Friday, August 15, 2014

Management Accounting - Funds Flow Statement

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’ 2014 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.

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