The financial manager makes decisions to ensure that the firm has sufficient funds to meet financial obligations when they are due and to take advantage of investment opportunities. To help the analyst appraise these decisions (made over a period of time), we need to study the firm’s flow of funds. By arranging a company’s flow of funds in a systematic fashion, the analyst can better determine whether the decision made for the firm resulted in a reasonable flow of funds or in questionable flows, which warrant further inspection.

The first definition that comes to mind is that funds are cash (and cash equivalents). So defined, we should be concerned with transactions that affect the cash accounts. These transaction affecting inflows and outflows of cash, are extremely important (and, in fact, help to explain the prominence afforded the statement of cash flows) But, defining funds as cash is somewhat limiting. A flow of funds analysis in which funds are defined strictly as cash would fail to consider transactions that did not directly affect “cash� and these transactions could be critical to a complete evaluation of a business. Major end-of-period purchases and sales on credit, the acquisition of property in exchange for stock or bonds and the exchange of one piece of property for another are just a few examples of transactions that would not be reported on a totally cash-based flow of funds statement. Broadening our conception of funds to include all of the firm’s investments and claims (against those investments) allows us to capture all of these transactions as both sources and uses of funds.

Accepting “investment and claims� as our definition of funds, we turn our attention to the firm’s balance sheet. The balance sheet is a statement of financial position (or “funds position�). On it we have arrayed all of the firm’s investment (assets) and claims (liabilities and shareholders’ equity) against these investments by creditors and by the owners. The firm’s flow of funds is therefore comprised of the individual changes in balance sheet items between two points in time. These points conform to beginning and ending balance sheet dates for whatever period of examination is relevant—a quarter, a year, or five year. The differences in the individual balance sheet account items represent the various “net� funds flows resulting from decisions made by management during the period.

Balance sheet = Stock of funds

Changes in Balance sheet items = “Net� Flows of Funds

We must emphasize that the flow of funds statement portrays net rather than gross changes between two comparable balance sheets at different dates. For examples, gross changes might be though to include all changes that occur between two statement dates, rather than the sum of these changes—the net change as defined. Although an analysis of the gross funds flow of a firm over time would be much more revealing than an analysis of net funds flow, we are usually constrained by the financial information available, namely, the basic financial statements. Though generally taking a broad view of funds, resulting funds statements will often focus on the firm’s change in cash position over a period of time or its change in net working capital (current assets minus current liabilities).

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