Understanding Funds Flow Statement

Ever wondered why value investors and fund managers often speak about the financial statements? It is because it is of much importance for them. These financial statements narrate everything about a company's cash-related transactions as liquidity is of utmost importance for the smooth running of a business.

Funds Flow Statement is one such statement, the details of which are discussed below. The fund's flow statement often shows us a prominent picture of a corporation's profitability and financial position.

What is a Fund Flow Statement?

Funds Flow Statement is a managerial technique that provides knowledge of a firm's liquidity and solvency based on the basis of the flow of funds of the company. To prepare it, the Profit & Loss Statement and two consecutive balance sheets are analyzed.

The fund flows reflect all the cash flowing in and out of a variety of financial assets. Thus, the Funds Flow Statement is the disclosure of the types of inflows and outflows that a particular company has experienced. The fund's flow statement records the movement of cash in and out of the company. A fund flow statement can also be called a "Statement of Sources and Application of Funds." 

A fund flow statement is analyzed and calculated by reading the Balance Sheet of a company. An in-depth and detailed study of the balance sheet of two years must reflect the actual movements of funds from the previous financial year to the current financial year. It is a statement of assets and liabilities affecting the working capital during an accounting period.

The funds flow statement has two meanings and purposes, i.e., accounting purpose and investing goal. Investors worldwide majorly rely on this financial statement as it helps them choose the best option for investment. It compares the source of inflows and outflows of funds during the concerned financial years. It is a comparative analytical statement between two consecutive years.

Analysis of Fund Flow Statement

The Funds Flow Statement Analysis is a crucial method that helps determine and analyze a company's financial position. We calculate the amount of change in funds of a company between two consecutive financial years and then understand the causes responsible for those changes. But before moving ahead, there are few things that we must learn and understand what these terms mean:

Current Assets

Based on the following criteria, a current asset needs to fulfil the following requirements:

• The Asset must be held primarily for trading.
• The Asset should be consumed or intended for sale in the company's standard operating cycle.
• The realization of Assets must be within 12 months after the reporting date.
• It includes: 
  • Current Investment.
  • Inventories.
  • Trade Receivables.
  • Cash and cash equivalents.
  • Short term loans and advances.

Non-Current Assets

Non-current assets are the assets held for more than one year. They are also known as long term assets. They include:

• Fixed Assets like land, buildings.
• Non-current investment.
• Deferred Tax Assets.
• Long term loans.

Current Liabilities

The current liability is a liability if it meets the following criteria:

• If the liability is held primarily for trading.
• It settles in the company's standard operating cycle.
• It is due within 12 months after the reporting date.
• It includes:
  • Short term borrowings.
  • Trade payables.
  • Unpaid dividend.
  • Outstanding expenses

Non-Current Liabilities

Non-Current liabilities are long term borrowings. They include:

• Bonds, Debentures, and Term loans.
• Deferred tax liabilities
• Long-term provisions etc.

Preparation of Funds Flow Statement

Statements prepared for the period of one year are called Funds Flow Statement. The following financial statements are required to prepare a funds flow statement:

• Last year's Balance Sheet.
• Current year's Balance Sheet.
• Income Statement or Profit & Loss Account for the current year.

After collecting information from the financial statements mentioned above, the following two statements are prepared:

• Statement of changes in working capital
• Statement of funds from operations
• Funds flow statement

Statement of changes in working capital

This statement depicts the amount of working capital at the beginning and the end of the year and the working capital changes during the year. This statement builds based on the formula: 

Working Capital = Current Assets - Current Liabilities

While calculating the increase or decrease in current assets and current liabilities, consider the following things:

• Growth in existing assets increases working capital.
• Reduction in current assets decreases working capital.
• An increase in current liabilities reduces working capital.
• A reduction in current liabilities increases working capital.

The format for this statement is as follows (based on a random example):

Statement showing funds from operations

In this, we calculate the increase in Working Capital resulting from various operating activities of a firm. It is computed by preparing the Adjusted Profit & Loss Account, which is shown below (based on the previous example):

*Given Profit & Loss balance for current year is 220 cr and for previous year it is 200 cr.

Statement showing flow of funds

This is the final step towards calculating the flow of funds. In this step, we use and consider the values obtained in the previous step.

Objectives of Funds Flow Statement

The main goals of a fund flow statement are as follows:

• To determine the amount of working capital in two consecutive financial years.
• To know the actual changes in working capital.
• To know the causes of change in working capital.
• To see the inflow of funds as per their sources and outflow of funds as per their application.
• To understand the financial policies of a company.

Applications of a Fund Flow Statement

• A Fund Flow Statement is prepared to know the actual reasons behind the changes in a company's financial position between two financial years.
• To measure the soundness and solvency, preparation of a fund flow statement is a must.
• A fund flow statement helps the management of a company know how much funds are available for its operations and applications.
• The distribution of dividends depends not only on how large the profit is but also on the funds available. Hence, a funds flow statement helps in the formation of a realistic dividend policy.
• It is a financial statement that reflects funds, their sources and their fulfilment of the financial needs of a company.
• The resources of a firm are always limited. Thus, with the help of a funds flow statement, a firm can plan the proper use and allocation of its financial resources.
• A fund flow statement can also help in getting a loan from banks and financial institutions. Banks ask for such statements to know their liquidity position and repaying capacity.

Limitations of Funds Flow Statement

Apart from its several uses and advantages, fund flow statements also have some limitations to it, which are as follows:

• Not a Substitute: A fund flow statement does not substitute for an Annual Report or Balance Sheet.
• Less Important than Changes in Cash: Changes in cash are more important than the working capital, which the funds flow statement does not reflect.
• Ignores Non-fund Transactions: It does not include non-fund transactions such as the issue of bonus shares or the issue of debentures.

Conclusion

Fund flow statement is important because it measures the inflows and outflows of cash during the given period. Such details of the cash status of a company can not only help the company or the financial analyst to strategize for the short term or long term but also facilitate the analysis of an optimum level of cash and working capital needed in the company.

We learned how a Fund Flow Statement could affect our investment decision. When it comes to investing in a company, one should always look for a fund flow statement. It helps us to know the business plan and cash handling ability of a firm.