Month: July 2020

Management Notes

Provisions of Ind AS-7 (Old AS 3), Objectives, Scope, Classification, Preparation

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Ind AS 7 prescribes the principles for presenting information about historical changes in cash and cash equivalents of an entity through a Statement of Cash Flows, classifying cash flows during the period into operating, investing, and financing activities. It is issued under the Companies (Indian Accounting Standards) Rules, 2015, notified by the Ministry of Corporate Affairs (MCA) under Section 133 of the Companies Act, 2013. This statement helps users evaluate an entity’s ability to generate cash and cash equivalents, its liquidity, and its needs to utilize those cash flows. It is a mandatory component of financial statements for entities applying Ind AS, providing crucial information not reflected in the Balance Sheet or Statement of Profit and Loss.

Objective of Ind AS 7:

1. Providing Information About Cash Flows

The primary objective of Ind AS 7, Statement of Cash Flows, is to provide information about the historical changes in cash and cash equivalents of an entity during an accounting period. It helps users understand how cash is generated and utilised by the business. The standard requires cash flows to be classified into operating, investing, and financing activities. This classification provides a clear understanding of the sources and uses of cash. The information helps investors, creditors, management, and other users assess the entity’s liquidity, financial flexibility, and ability to generate cash from its various business activities.

2. Assessing Cash Generating Ability

Ind AS 7 aims to help users assess an entity’s ability to generate cash and cash equivalents from its operations and other activities. Cash generation is important for meeting regular expenses, paying creditors, servicing loans, and making investments. The Cash Flow Statement provides information about actual cash inflows and outflows during the reporting period. By analysing operating cash flows, users can evaluate whether the entity’s core business activities are generating sufficient cash. This information helps investors and creditors assess the entity’s financial strength, liquidity, and ability to meet future financial obligations effectively.

3. Assessing Liquidity and Solvency

An important objective of Ind AS 7 is to provide information useful for assessing an entity’s liquidity and solvency. Liquidity refers to the ability to meet short term obligations, while solvency relates to the ability to meet financial obligations over the longer term. The Cash Flow Statement shows the availability and movement of cash and cash equivalents and provides information about cash generated from operating activities and cash used for financing and investing activities. This enables investors, creditors, and management to assess whether the entity can meet its financial commitments and payment obligations on time.

4. Understanding Changes in Cash and Cash Equivalents

Ind AS 7 aims to explain the changes in an entity’s cash and cash equivalents during an accounting period. The statement reconciles the opening cash position with the closing cash position by presenting cash inflows and outflows from operating, investing, and financing activities. This helps users understand why the cash balance has increased or decreased during the period. Such information is useful for analysing the entity’s cash management and financial activities. Therefore, the standard provides a systematic framework for understanding the sources, uses, and movement of cash and cash equivalents during the reporting period.

5. Evaluating Financial Flexibility

Ind AS 7 provides information that helps users evaluate an entity’s financial flexibility, which refers to its ability to respond effectively to unexpected financial requirements and changing business conditions. Information about cash flows shows whether the entity has sufficient cash generating capacity and access to financing sources. Strong cash flows may enable an entity to undertake investments, repay debt, or meet unexpected obligations. Analysis of operating, investing, and financing cash flows helps users understand the entity’s ability to adapt to changing circumstances. Thus, the standard supports assessment of the entity’s financial flexibility and capacity to manage future financial needs.

Scope of Ind AS 7:

1. Applicability to Cash Flow Statements

Ind AS 7, Statement of Cash Flows, deals with the preparation and presentation of cash flow information by entities that prepare financial statements under Indian Accounting Standards. It requires an entity to prepare a Cash Flow Statement showing changes in cash and cash equivalents during an accounting period. The statement provides information about cash generated and utilised through operating, investing, and financing activities. The standard helps users understand the movement of cash within an entity. Its requirements apply to entities covered by the Ind AS framework, subject to the applicable requirements and exemptions under the relevant regulations.

2. Classification of Cash Flows

The scope of Ind AS 7 covers the classification of cash flows into three major categories: operating activities, investing activities, and financing activities. Operating activities relate to the principal revenue producing activities of an entity. Investing activities generally involve the acquisition and disposal of long term assets and investments. Financing activities result in changes in the size and composition of equity and borrowings. This classification enables users to understand the different sources and uses of cash. Ind AS 7 therefore provides a systematic framework for presenting cash flows and analysing the entity’s cash generation and utilisation.

3. Cash and Cash Equivalents

Ind AS 7 covers information relating to cash and cash equivalents. Cash includes cash on hand and demand deposits, while cash equivalents are short term, highly liquid investments that can be readily converted into known amounts of cash and are subject to an insignificant risk of changes in value. The standard explains how movements in these balances should be presented in the Cash Flow Statement. It also helps users distinguish between cash transactions and other financial transactions. Therefore, the scope of Ind AS 7 is centred on reporting changes in cash and cash equivalents during the accounting period.

4. Operating Activities

The scope of Ind AS 7 includes cash flows arising from operating activities, which are the principal revenue producing activities of an entity. These activities generally include cash receipts from customers and cash payments to suppliers and employees. Operating cash flows provide important information about the entity’s ability to generate sufficient cash from its normal business operations. They are particularly useful for assessing the sustainability of the business and its capacity to meet operating expenses and financial obligations. Thus, Ind AS 7 requires operating cash flows to be separately identified and appropriately presented in the Statement of Cash Flows.

5. Investing Activities

Ind AS 7 also covers cash flows arising from investing activities. These activities relate mainly to the acquisition and disposal of long term assets and investments that are not considered cash equivalents. Examples include payments for purchasing property, plant and equipment and receipts from their sale. Cash payments for acquiring investments and cash receipts from their disposal may also fall under investing activities, subject to the requirements of the standard. Separate presentation of investing cash flows helps users understand the extent to which an entity is using cash for future growth, asset acquisition, and investment activities.

