Funds Flow Statement

A Funds Flow Statement is a financial report that shows the sources and uses of funds in a business over a specific period. It helps in understanding the movement of working capital within the organization. Unlike the Profit and Loss Account, which focuses on profitability, the Funds Flow Statement focuses on the changes in the financial position of a business. It bridges the gap between two balance sheets, explaining how the company's financial health has changed.

Purpose and Importance of Funds Flow Statement

The primary purpose of a Funds Flow Statement is to analyze the changes in a company's financial position. It helps management, investors, and creditors to understand:

• Where the company obtained its funds from (sources).
• How the company utilized these funds (uses).
• The reasons for changes in working capital.
• The company's ability to generate funds from its operations.
• The impact of financing and investing activities on the company's liquidity.

This statement is crucial for financial planning, decision-making, and assessing the long-term solvency and liquidity of a business.

Components of Funds Flow Statement

The statement is broadly divided into two main parts:

1. Sources of Funds: These are the inflows of funds into the business. They can arise from operations, sale of assets, issue of shares or debentures, long-term borrowings, etc.
2. Uses of Funds: These are the outflows of funds from the business. They include payment of dividends, purchase of assets, repayment of loans, redemption of preference shares, etc.

The difference between the total sources and total uses of funds represents the net increase or decrease in working capital.

Preparation of Funds Flow Statement

The preparation involves several steps:

1. Adjusted Profit and Loss Account: This step involves adjusting the net profit or loss by adding back non-cash expenses (like depreciation, amortization) and subtracting non-operating incomes (like profit on sale of assets). This gives the fund generated from operations.
2. Analysis of Balance Sheet Changes: Changes in all balance sheet items (assets and liabilities) between two consecutive periods are analyzed.
• Increases in Liabilities or Decreases in Assets: Generally represent sources of funds.
• Decreases in Liabilities or Increases in Assets: Generally represent uses of funds.
3. Identification of Sources and Uses: Based on the adjusted P&L and balance sheet analysis, all sources and uses of funds are listed.
4. Preparation of the Statement: A statement is prepared listing all sources of funds on one side and all uses of funds on the other. The total of both sides must be equal.

Fund from Operations (FFO)

Fund from Operations is a key component representing the cash generated from the normal business activities. It is calculated by adjusting the net profit/loss for non-cash and non-operating items.
Formula:

Net Profit before Extraordinary Items
+ Non-cash expenses (Depreciation, Amortization, Bad Debts Written Off, Preliminary Expenses Written Off, Discount on Issue of Shares/Debentures Written Off)
- Non-operating incomes (Profit on Sale of Assets, Interest Received, Rent Received, Dividend Received)
= Fund from Operations

Working Capital

Working Capital is the difference between current assets and current liabilities.
Formula:

Working Capital = Current Assets - Current Liabilities

Changes in working capital are a significant part of the funds flow statement. An increase in working capital is a use of funds, while a decrease in working capital is a source of funds.

Example Scenario for Funds Flow

Consider a company with the following:

• Net Profit: $1,00,000
• Depreciation: $20,000
• Profit on Sale of Machinery: $15,000
• Issued new shares: $50,000
• Purchased new machinery: $70,000
• Repaid a loan: $30,000

Fund from Operations: $1,00,000 + $20,000 - $15,000 = $1,05,000
Total Sources: FFO ($1,05,000) + Issue of Shares ($50,000) = $1,55,000
Total Uses: Purchase of Machinery ($70,000) + Repayment of Loan ($30,000) = $1,00,000
The difference of $55,000 ($1,55,000 - $1,00,000) would represent the net increase in working capital.

Cash Flow Statement as per AS 3

A Cash Flow Statement, as per Accounting Standard (AS) 3 (Revised), reports the cash generated and used by an entity during a period. It classifies cash flows into three main activities: Operating Activities, Investing Activities, and Financing Activities. This statement provides more detail than the Funds Flow Statement by focusing specifically on cash and cash equivalents.

Objectives of Cash Flow Statement

The primary objectives are to:

• Provide information about the historical changes in cash and cash equivalents.
• Help users assess the entity's ability to generate cash and cash equivalents.
• Help users assess the need of the entity to use those cash flows.
• Evaluate the timing and certainty of future cash flows.

It is a crucial tool for liquidity and solvency analysis.

Components of Cash Flow Statement

Cash flows are classified into three categories:

1. Cash Flow from Operating Activities: This includes cash generated from the primary revenue-generating activities of the enterprise. It is generally derived from the transactions and other events that enter into the determination of net profit or loss.
2. Cash Flow from Investing Activities: This comprises the purchase and sale of long-term assets and other investments not included in cash equivalents. Examples include the purchase/sale of property, plant, and equipment, and investments in securities of other entities.
3. Cash Flow from Financing Activities: This relates to transactions that result in changes in the size and composition of the equity capital and borrowings of the enterprise. Examples include issuing shares, repurchasing shares, paying dividends, and obtaining/repaying loans.

