Key Takeaways:
- Understand the concept, structure, and significance of a funds flow statement, including the meaning of funds and working capital.
- Learn the chronological steps to prepare a funds flow statement: schedule of changes in working capital, calculation of funds from operations, and statement preparation.
- Explore practical uses, limitations, and apply your knowledge through a solved example.
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Financial statement analysis provides a window into a company’s economic reality. Among its tools, Funds Flow Analysis stands out for revealing how resources move within the business over time. This topic often appears daunting for first-time learners, but with a logical approach, even its subtleties become clear. Let’s systematically develop your understanding.
Introduction
When we talk about analyzing financial statements, we’re not just interested in profits or losses. We want to know How resources were generated and used. Funds flow analysis answers this by examining changes in working capital and by tracking the sources and applications of funds over a period.
Funds, in this context, refer to working capital the difference between current assets and current liabilities. This analysis highlights strategic decisions:
Did the company invest in new machinery? Did it repay long-term debt? Understanding these movements sharpens both management and investor decision-making.
Definition and Meaning
a. What is a Funds Flow Statement?
A funds flow statement is a financial report that maps out the movement of funds (working capital) between two balance sheet dates. It identifies where funds came from (sources) and how they were used (applications) within an accounting period. Unlike a cash flow statement, which tracks cash specifically, a funds flow statement focuses on broader changes affecting working capital, including non-cash transactions and long-term investments.
b. Meaning of Funds & Working Capital
Funds, for this analysis, mean net working capital (Current Assets – Current Liabilities). Any transaction that increases or decreases this net figure is considered a movement of funds. For instance, purchasing inventory (current asset) using cash (also a current asset) doesn’t affect working capital, but selling a fixed asset for cash does, as it increases current assets without a corresponding current liability increase.
Steps in Funds Flow Analysis
a. Schedule of Changes in Working Capital
This is the foundation. Start by preparing a schedule showing the variation in current assets and current liabilities between two balance sheet dates. The net increase or decrease in working capital forms the basis for the next steps.
| Particulars | Year 1 | Year 2 | Increase | Decrease |
|---|---|---|---|---|
| Current Assets: | ||||
| Cash | 10,000 | 15,000 | 5,000 | - |
| Inventory | 30,000 | 35,000 | 5,000 | - |
| Current Liabilities: | ||||
| Creditors | 20,000 | 18,000 | - | 2,000 |
| Net Working Capital | 20,000 | 32,000 | Increase: 12,000 | |
Such a schedule highlights whether working capital increased or decreased and by how much.
b. Calculation of Funds from Operations
Funds from operations represent the company’s internal generation of funds from its core business, adjusted for non-cash and non-operating items. To calculate:
- Start with net profit.
- Add back non-cash expenses (depreciation, amortization, loss on sale of assets).
- Subtract non-operating incomes (profit on sale of assets, dividend received).
This reveals what the business actually generated from its routine activities, separate from extraordinary or non-operational events.
c. Preparation of Funds Flow Statement
Now, compile all sources (funds generated) and applications (funds used). The statement is usually presented in two columns:
‘Sources of Funds’ and ‘Application of Funds.’
The net change should reconcile with the change in working capital determined earlier.
| Sources of Funds | Amount |
|---|---|
| Funds from Operations | XX |
| Issue of Shares/Debentures | XX |
| Sale of Fixed Assets | XX |
| Application of Funds | Amount |
| Purchase of Fixed Assets | XX |
| Repayment of Loan | XX |
| Increase in Working Capital | XX |
Every source and application should be supported by the transactions identified through your analysis.
Example
Let’s cement these concepts with a practical illustration.
Company X presents the following data (₹ in thousands):
- Net Profit for the year: ₹20,000
- Depreciation charged: ₹5,000
- Loss on sale of machinery: ₹1,000
- Profit on sale of investment: ₹2,000
- Increase in inventory: ₹3,000
- Decrease in creditors: ₹2,000
- Sale of fixed assets: ₹10,000
- Repayment of loan: ₹6,000
- Purchase of new machinery: ₹8,000
Step 1: Schedule of Changes in Working Capital
If net working capital increased by ₹5,000, this is an application of funds.
Step 2: Calculation of Funds from Operations
- Start with Net Profit: ₹20,000
- Add Depreciation: ₹5,000
- Add Loss on sale of machinery: ₹1,000
- Less Profit on sale of investment: ₹2,000
Funds from Operations = 20,000 + 5,000 + 1,000 - 2,000 = ₹24,000
Step 3: Preparation of Funds Flow Statement
| Sources of Funds | Amount (₹) |
|---|---|
| Funds from Operations | 24,000 |
| Sale of Fixed Assets | 10,000 |
| Application of Funds | Amount (₹) |
| Repayment of Loan | 6,000 |
| Purchase of New Machinery | 8,000 |
| Increase in Working Capital | 5,000 |
This format ensures a logical connection between each movement of funds and its effect on working capital.
Uses and Limitations
a. Uses of Funds Flow Analysis
- Assists management in tracking long-term financial planning and resource allocation.
- Highlights how operational results impact working capital and liquidity.
- Helps external stakeholders, like investors and lenders who evaluate the financial health and capital structure changes.
- Identifies whether funds are being sourced internally or externally, which informs risk assessment and sustainability.
b. Limitations of Funds Flow Analysis
- Does not focus on short-term cash flows or immediate liquidity, the cash flow statement is more appropriate for that.
- Ignores non-cash transactions that do not affect working capital but may still impact the firm’s financial structure.
- Based on historical data, so it may not reflect current realities or future trends.
- Lacks standardization in format, which can make inter-company comparisons challenging.
To sum up, funds flow analysis remains a core analytical tool for understanding the Structural changes in financial position over time. It complements other financial statements by answering questions about the sources and uses of funds and how management strategies translate into changes in working capital. Analyze it thoughtfully, and you’ll see where a business is truly headed.