6. Financing Activities

The scope of Ind AS 7 includes cash flows from financing activities, which result in changes in the size and composition of the contributed equity and borrowings of an entity. Examples include proceeds from issuing shares or other equity instruments, proceeds from loans and borrowings, repayment of borrowings, and certain payments to owners. Separate reporting of financing cash flows helps users understand how the entity obtains financial resources and how it repays or distributes those resources. Therefore, Ind AS 7 provides information about changes in the entity’s capital structure and financing arrangements during the accounting period.

7. Disclosure of Cash Flow Information

The scope of Ind AS 7 extends to the presentation and disclosure of relevant information about cash flows. An entity is required to present cash flows in a manner that enables users to understand the movement of cash and cash equivalents during the reporting period. The standard also contains requirements relating to the disclosure of certain financing and investing transactions and other relevant information. Such disclosures improve the transparency and usefulness of financial statements. Investors, creditors, and management can use this information to assess liquidity, financial flexibility, and the entity’s ability to generate and utilise cash effectively.

Classification of Cash and Cash Equivalents:

1. Cash in Hand

Cash in hand refers to physical currency held by an entity for meeting its immediate payment requirements. It includes notes and coins available at the business premises or with authorised personnel. Cash in hand is considered a part of cash and cash equivalents because it is immediately available for use and does not involve any conversion process. It is commonly used for small business expenses, petty cash payments, and other routine transactions. Under Ind AS 7, cash balances form the basis for determining the movement in cash and cash equivalents during an accounting period. Therefore, cash in hand represents the most liquid financial resource of an entity.

2. Cash at Bank

Cash at bank represents funds maintained by an entity in current accounts and other demand deposits with banks. These balances are readily available for making payments, receiving collections, and meeting the entity’s regular financial obligations. Demand deposits can generally be withdrawn whenever required and therefore form part of cash for the purpose of Ind AS 7. Bank balances provide an important source of liquidity for day to day business operations. They are also used to reconcile the opening and closing cash positions in the Cash Flow Statement. Thus, cash at bank represents readily accessible financial resources available to the entity.

3. Cash Equivalents

Cash equivalents are short term, highly liquid investments that can be readily converted into known amounts of cash and are subject to an insignificant risk of changes in value. Under Ind AS 7, an investment normally qualifies as a cash equivalent when it has a short maturity, generally three months or less from the date of acquisition. Examples may include certain short term investments and highly liquid instruments that satisfy the required conditions. Cash equivalents are held primarily for meeting short term cash commitments, rather than for investment or other purposes. Therefore, they are treated together with cash while preparing the Cash Flow Statement.

4. Demand Deposits

Demand deposits are deposits that can be withdrawn from a bank on demand without significant restriction. They provide immediate access to funds and are therefore generally included within cash for purposes of Ind AS 7. Demand deposits are commonly maintained in current or similar bank accounts used for regular business transactions. They help an entity meet short term payment requirements such as payments to suppliers, employees, and other parties. Their high liquidity makes them an important component of the entity’s cash resources. Therefore, demand deposits are considered while determining the opening and closing balances of cash and cash equivalents in the Cash Flow Statement.

5. Short Term Highly Liquid Investments

Short term highly liquid investments may qualify as cash equivalents when they can be readily converted into known amounts of cash and carry an insignificant risk of changes in value. According to Ind AS 7, the investment generally needs to have a short maturity, normally three months or less from the date of acquisition. The purpose of holding such investments should primarily be to meet short term cash commitments, rather than to earn investment returns. Examples may include certain highly liquid short term instruments that satisfy these conditions. Therefore, only investments meeting the prescribed characteristics are classified as cash equivalents under the standard.

Methods of Ind AS 7:

1. Direct Method

The Direct Method presents major classes of gross cash receipts and gross cash payments arising from operating activities. It directly shows cash received from customers, cash paid to suppliers, cash paid to employees, interest paid, taxes paid, and other operating cash transactions, as applicable. This method provides detailed information about the actual sources and uses of operating cash. It is considered useful for understanding the entity’s cash generating ability. Under Ind AS 7, entities are encouraged to report operating cash flows using the Direct Method because it provides information that may be useful in estimating future cash flows.

2. Indirect Method

The Indirect Method starts with profit or loss and adjusts it for non cash items, changes in working capital, and items whose cash effects relate to investing or financing activities. Important adjustments may include depreciation, provisions, changes in inventories, trade receivables, and trade payables. The objective is to arrive at cash generated from operating activities. Unlike the Direct Method, it does not separately show individual cash receipts and payments from operations. The Indirect Method is widely used because it provides a reconciliation between accounting profit and net cash flow from operating activities, helping users understand the difference between profit and cash generation.

Preparation and Presentation of Cash Flow Statement:

1. Determine Opening and Closing Cash Balances

The preparation of a Cash Flow Statement begins with identifying the opening and closing balances of cash and cash equivalents. The opening balance represents cash available at the beginning of the accounting period, while the closing balance represents cash available at the end. These balances are obtained from the relevant Balance Sheet and accounting records. The difference between the opening and closing balances is explained through cash inflows and outflows during the period. This ensures that the Cash Flow Statement properly reconciles the movement in cash and cash equivalents and provides a clear picture of the entity’s cash position.

