Financial Statements, by themselves, do not provide information regarding changes in the firm’s financial position during a particular period of time. They do not indicate the causes of changes or the movement of finances between two periods.
A firm basically generates funds / cash and uses / spends cash. The firm uses funds / cash when it redeems securities, pays interest and dividends, purchases materials, acquires asset etc. The activities that generate funds / cash are called sources of funds / cash and the activities that absorb funds / cash are called uses of funds / cash. A firm generates funds / cash when it increases its liabilities (as well as owners’ equity); on the other hand the firm uses funds / cash when it buys assets or reduces its liability (as well as owners’ equity)
| Sources of Funds / Cash | Uses of Funds / Cash |
| Increase in liabilities and Owners’ Equity) | Decrease in liabilities and decrease Owners’ Equity |
| Decrease in Assets | Increase in Assets |
This statement (also referred to as the Cash flow Statement) reports the amount of cash coming in (cash receipts) and the amount of cash going out (cash payments or disbursements) during a specified period. Business activities result in either a net cash inflow (receipts greater than payments) or a net cash outflow (payments greater than receipts) during a period. The cash flow statement shows the net increase or decrease in cash during the period and the cash balance at the end of the period. It explains the causes for the changes in the cash balance. The cash flow statement covers a span of time.
Purpose:
- To provide information about the operating, financing and investing activities of the enterprise and the effect of those activities on cash resources;
- To tell how much cash came in during the period, how much cash went out during the period and what the net cash flow was during the period.
Cash and the Accounting Equation:
Assets = Liabilities + Shareholder’s Equity and Assets = Cash + Other Assets
Therefore:
Cash + Other Assets = Liabilities + Shareholder’s Equity Cash = Liabilities + Shareholder’s Equity – Other Assets
This last equation is used to determine whether the increases or decreases in liabilities, shareholder’s equity and other assets will increase or decrease cash
- Increases in liabilities and shareholder’s equity will increase cash.
- Decreases in liabilities and shareholder’s equity will decrease cash.
- Increases in other assets will decrease cash.
- Decreases in other assets will increase cash.
A Statement is prepared to measures the changes (flows) that have taken place in the financial position of a firm between two balance sheet dates. This statement, called Statement of
Changes in Financial Position enable us to understand the changes. Basically the statement summarizes the sources from which funds (could flow) have been obtained and the uses to which they have been applied.
Inflow of funds – All the changes which result in an increase in Funds of the enterprise
Constitute sources of funds. Generally funds flow in a business
Concern from the following sources:
- The earnings of the enterprise
- Expansion in liabilities through increased use of borrowed funds or increased trade credit
- Decrease in assets such as liquidation in current assets, the sale of fixed, miscellaneous or intangible assets and earned depreciation on such assets.
- Contribution of additional funds by owners of the company
Outflow of funds – All the changes that cause decrease in total funds of the enterprises are regarded as uses of funds indicating outflow. The following items are included under the head uses of funds:
- Net Losses – When losses are incurred, funds go out of the business
- Decrease in Liabilities – When current liabilities or funds debt decrease, funds go out of the business by the amount of liabilities
- Increase in Assets – With increase in fixed assets, inventory, receivables, investment or other assets, amount of funds decrease indicating application of funds
- Decrease in capital funds – Retirement of stock bringing decrease in owner’s capital involves outflow of funds
Fund flows are ultimately related to the changes in the Working Capital through statements called ‘Statement of Changes in Working Capital’ and ‘Fund Flow Statement’ looking at the changes in the total financial resources.
Statement of Changes in Working Capital and Fund Flow Statement
Statement of Changes in Working Capital
The Net Working Capital (WC) is the difference between Current Assets (CA) and Current Liabilities (CL). Symbolically, WC = CA – CL.
From the above, the following may be deduced:
- An increase in CA causes an increase in WC, which means Funds inflow into Working Capital i.e. sources of working capital. Ex: Sale of buildings for cash
- A decrease in CA causes a decrease in WC, which means Funds outflow from Working Capital i.e. uses of working capital. Ex: Purchase of Machinery for cash
- An increase in CL causes a decrease in WC, which means Funds outflow from Working Capital i.e. uses of working capital. Ex: Purchase of furniture on credit
- A decrease in CL causes an increase in WC, which means Funds inflow into Working Capital i.e. sources of Working capital. Ex: Issue of equity shares to creditors in part settlement of their claims.
A similar increase or decrease in CA and CL does not affect WC and there is no flow of fund. Similarly, in case of increase or decrease in NCA and NCL does not affect WC and there is no flow of fund.
Change in Working Capital and Flow of funds takes place only when there is a transaction involving a Current Account (Current Asset / Current Liability) and Non-Current Account (Fixed Assets or Long-term Liabilities / Owners’ Equity).
Fund Flow Statement
Working Capital Basis
The major Sources and uses of Working Capital are listed below:
Sources of Working Capital
- Funds from Business Operations (adjusted net income)
- Sale of non-current assets (sale of long-term investments / fixed assets – tangible / intangible)
- Long-term borrowings
- Equity or Preference shares
- Short-term borrowings such bank borrowings
- Uses of Working Capital
- Losses from business operations (adjusted net loss)
- Purchase of non-current assets (purchase of long-term
- investments / fixed assets – tangible / intangible
- Repayment of long-term debts like debentures and short
- term debts like bank borrowings
- Redemption of redeemable preference shares
- Dividends to shareholders