FUNDS FLOW ANALYSIS

Funds flow analysis is a technique of financial analysis used to study

the resources deployment of business. This technique is based on the
concept of business operation as a series of resource deployment for profit,
based on management decisions. The business operation of any industrial or
business unit consists of -

(a) Investment of resources

(b) Financing to provide these resources and
(c) Operation of the business with the help of these resources with
the objective of profit.

As is known, the balance-sheet presents a snap-shot picture of

the financial position at a given point of time and the income statement
shows a summary of revenues and expenses during the accounting period.
The funds flow statement also referred to as a 'statement of changes in
financial position or the statement of sources or uses of funds', drawing on
the information contained in the basic financial statements shows the sources
and application of funds during the period. The funds flow analysis provides
insight into the movement of funds and helps in understanding the changes
in the structure of assets, liabilities and owners' equity.

Funds flow analysis presents a decisional view of the business

and helps in answering questions like:

 Have capital investments been supported by long-term financing?

 How much funds have been generated from the operations of the
business?

 How much has the firm relied on external source of financing?

 What major commitment of funds have been made during the year?

 Has the liquidity position of the fund improved?

What are funds

Very broadly, funds are defined as total resources. However,

most commonly funds are defined as working cpaital or cash. The word
"Working Capital" here refers to net working capital (NWC) which is defined
as current assets minus current liabilities. As such funds flow statement can
be prepared on the basis of these three measures: total resources, working
capital and cash.
Funds Flow Statement - Total Resources Basis

The preparation of the funds flow statement on total resources

basis is fairly simple. The successive balance-sheets are compared and
changes in each of the balance sheet items are noted and classified as
sources of funds or as use of funds as follows :

Sources Uses

Increase in owners' equity Decrease in owners' equity

Increase in a liability Decrease in a liability
Decrease in an asset Increase in an asset

Funds flow statement on total resource basis is prepared in two

parts - Part A shows the changes under various balance-sheet items and Part
B classifies these changes into sources of funds and uses of funds. It may be
noted that when funds are defined as total resources, the sources of funds
are equal to the use of funds due to the double entry principle of book
keeping. It may also be appreciated that under the total resources method,
only the successive balance sheets are used and the income statement/Profit
and Loss Account are not put to use.

Amplified Funds Flow Statement

The statement of source and uses of funds may be amplified,

drawing on the information contained in income statement. The amplification
consists of providing details underlying changes in (i) reserves and surplus
and (ii) net fixed assets. This is dones as follows:

i) Changes in reserves and surplus is essentially out of retained

earnings and is shown as:
- Profit before tax and interest
- Interest
- Taxes
- Dividends

Now, profit before tax and interest is shown as a source of funds

while taxes, interest and dividends are shown as uses of funds.

A change in net fixed assets is analysed as the net fixed assets

balance at the end of 1995 + depreciation = gross fixed assets at the end of
1995. This when compared to net fixed assets balance at the end of 1994 will
give us the figure of actual increase in the fixed assets during the year 1995.

Now the depreciation for the year is shown as a source and

increase of fixed assets is shown as use of funds.
Funds Flow Statement - Working Capital Basis

The funds flow statement, on a working capital basis presents

i) sources of working capital, ii) uses of working capital, and iii) the net
change in working capital (working capital is defined here as current assets
minus current liabilities).

What are the sources and uses of working capital ?

These can be depicted as under :

Sources Uses
Operations Dividend Payment
Tax, Interest
Issue of share capital Repayment of long-term borrowings
Long term borrowings Purchase of non-current assets
Sale of non-current assets

Sources of Working Capital

1. Operations

The operations of the business generate revenues and entail expenses.

While revenues augment working capital, expenses other than depreciation
and other amortizations decrease working capital. Hence the working capital
increase on account of operations is equivalent to :

Net Income + Depreciation

2. Issue of Share Capital

An issue of share capital results in an inflow of working capital
because it brings a cash inflow.

3. Long-term Borrowings

When a long-term loan is taken, there is an increase in working capital

because of cash inflow. The short-term loan, however, does not have any
effect on working capital. The reason being a short-term loan increases a
current asset (cash) and a current liability (short-term loan) by the same
amount, leaving the working capital position unchanged.

4. Sale of Non-Current Assets

 When a fixed asset or a long-term investment or any other long-term
asset is sold, there is a working capital inflow represented by cash or short-
term receivables.

5. Uses of Working Capital

i) Payment of taxes, dividend, interest etc.

These transactions result in cash (working capital) outflow.

ii) Repayment of long-term liability

The repayment of long-term loans, debentures and other long-term
liabilities involves cash outflows and hence a use of working capital. The
repayment of a current liability, it may be noted does not affect the working
capital position because it entails an equal reduction in current liabilities and
current assets.
iii) Purchase of Non-Current Assets
When a firm purchases fixed assets, long-term investments or other
non-curent assets' it pays cash or incurs a short-term debt. Hence, working
capital decreases.

Funds Flow Statement : Cash Base

Funds flow statement on cash basis shows (i) sources of cash, (ii) uses
of cash and (iii) net change in cash. The sources of cash are the sources of
working capital plus changes within the working capital account which
augment the cash resources of the business. The changes in working capital
that augment the cash flow of the business are accounted for by decrease in
current assets other than cash. The use of cash is 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
increase in current assets other than cash. The sources and uses of cash are
illustrated below:

Sources of Cash

- Operations
Net Income
Depreciation
- Issue of Share Capital
- Long-term Borrowings
- Sale of non-current asset
- Increases in current liabilities
- Decreases in current assets other than cash

Uses of Cash

- Payment of dividend
- Purchase of non-current assets
 - Repayment of long-term borrowings
- Decreases in current liabilities
- Increases in current assets other than cash.

The net effect of the movement of funds is easily discernible in

each of the three methods under which funds flow statements have been
prepared. The funds flow system in a business is often likened to a hydraulic
system. The concept of flow implies an inflow, an outflow and a storage
where the level is determined by the rate of inflow and outflow.

To summarise, the funds flow statement is very closely related

to the financial statements, the balance-sheets and profit and loss accounts.
Secondly, the funds flow statement is related to a time span say one year or
six months as the case may be. Thirdly, the funds flow analysis is very
closely related to the normal decision making process in the business -
decisions relating to investment, operations and finance as stated at para 1
above.

Projected Funds Flow Statement

A funds flow statement can be prepared either on the basis of past

data or for a future period of time provided the time span is specified. All the
questions to which answers are sought on the basis of past data can also be
answered for future period of time provided the projections are based on
realistic assumptions. In fact, projected funds flow statement is of great
practical relevance to bankers as some of the important questions pertaining
to the financial position, profitability and servicing of working capital/term
loans etc. extended by banks can be answered with a fair degree of
reliability. This to a great extent relieves the banker of his anxiety as to
whether a credit decision to be taken at present is worth while from a
commercial point of view.

As bankers, funds flow analysis is used mainly to find answers to:

(a) How the long term and short term resources will be raised and used?
(b) When and how much finance the unit would require?
(c) When and how the business will repay the loan/s?
(d) Are the financial policies followed by the unit proper and financial
planning acceptable?
(e) What is the dividend policy of the company?
(f) What is the contribution of funds provided by internal sources to the
growth of business?
(In the past and in future)

A funds flow statement as a third financial statement in addition to the

balance-sheet and profit and loss account has a distinct role to play in
evaluating the use of resources and the pattern of financing them.
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