2. Classify Cash Flows

Under Ind AS 7, cash flows are classified into three major categories: operating activities, investing activities, and financing activities. Operating activities include cash flows arising from the principal revenue producing activities of the business. Investing activities mainly include the acquisition and disposal of long term assets and investments. Financing activities relate to changes in equity and borrowings. Proper classification is essential because it enables users to understand the different sources and uses of cash. This classification also helps management, investors, and creditors assess the entity’s cash generating ability, investment decisions, and financing position.

3. Calculate Cash Flow from Operating Activities

Cash flow from operating activities represents cash generated or used by the principal revenue producing activities of the business. Under Ind AS 7, operating cash flows may be presented using either the Direct Method or the Indirect Method. The Direct Method shows major classes of cash receipts and payments, while the Indirect Method begins with profit or loss and adjusts it for non cash items and changes in working capital. The resulting figure indicates whether the entity’s normal business operations are generating sufficient cash. Operating cash flow is important for assessing liquidity and financial sustainability.

4. Calculate Cash Flow from Investing Activities

Cash flow from investing activities includes cash payments and receipts relating mainly to the acquisition and disposal of property, plant and equipment, investments, and other long term assets. Cash paid for purchasing long term assets is generally shown as an investing cash outflow, while cash received from their sale is shown as an investing cash inflow. These cash flows provide information about the extent to which an entity is using its resources for future growth and investment. Proper identification of investing activities helps users understand the entity’s investment strategy and its effect on the overall cash position.

5. Calculate Cash Flow from Financing Activities

Cash flow from financing activities shows changes in the size and composition of the entity’s equity and borrowings. It generally includes cash received from issuing shares, obtaining loans, and other financing arrangements, as well as cash payments relating to repayment of borrowings and certain distributions to owners. These activities help users understand how the entity obtains financial resources and how those resources are repaid or distributed. Proper presentation of financing cash flows provides useful information about the entity’s capital structure, borrowing position, and financing strategy and helps assess its ability to meet long term financial commitments.

6. Determine Net Increase or Decrease in Cash

After calculating cash flows from operating, investing, and financing activities, the net increase or decrease in cash and cash equivalents is determined. The amount is calculated by adding the cash flows from all three categories. The resulting figure explains the overall change in the entity’s cash position during the accounting period. It may represent either a net increase or a net decrease in cash and cash equivalents. This figure is then added to the opening cash and cash equivalents to determine the closing cash and cash equivalents, ensuring proper reconciliation of the Cash Flow Statement.

7. Present the Cash Flow Statement

The Cash Flow Statement is presented in a systematic format showing cash flows from operating, investing, and financing activities separately. Under Ind AS 7, the statement should clearly disclose the movement in cash and cash equivalents during the reporting period. The final section generally shows the net increase or decrease in cash, opening cash and cash equivalents, and closing cash and cash equivalents. Appropriate disclosures should also be provided for significant non cash transactions and other relevant information as required by the standard. Proper presentation improves the clarity, comparability, and usefulness of cash flow information.

Management Notes

Statement of Funds from Operations

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Funds from operations is the cash flows generated by the operations of a business, usually a real estate investment trust (REIT). This measure is commonly used to judge the operational performance of REITs, especially in regard to investing in them. Funds from operations does not include any financing-related cash flows, such as interest income or interest expense. It also does not include any gains or losses from the disposition of assets, or any depreciation or amortization of fixed assets. Thus, the calculation of funds from operations is:

Funds from operations = Net income – Interest income + Interest expense + Depreciation – Gains on asset sales + Losses on asset sales

After preparing the schedule of changes in net working capital, the second step is to determine the amount of funds (loss) from business operations. It refers to the funds or loss, which is generated or suffered in the business as a result of its regular operations during the period. The funds from operation is an important source of fund, while loss from operation is one of the important applications of funds. The funds or loss from operation is determined by adjusting the firm’s net income in a statement called the statement of funds from operations. In this statement, the items such as non-operating incomes and non-cash expenses are adjusted while determining the amount of funds (loss) from operations.

Non-cash expenses such as depreciation and amortization of intangible assets do not result in actual cash outflow. Non-operating expenses are those which are not treated as regular expenses of the business. These expenses matter while ascertaining the business income, but are irrelevant in determining the funds (loss) from operations. Therefore non-operating incomes should be deducted from and non-operating and non-cash expenses should be added back to the business income shown by the income statement.

Non-operating and non-cash expenses

  • Depreciation for the year
  • Amortization of Goodwill, Copyright, Patent, Trademark, Preliminary expenses
  • Discount on issue of share and debenture written off
  • Loss on sale of fixed assets or investment
  • Loss of revaluation of fixed assets
  • Premium on redemption of debentures and preference share

Incomes and gains which are not earned from the normal business operations are called non-operating incomes. These incomes are included while ascertaining the business income, but are excluded while determining the funds (loss)from operations. The following are the examples of non-operating incomes.

  • Gain on sale of fixed assets or investment
  • gain on revaluation of fixed assets
  • Discount on redemption of debentures and preference share
  • Compensation received
  • Interest received
  • Refund of tax
  • Transfer fees received
  • Appreciation on fixed assets

Preparation of Statement Of Funds From Operation

Funds from operations can be determined by using one of the two following methods.

  1. Add Back Method

Under this method,net profit is taken as the base. All the non-operating and non-cash expenses are added to net profit and non-operating incomes are deducted.

Funds from operations = Net profit+Non-operating and non-cash expenses-Non operating Incomes.

  1. Profit And Loss Adjustment Account Method

Funds from operations can also be determined by preparing an account called profit and loss adjustment account begins with opening balance of profit on its credit side and closing balance on the debit side. Instead of opening and closing balance of profit and loss account, only the amount of net profit for the year can also be brought down to the debit side of this account. Then the items of non-operating expenses and non-cash expenses are adjusted to the debit side and the items of non-operating incomes are adjusted to the credit side to determine the amount of funds (loss) from operations.

