are put.
Cash flow statement starts with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses.
Funds flow statement is more useful in assessing the long-term financial position.
Cash flow statement is more useful in assessing the short-term financial position of the business.
Schedule of Changes in Working Capital
In funds flow statement changes in current assets and current liabilities are shown through the schedule of changes in working capital.
In cash flow statement changes in current assets and current liabilities are shown in the cash flow statement.
Funds flow statement shows the causes of changes in net working capital.
Cash flow statement shows the causes of changes in cash.
Principal of Accounting
Funds flow statement is based on the accrual basis of accounting.
In cash flow statement, data are obtained on accrual basis which are converted into cash basis.
There is no prescribed form for preparation of Funds flow statement.
Cash flow statement is compulsory to be prepared in prescribed proforma as given in AS – 3.
Funds flow statement can be prepared from the cash flow statement under indirect method.
But a cash flow statement cannot be prepared from funds flow statement.
Financial Health
Sound fund position does not necessarily mean sound cash position.
But sound cash position is always followed by sound fund position.

(c) Difference between Income Statement and Funds Flow Statement
Income Statement
Funds Flow Statement
Income statement is a summary of total income and total expenses and losses of a particular period.
Funds flow statement is the statement of changes in financial position.
Income statement is prepared to ascertain the profit earn or loss suffered by a firm.
Funds Flow Statement is prepared to identify how the profit has been utilized.
Income statement is prepared on the basis of nominal accounts.
Funds flow statement is prepared on the basis of balance sheet.
Income statement is helpful in measuring the profitability of a firm.
Funds flow statement is helpful in determining the net changes in working capital.
It is usually prepared after six months or a year.
It is usually prepared every month.
This matches the cost of goods sold with the revenue in order to know the profit or loss.
This statement matches the funds raised with funds applied without making any distinction between capital and revenue items.
It presents the result of all financial transactions of the business during a specified period.
It presents information only relating to working capital and thus its scope is limited.
It is not very reliable as items shown in profit or loss account can be easily manipulated by the management.
It is more reliable as items shown in this statement cannot be easily manipulated by the management.

(d) Difference between Cash flow statement and Cash Budget:
Cash Flow Statement
Cash Budget
It is prepared to explain to management the sources of cash and its uses during a particular period of time.
It is prepared to show the probable cash position at a planned operation.
It summarises effect of specific cash transactions into three categories operating, investing and financing activities of an enterprise during a period in prescribed format.
It can also be coordinated in relation to total working capital, sales, investments and debts.
It means inflows and outflows of cash and cash equivalents.
It is estimated receipts and payments of cash over a period of time.
Technique of analysis
It is a technique of past analysis.
It is a technique of future financial forecasting.
It covers a period of one year.
It is broken into monthly, weekly segments.
Emphasis of source
It does not emphasise on a particular source and use.
It emphasises on the financial pattern to meet seasonal or temporary cash needs.