Funds flow in a business

The balance sheet and income statement are traditional basic finance statements. These statements have serious limitations. As such these do not provide any information the changes in the financial position of a firm.

For example, by observing two consecutive balance sheets we may observe that there is a rise of investment in plant and machinery but we cannot determine from these two consecutive balance sheets the source of investment that financed these assets, as either from long term sources or from short term sources. Similarly, for many questions like working capital position funds generated from operations etc., these traditional statements fail to answer.

The statement of changes in financial position or the funds flow statement is one which summarizes the sources from which the funds have been obtained and the uses to which they have been applied. The term funds can be defined as either total funds or cash or working capital. So the changes in financial position can be based on (1) Total resource basis (2) Working capital (3) Cash. Funds Flow Statements are prepared based on the finance statements for two successive or more periods.

Funds Flow statement – Total Resources Basis:

The preparation of the funds flow statements on total resources basis involves comparison of the successive balance sheets and changes in each balance sheet item is noted and classified as a source of fund or a use of fund.

For example, equity capital, increase in equity capital between two successive balance sheets implies there is an inflow of capital which is a source. If a company involves in purchasing of machinery (increase in fixed assets) then there will be outflow of capital this is classified as uses of funds. Accordingly various sources and uses of funds on total resource basis is shown in the table below.

Sources and Uses of Funds on Total Resource Basis:

1. Operations
Profit after tax
Depreciation, Good will written off, amortization and other non-cash expenses
2. Increase in equity capital
3. Decrease in assets
4. Increase in liabilities.

1. Decrease in owners’ equity
2. Increase in assets
3. Decrease in liabilities.

Non Cash Expenses: These are the expenses incurred but do not involve outflow of cash.

Funds Flow statement – Working Capital Basis

The funds flow statement, on working capital basis, presents (1) the source of working capital. (2) The use of working capital (3) the net change in working capital. Various sources and uses of working capital shown in the table below

Net change in working capital = Uses of working capital – Sources of working capital

Sources and Uses of Funds on working Capital Basis:

1. Funds from operations
2. sales of non-current assets
3. Long term financing
(i) Long term borrowings (loans/bonds etc)
(ii) Issuance of equity and preference shares.

1. Purchase of non-current assets
2. Repayment of long term and short term debt
3. Payment of cash dividends

Funds Flow Statement – cash Basis

The funds flow statement, on cash basis, shows (1) the sources of cash (2) the uses of cash (3) the net change in cash. The sources of cash are the sources of working capital plus changes within the working capital account which augments the cash resources of the business. The uses of cash again are the changes which use working capital plus changes within the working capital account which deplete the cash resources of the business. These latter changes are simply the increase in current assets other than cash. The sources and uses of cash are shown below. Net change in cash = Sources of cash – Uses of cash.

Sources and Uses of Funds on cash Basis:

1. Profits from operations
2. Decrease in any asset (other from cash)
3. Increase in liabilities
4. Issue of shares

1. Loss from operation
2. Increase in any asset (other from cash)
3. Decrease in liability
4. Payment of cash dividends

The main difference between the working capital basis and the cash basis is that, working capital basis treats increase in inventories and accounts receivable as equivalent to increase in cash. But in statement on cash basis it summarizes only the cash inflows and outflows over a period of time and as the cash from inventory is realized after a period, inventory is not treated as a source of cash. So, you can understand the difference of meaning of fund in working capital basis and in cash basis.