Management Notes

Statement of Sources and Applications of Funds

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Generally, the statement consists of two sections: the source (where the money has come from) and the application (where the money has gone).

The sources of funds originate from:

  • A decrease in liabilities or an increase in assets
  • Net income after tax
  • The disposal or revaluation of fixed assets
  • Proceeds of loans obtained
  • Proceeds of shares that were issued
  • Repayments received on loans previously granted by the company
  • Any increase in net working capital

The application of funds includes:

  • Losses to be met by the company
  • The purchase of fixed assets/investments
  • The full or partial payment of loans
  • Granting of loans
  • Liability for taxes
  • Dividends paid or proposed
  • Any decrease in net working capital

Sources of Funds

Items to be shown under the head Sources of Funds are as follows:

  • Issue of Shares and Debentures for Cash: The total amount received from the Issue of Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be shown here as there is no inflow of Cash
  • Long Term Loans: The Amount received on raising Long Term Loans is shown under this head. Short Term Loans are not to be shown here as their treatment has already been done while preparing the Statement of Changes in Working Capital.
  • Sale of Investments and other Fixed Assets: The Total Amount received on the sale of Investments and other Fixed Assets is to be shown under this head.
  • Funds from Operations: The Funds generated from Operations as computed in Step II are also required to be shown here.
  • Decrease in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement

Application of Funds

Items to be shown under Application of Funds are as follows:

  • Purchase of Fixed Assets and Investments: The Cash Payment made for purchase of Fixed Assets and Investments is an application of Funds. But if the purchase if made by issue of shares or debentures, such a transaction will not constitute application of funds. Similarly, if the purchases are on credit, these will not constitute fund applications.
  • Redemption of Debentures, Preference Shares and Repayment of Loan: Payment made including Premium (less: Discount) is to be taken as fund application
  • Payment of Dividend & Tax: Payment of Dividend and Tax are to be taken as applications of fund if the provisions are excluded from Current Liabilities and Current Provisions are added back to profit to determine the “Funds from Operations”
  • Increase in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement
Management Notes

Procedure for preparation of Fund Flow Statement

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Steps for Preparing Funds Flow Statement:

The steps involved in preparing the statement are as follows:

  1. Determine the change (increase or decrease) in working capital.
  2. Determine the adjustments account to be made to net income.
  3. For each non-current account on the balance sheet, establish the increase or decrease in that account. Analyze the change to decide whether it is a source (increase) or use (decrease) of working capital.
  4. Be sure the total of all sources including those from operations minus the total of all uses equals the change found in working capital in Step 1.

General Rules for Preparing Funds Flow Statement:

The following general rules should be observed while preparing funds flow statement:

  1. Increase in a current asset means increase (plus) in working capital.
  2. Decrease in a current asset means decrease (minus) in working capital.
  3. Increase in a current liability means decrease (minus) in working capital.
  4. Decrease in a current liability means increase (plus) in working capital.
  5. Increase in current asset and increase in current liability does not affect working capital.
  6. Decrease in current asset and decrease in current liability does not affect working capital.
  7. Changes in fixed (non-current) assets and fixed (non-current) liabilities affects working capital.

Format of Funds Flow Statement:

A funds flow statement can be prepared in statement form or ‘T’ form.

Both the formats are given below:

Schedule of Changes in Working Capital:

Many business enterprises prefer to prepare another statement, known as schedule of changes in working capital, while preparing a funds flow statement, on a working capital basis. This schedule of changes in working capital provides information concerning the changes in each individual current assets and current liabilities accounts (items).

This schedule is a part of the funds flow statement and increase (decrease) in working capital indicated by the schedule of changes in working capital will be equal to the amount of changes in working capital as found by funds flow statement. The schedule of changes in working capital can be prepared by comparing the current assets and current liabilities at two periods.

The format of schedule of changes in working capital is as follows:

Management Notes

Statement of changes in Working Capital

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In the preparation of funds flow statement, the first step is to find out the net amount of increase or decrease of working capital, as increase in net working capital is a use of funds and decrease in net working capital is a source. Since net working capital is excess of current assets over current liabilities, the increase or decrease in the net working capital can be found out by comparing the current assets and current liabilities contained in the balance sheets of two following dates. For this purpose, a statement is prepared which is called statement or schedule of changes in net working capital. This statement helps to identify the change in position of the working capital. While preparing the statement of changes in working capital, the following points are considered.

* Increase in current assets , increase in net working capital
* Decrease in current assets , decrease in net working capital
* Increase in current liabilities , decrease in net working capital
* Decrease in current liabilities, increase in net working capital

The statement or schedule of changes in net working capital can be prepared by using one of the following forms.

  1. Using only current account

The statement or schedule of changes in net working capital can be prepared by using only current account, viz. account of current assets and current liabilities. While preparing the statement, the current assets and current liabilities of the previous year are compared with those of the current year and changes (increase or decrease) therein are determined. If the total of increase is more than that of decrease, there is an increase in net working capital, or vice versa.

  1. Using both current and non-current accounts

The statement or schedule of changes in net working capital can also be prepared by using both current as well as non-current accounts. Current account is the account of current assets and current liabilities and non-current account of non-current assets and non-current liabilities and owner’s equity. Increase in an item of current assets or decrease in an item of current liabilities from previous year to this year is debited, while increase in an item of current liabilities or decrease in an item of current assets is credited to current account. On other hand, increase in an item of non-current assets or decrease in an item of non-current liabilities from the previous year to this year is debited, while increase in an item of non-current liabilities and owner’s equity and decrease in an item of non-current assets is credited to non-current account.

The preparation of statement of changes in networking capital under this method is advantageous as compared to the previous method as it is easy to prepare funds flow statement there from.

Changes in Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)

Or

Change in a Net Working Capital = Change in Current Assets – Change in Current Liabilities

  • Step 1: Find the Current Assets for the current year and previous year

From the point of the current asset of view, we consider the below:

      • Inventory
      • Accounts Receivable
      • Prepaid Expenses
  • Step 2: Find the Current Liability for the Current Year and Previous Year

From the current liabilities, we consider the below:

      • Accounts Payable & Accrued Expenses
      • Interest Payable
      • Deferred Revenue
  • Step 3: Find Working Capital for the Current Year and Previous Year
      • Working Capital (Current Year) = Current Assets (current year) – Current Liabilities (current year)
      • Working Capital (Current Year) = Current Assets (current year) – Current Liabilities (current year)
  • Step 4: Calculate Changes in Net Working Capital using the formula below –
      • Changes in Net Working Capital Formula = Working Capital (Current Year) – Working Capital (Previous Year).

Management Notes

Uses and Limitations of Fund Flow Statement

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Uses of Funds Flow Statement:

By highlighting the changes in the distribution of the resources of an undertaking, the funds flow statement enables the financial manager to have a clear perspective of the organization’s financial strengths and weaknesses. It provides answers to a number of difficult questions.

(a) It explains the financial consequences of business operations. For example, a business may be earning huge profits, but its liquidity position would be highly unsatisfactory.

The funds statement will explain the causes for such situation by showing what has become of the profits earned. Further, the statement would explain the direction of flow of funds into productive or non-productive activities.

When a balance sheet presents a distorted picture of an undertaking because of a number of non-fund transactions, the funds statement would be an illuminating document.

(b) Debt capital is very essential for increased profitability of any enterprise. But the creditors may like to ascertain the credit worthiness and the funds generating capacity of the organization.

They may like to know in what way the management has utilized the funds in the past and how the funds would be utilized in future. The funds flow statement would enable the finance manager to answer such questions in a befitting manner.

(c) It acts as an instrument for allocation of the company’s scarce resources. A proposed funds statement will help to find out how the management is going to allocate the resources for meeting future productive programmes of the business.

When the projected funds statement is tied to the capital budget, it will help management to maintain the financial health of the organization.

(d) It is a test for evaluating the effective use of working capital by the management. Information on the adequacy or inadequacy of working capital will enable the management to decide what possible steps it should take for effective use of surplus working capital, or in the case of inadequate working capital to make suitable arrangements to make up the deficiency.

Limitations of Funds Flow Statement:

Despite its multiple managerial uses, the funds flow statements suffer from certain limitations.

  1. As this statement ignores non-fund items, it becomes a crude device compared to the income statement and balance sheet.
  2. The statement does not reveal shifts among the items making up the current assets and current liabilities. It does not tell whether any loss of working capital has unduly weakened the financial position.

Only an examination of the balance sheet at the end of the period will show the end of these changes. Therefore, funds flow statement cannot supplant but only supplement the conventional financial statements, either in whole or in part.

  1. The information used for the preparation of funds flow statement is essentially historical in nature, though attempts are made to project the funds statement for the future period.

Despite these limitations, the information supplied by the funds flow statement is really an invaluable aid to management in planning capital expenditure, devising dividend and other financial policies.

Management Notes

Fund Flow Statement, Introductions, Objectives, Steps, Importance

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Fund Flow Statement is a financial report that explains the movement of funds within a business during a specific period. It shows the sources from which funds were obtained and the ways in which those funds were utilized. Unlike the income statement, which focuses on profitability, or the balance sheet, which reflects financial position at a given date, the Fund Flow Statement highlights changes in working capital and long-term financial planning.

The statement is particularly useful in analyzing how operational activities, investments, and financing decisions impact the financial health of the organization. For example, it reveals whether funds were generated from internal operations like profits or from external sources such as loans or equity. Similarly, it shows whether funds were applied to purchase fixed assets, repay debts, or increase working capital.

By identifying these movements, the Fund Flow Statement helps managers evaluate liquidity, financial stability, and the effectiveness of capital utilization. It also supports decision-making regarding investments, dividend policies, and future financing requirements. Thus, it serves as a bridge between the balance sheet and income statement, providing a dynamic view of how resources are managed within the business.

Objectives of Fund Flow Statement:

  • Analyzing Sources and Applications of Funds

The primary objective of a fund flow statement is to explain where the business obtained its funds and how they were utilized during a given period. It identifies sources such as profits, loans, or equity and applications such as asset purchases, debt repayment, or dividend distribution. This clarity enables managers, investors, and stakeholders to understand the flow of resources. By analyzing both inflows and outflows, the statement provides a comprehensive view of financial management practices.

  • Assessing Changes in Working Capital

The fund flow statement focuses on movements in working capital, which includes current assets and liabilities. It highlights whether operations have increased or decreased liquidity. For instance, if funds are tied up in inventories or receivables, working capital may decline. Conversely, efficient collections or reduced liabilities may improve liquidity. This assessment helps managers identify areas of concern in short-term financial management and ensures sufficient working capital is maintained for smooth operations.

  • Supporting Long-Term Financial Planning

Another important objective of the fund flow statement is to assist in long-term financial planning. It reveals how funds are raised and applied to long-term uses such as purchasing fixed assets, expanding capacity, or restructuring debt. By showing how operations and financing decisions affect long-term stability, the statement becomes a tool for evaluating strategic initiatives. This information allows management to plan investments, funding strategies, and future capital needs with greater accuracy and foresight.

  • Evaluating Financial Stability and Strength

The fund flow statement helps in evaluating a company’s overall financial strength and stability. By examining how funds are generated and applied, it indicates whether the business relies too heavily on external borrowing or sustains itself through internal operations. It also highlights repayment capacity and ability to finance growth. Investors and creditors use this information to assess risk and financial soundness, while management relies on it to safeguard the company’s long-term financial position.

  • Identifying Causes of Financial Changes

One of the key objectives of the fund flow statement is to explain why a company’s financial position has changed between two balance sheet dates. It identifies specific factors such as increased borrowing, asset purchases, repayment of liabilities, or retained earnings that contributed to financial changes. By pinpointing exact causes, management can evaluate whether changes were beneficial or harmful to the business. This makes the statement a valuable diagnostic tool for financial analysis.

  • Facilitating Decision-Making

The fund flow statement aids management in making informed financial decisions. By showing the movement of funds, it allows managers to decide on future investments, borrowing needs, or dividend policies. For instance, if funds are largely used for fixed asset purchases, management may delay dividends to preserve liquidity. Conversely, if internal operations generate sufficient funds, expansion plans can be pursued confidently. This decision-making support is one of the statement’s most practical and impactful objectives.

  • Ensuring Efficient Utilization of Funds

Efficiency in utilizing available funds is crucial for business success. The fund flow statement helps assess whether resources are being applied productively or wasted. For example, funds used excessively in idle inventories reflect inefficiency, whereas investment in profitable ventures demonstrates effective use. By highlighting such patterns, the statement encourages better allocation of resources. Management can reallocate funds toward more productive areas, ensuring that capital contributes to growth, profitability, and sustainable business performance.

  • Enhancing Communication with Stakeholders

The fund flow statement also serves as a communication tool between management and external stakeholders such as investors, creditors, and regulators. It provides transparency by disclosing how the business manages its financial resources. Stakeholders gain confidence when they see funds being generated and applied prudently. This enhances credibility and trust in the organization. By fulfilling this objective, the fund flow statement not only improves internal management control but also strengthens external stakeholder relationships.

Steps in Preparing a Fund Flow Statement:

Step 1. Collecting Financial Statements

The first step in preparing a fund flow statement is to collect the necessary financial information, primarily the balance sheets of the current year and the previous year. Additional data such as the income statement and schedules of non-current assets and liabilities may also be required. These documents provide the foundation for identifying changes in assets, liabilities, and equity. Without accurate and complete financial statements, preparing a reliable fund flow statement is not possible, making this step essential.

Step 2. Preparing a Schedule of Changes in Working Capital

After collecting data, the next step is to prepare a schedule of changes in working capital. This involves listing current assets and current liabilities from two consecutive balance sheets. The difference between them indicates an increase or decrease in working capital. An increase in current assets or decrease in current liabilities increases working capital, while the opposite reduces it. This schedule helps highlight how day-to-day operations and financial activities affect liquidity, forming the basis for analysis.

Step 3. Identifying Non-Current Items

The third step involves identifying non-current items such as fixed assets, long-term investments, long-term loans, and reserves. These items directly affect the flow of funds but are not part of working capital. For example, the purchase of machinery requires funds, while issuing long-term debentures generates funds. By isolating these items, businesses can evaluate how long-term financing and investment activities have influenced overall financial movement, providing a broader perspective beyond just operational working capital changes.

Step 4. Calculating Funds from Operations

Funds from operations represent the internal source of funds generated through business activities. To calculate this, the net profit from the income statement is adjusted for non-cash expenses like depreciation, amortization, and provisions, as well as non-operating incomes such as profit from asset sales. The adjusted figure reflects the actual cash flow generated from operations. This step ensures that only operating performance, free from accounting adjustments, is considered in the fund flow statement for accuracy.

Step 5. Determining Sources of Funds

After calculating operational funds, the next step is to list all sources of funds. These may include issuance of shares, raising long-term loans, sale of fixed assets, or internal accruals. Identifying sources is important because it reveals how the organization has financed its activities. By analyzing these sources, management can evaluate whether the company relies more on internal generation or external borrowing, which directly impacts long-term financial stability and strategic planning decisions.

Step 6. Determining Applications of Funds

Once sources are identified, the next step is to determine how those funds have been applied. Applications may include purchasing fixed assets, repaying loans, paying dividends, or increasing working capital. This step ensures that every inflow of funds is matched with a corresponding outflow. By listing applications, the statement highlights whether funds are used for growth, debt reduction, or operational needs. This analysis helps managers assess the efficiency and appropriateness of fund utilization within the business.

Step 7. Preparing the Fund Flow Statement

At this stage, the actual fund flow statement is prepared in a tabular format, clearly showing sources of funds on one side and applications of funds on the other. The statement also reconciles changes in working capital, ensuring that the net increase or decrease is fully explained. This structured presentation provides clarity on how funds have moved within the organization. It serves as a comprehensive financial summary that can be used by management, investors, and creditors.

Step 8. Analyzing and Interpreting Results

The final step is analyzing and interpreting the fund flow statement to draw meaningful conclusions. Managers examine whether funds were raised from internal or external sources and whether they were applied effectively. For example, heavy reliance on loans may signal financial risk, while investment in fixed assets may indicate expansion. This interpretation supports decision-making regarding future financing, cost control, and investment strategies. Without this step, the statement remains only a record rather than a decision-making tool.

Importance of Fund Flow Statement in Business Decision-Making:

  • Evaluates Financial Health

A fund flow statement highlights the changes in financial position by showing sources and applications of funds. It helps in understanding whether funds are being generated from operations or borrowed from external sources. This evaluation provides a clear picture of the organization’s financial health. Business leaders use this information to assess liquidity, solvency, and financial strength. By examining how funds flow, managers can determine the long-term sustainability of operations and make strategic decisions for future growth.

  • Assists in Working Capital Management

Effective working capital management is essential for ensuring smooth day-to-day operations. The fund flow statement provides insights into how working capital is increasing or decreasing and the reasons behind such changes. Managers can use this information to avoid liquidity crises, maintain an adequate cash balance, and manage current assets and liabilities effectively. This helps businesses balance short-term obligations with available resources, reducing financial stress and improving operational efficiency, which is vital for sustaining market competitiveness.

  • Supports Investment Decisions

The fund flow statement helps businesses identify whether funds have been effectively utilized in long-term investments, such as purchasing fixed assets or expanding capacity. By analyzing applications of funds, managers can determine whether investments are productive and aligned with business goals. It also highlights the availability of surplus funds that can be reinvested for future growth. This clarity ensures that decisions regarding expansion, modernization, or diversification are based on reliable financial insights, reducing investment risks significantly.

  • Guides Financing Decisions

Financing is a critical area in business decision-making. A fund flow statement shows the extent to which a company depends on external borrowings or internal accruals. It highlights how funds are raised through equity, debentures, or loans. This helps management decide on the most suitable financing mix. Understanding reliance on debt versus equity enables businesses to control financial risk, reduce interest costs, and maintain an optimal capital structure, ensuring long-term financial stability and investor confidence.

  • Measures Operational Efficiency

By analyzing funds generated from operations, the fund flow statement reflects the efficiency of the core business activities. If a company consistently generates positive funds from operations, it signals strong performance. On the other hand, negative funds may indicate inefficiencies or over-dependence on external financing. This measure allows managers to evaluate profitability beyond accounting profits by focusing on actual cash flows. Thus, it plays an important role in monitoring operational efficiency and improving performance strategies.

  • Aids in Strategic Planning

The fund flow statement provides a comprehensive overview of financial movements, making it a powerful tool for long-term strategic planning. Managers can use the insights to decide on future investments, debt restructuring, or cost-cutting measures. For example, if the statement shows excessive funds spent on debt repayments, strategies can be made to strengthen internal cash generation. By aligning fund flows with business objectives, management ensures that strategic plans are realistic, sustainable, and financially feasible.

  • Enhances Stakeholder Confidence

Investors, creditors, and financial institutions rely on fund flow statements to evaluate the company’s financial management practices. A well-prepared fund flow statement demonstrates transparency in fund utilization and effective financial control. This enhances the confidence of stakeholders, encouraging them to invest or extend credit. It assures them that funds are not misused but allocated to productive areas. Building such trust strengthens business relationships and supports long-term growth by securing financial support when needed.

  • Identifies Financial Risks

The fund flow statement is valuable in identifying potential financial risks, such as excessive reliance on borrowings or inefficient use of funds. By analyzing mismatches between sources and applications, management can detect early warning signs of financial distress. This allows corrective measures to be taken before issues escalate into crises. For example, if funds are being used primarily for debt repayment instead of expansion, it may signal liquidity problems. Early identification ensures timely and effective risk management.

Fund Flow Statement vs Cash Flow Statement

Aspect Fund Flow Statement Cash Flow Statement
Focus Working Capital Cash & Equivalents
Basis Accrual Cash
Period Long-term Short-term
Objective Financial Position Liquidity
Time Horizon Years Months/Year
Coverage All Funds Only Cash
Nature Analytical Realistic
Usefulness Planning Control
Preparation Non-standard Standard (AS-3/IAS-7)
Data Source Balance Sheet Cash Records
Key Output Fund Changes Cash Movements
Reporting Style Broad Specific
User Orientation Investors/Management Management/Creditors
Management Notes

Meaning and Concept of Fund, Funding, Reasons, Types

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A fund is a pool of money set aside for a specific purpose, often managed by individuals, institutions, or governments. Funds are used to finance projects, investments, or operations, such as retirement funds, mutual funds, or emergency funds. In business, funds can be internally generated from profits or externally raised through investors. Funds are typically tracked and managed carefully to ensure they serve their intended purpose. Whether for personal savings, charitable causes, or business ventures, a fund provides structured financial resources to support ongoing or future needs, helping ensure stability, planning, and financial control.

Funding

Funding refers to the act of providing financial resources to support a business, project, or cause. It can come from various sources such as personal savings, loans, investors, crowdfunding, or government grants. In startups and entrepreneurship, funding is crucial for product development, marketing, hiring, and scaling operations. There are different stages of funding like seed, venture capital, and series funding. The type and amount of funding depend on business needs and growth objectives. Effective funding ensures a project’s financial health, enabling innovation and expansion while often involving ownership or repayment agreements with fund providers.

Reasons of Funding:

  • Startup Capital

Funding launches a business by covering initial costs like product development, licenses, and early hires. Without capital, ideas remain unrealized. Investors (angels, VCs) provide this runway in exchange for equity or future returns.

  • Scaling Operations

Expanding to new markets, hiring talent, or boosting production requires significant capital. Funding fuels growth beyond bootstrapping limits, helping businesses capture market share before competitors.

  • Research & Development (R&D)

Innovation demands investment in tech, prototypes, and testing. Funding accelerates R&D cycles, enabling breakthroughs (e.g., AI tools, pharmaceuticals) that secure a competitive edge.

  • Marketing and Customer Acquisition

Brand awareness and lead generation require budgets for ads, SEO, and sales teams. Funding ensures campaigns reach critical mass to drive sustainable revenue.

  • Survival in Crisis

Economic downturns, cash flow gaps, or unexpected setbacks (e.g., pandemic disruptions) threaten survival. Emergency funding (loans, grants) stabilizes operations.

  • Debt Refinancing

Businesses secure funding to repay high-interest loans, reducing financial strain and improving credit health for future growth.

  • Strategic Acquisitions

Funding enables purchasing competitors, patents, or complementary businesses to consolidate market power and diversify offerings.

Types of Funding:

  • Bootstrapping (Self-Funding)

Bootstrapping means funding a business using personal savings or revenue generated by the company. It’s common in the early stages when external investors are not yet involved. Entrepreneurs retain full ownership and control, avoiding debt or equity dilution. Though it limits initial capital, bootstrapping encourages careful spending and lean operations. It’s ideal for startups with low overhead and scalable models. However, the risk is high as the founder bears all financial burdens. Success depends on disciplined budgeting and reinvesting profits to grow steadily without relying on outside help.

  • Crowdfunding

Crowdfunding involves raising small amounts of money from a large number of people, typically via online platforms like Kickstarter or Indiegogo. Entrepreneurs present their idea to the public, who fund it in exchange for rewards, early access, or equity. This method validates market demand while generating capital. It suits creative products or innovative startups looking to build a community. However, success depends on marketing appeal and transparency. Failure to meet targets or fulfill promises may damage reputation. Crowdfunding also requires detailed planning, engaging presentations, and often, a pre-existing audience to attract contributions.

  • Angel Investment

Angel investors are wealthy individuals who provide capital to early-stage startups in exchange for equity or convertible debt. They often bring mentorship, industry experience, and networking opportunities. Angel funding typically bridges the gap between self-funding and venture capital, offering both financial support and strategic guidance. It’s beneficial for startups with growth potential but limited access to institutional funding. However, it involves giving up a portion of ownership and may lead to differences in vision. Angel investors are more risk-tolerant than banks and usually invest in ideas they believe in personally or professionally.

  • Venture Capital

Venture Capital (VC) funding is provided by investment firms to high-potential startups in exchange for equity. VCs usually invest during the growth stage, expecting significant returns as the business scales. They offer large capital, mentorship, and market connections. However, startups must demonstrate scalability and a strong business model. VC funding comes in multiple rounds (Series A, B, C, etc.), and founders often give up substantial control. The goal of VC firms is eventual exit through IPO or acquisition. While risky, it is one of the most aggressive and fast-paced funding methods.

  • Bank Loans

Bank loans are a traditional funding method where businesses borrow money from financial institutions and repay it with interest over time. It’s a non-dilutive source, meaning owners retain full equity. Banks evaluate credit history, collateral, and business plans before approval. Bank loans are suitable for stable businesses with predictable cash flow and assets to secure the loan. However, they come with rigid repayment schedules and interest obligations. Startups may find it difficult to qualify without strong financial records. Nonetheless, loans offer a structured and regulated financing option for businesses seeking long-term capital.

Management Notes

Differences between Cash Flow Statement and Fund Flow Statement

indiafreenotesby indiafreenotes2

A cash flow statement shows the inflows and outflows of cash and cash equivalents. Cash includes cash in hand and demand deposits with the banks while cash equivalents are highly liquid investments i.e., they can be readily converted into cash like marketable securities, commercial papers, and short-term government bonds. It explains the changes in the cash in hand and cash at bank at the beginning and the end of the accounting period.

Accounting standard 3 deals with the cash flow statement. It has been classified into three broad categories:

  • Operating Activities: Representing movements of money due to regular business operations like the purchase, sale, production, etc. of goods.
  • Investing Activities: Representing the movement of cash due to the purchase or sale of assets or any other investment activities of the business.
  • Financing Activities: Accounts for the funds raised through the issue of shares or debentures, long term loans, etc. and utilised for the redemption of shares or debentures and payment of dividend, etc.

There are two methods of preparation of a Cash Flow Statement, they are:

  • Direct Method
  • Indirect Method

Fund Flow Statement

Funds refer to the working capital of the company, so fund flow statement is a statement that studies the changes in the working capital of the business between two accounting years. It shows the additions in the working capital through various sources like issuing shares, debentures or raising loans, etc. and reduction in it through different applications like the redemption of shares or debentures, repayment of loans, purchase of fixed assets, etc.

Fund Flow Statement explain the reasons for the change in the working capital of the business between two Balance Sheet dates through various Non-Current Assets and Non-Current Liabilities, which are responsible for the increase or decrease in the working capital. A fund flow statement displays the financial status of an organisation, which ensures easy comparison and analysis between two accounting periods. It clarifies the variability in the assets, liabilities and equity of the company.

It is prepared based on cash and cash equivalents. It is prepared based on fund as working capital.
Cash from operation is calculated. Funds from operation is calculated.
Statement of changes in working capital is not prepared. Statement of changes in working capital is prepared.
It is started with cash flows from operating activities. It is started with funds from operation or funds lost in operation.
It is ended with closing cash in hand and cash equivalents. It is ended with either increase in working capital or decrease in working capital.
The reasons for the change in cash are known through cash flow statement. The reasons for the change in working capital are known through fund flow statement.
Short term financial pIanning is done through cash flow statement. Medium term and long term financial planning is done through funds flow statement.
Cash flow analysis is based on cash concept. Funds flow analysis is based on accrual concept.
It is used for preparing cash budgeting. It is used for preparing capital budgeting.
It shows only changes in cash position. It is concerned with the changes in working capital between two balance sheet dates.
It is worked as an indicator of improved working capital. It is not necessary that an improved fund position will be an indicator of improved and sound cash position.
Increase in current liability or decrease in current assets brings decrease in working capital and vice versa. Increase in current liability or decrease in current asset brings increase in cash and vice versa.

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