Methods for Preparing Cash Flow from Operating Activities

AS 3 permits two methods for reporting cash flows from operating activities:

1. Direct Method: This method discloses major classes of gross cash receipts and gross cash payments. For example, cash received from customers, cash paid to suppliers, cash paid to employees, cash paid for operating expenses, etc. While more informative, it is less commonly used due to the difficulty in obtaining the required data.
2. Indirect Method: This method starts with net profit or loss for the period and adjusts it for the effects of transactions of a non-cash nature, deferrals or accruals, and items relating to investing or financing activities. This is the more common method.

Preparation of Cash Flow Statement (Indirect Method)

Steps involved:

1. Cash Flow from Operating Activities:
   • Start with Net Profit before Tax.
   • Add back non-cash expenses (Depreciation, Amortization, Impairment losses).
   • Subtract non-cash incomes (Profit on Sale of Assets).
   • Adjust for changes in Current Assets and Current Liabilities.
     • Increase in Current Assets (e.g., Debtors, Inventory) is a subtraction.
     • Decrease in Current Assets is an addition.
     • Increase in Current Liabilities (e.g., Creditors, Bills Payable) is an addition.
     • Decrease in Current Liabilities is a subtraction.
   • Add/Subtract items related to extraordinary items.
   • Subtract taxes paid.
2. Cash Flow from Investing Activities:
   • Record cash inflows from sale of fixed assets, sale of investments, interest received, dividends received.
   • Record cash outflows for purchase of fixed assets, purchase of investments.
3. Cash Flow from Financing Activities:
   • Record cash inflows from issue of shares/debentures, long-term borrowings.
   • Record cash outflows for redemption of shares/debentures, repayment of loans, payment of dividends, buyback of shares.
4. Reconciliation: Calculate the net increase or decrease in cash and cash equivalents by summing up the cash flows from the three activities. Add this to the opening balance of cash and cash equivalents to arrive at the closing balance. This closing balance should match the cash and bank balances shown in the current balance sheet.

Key Differences: Funds Flow vs. Cash Flow

While both statements analyze financial changes, they differ significantly:

Feature	Funds Flow Statement	Cash Flow Statement
Scope	Deals with all changes in financial position, including non-cash items like depreciation, issue of shares for purchase of assets. Focuses on 'funds' (often interpreted as working capital).	Deals only with cash and cash equivalents. Excludes non-cash transactions.
Basis	Accrual basis, but focuses on changes in working capital.	Cash basis.
Standard	No specific standard, though principles are similar to AS 3.	Prepared as per AS 3 (Revised).
Operating Activities	Calculates 'Fund from Operations' by adjusting net profit for non-cash and non-operating items.	Starts with net profit and adjusts for non-cash items and changes in working capital.
Focus	Long-term financial health and liquidity.	Short-term liquidity and cash generation ability.

Example Scenario for Cash Flow (Indirect Method)

Assume: Net Profit before Tax = $1,20,000. Other data: Depreciation = $30,000, Gain on Sale of Asset = $10,000, Increase in Debtors = $20,000, Increase in Creditors = $15,000, Purchase of Asset = $50,000, Issue of Shares = $40,000, Tax Paid = $25,000.

Operating Activities:
Net Profit before Tax: $1,20,000
+ Depreciation: $30,000
- Gain on Sale of Asset: $10,000
- Increase in Debtors: $20,000
+ Increase in Creditors: $15,000
Cash Generated from Operations: $1,35,000
- Tax Paid: $25,000
Net Cash from Operating Activities: $1,10,000

Investing Activities:
- Purchase of Asset: ($50,000)
Net Cash used in Investing Activities: ($50,000)

Financing Activities:
+ Issue of Shares: $40,000
Net Cash from Financing Activities: $40,000

Net Increase in Cash: $1,10,000 - $50,000 + $40,000 = $1,00,000
If opening cash balance was $50,000, the closing balance would be $1,50,000.

Budgets and Budgetary Control

A budget is a financial plan for a future period, outlining expected revenues and expenditures. It serves as a roadmap for an organization, helping to allocate resources effectively and achieve its objectives. Budgetary control is the process of establishing budgets, measuring actual performance against these budgets, identifying variances, and taking corrective actions to ensure that the organization's goals are met.

Purpose and Importance of Budgets

Budgets are essential for:

• Planning: They force management to think ahead and anticipate future conditions.
• Coordination: Budgets help synchronize the activities of different departments.
• Communication: They communicate management's plans and expectations throughout the organization.
• Motivation: Well-designed budgets can motivate employees to achieve targets.
• Control: They provide a benchmark against which actual performance can be measured and controlled.
• Performance Evaluation: Budgets facilitate the assessment of departmental and individual performance.

Types of Budgets

Budgets can be classified based on various criteria:

1. Based on Time Period:
   • Short-term Budgets: Typically cover a period of up to one year (e.g., annual budget).
   • Long-term Budgets: Cover periods longer than one year, often for strategic planning (e.g., 3-5 year plans).
2. Based on Function:
   • Functional Budgets: Prepared for specific departments or functions. Examples include:
     • Sales Budget: Forecasts sales volume and revenue.
     • Production Budget: Plans the quantity of goods to be produced.
     • Raw Material Budget: Details the quantity and cost of raw materials needed.
     • Labour Budget: Estimates direct labour hours and costs.
     • Overhead Budget: Plans for indirect costs (factory, administrative, selling).
     • Cash Budget: Forecasts cash inflows and outflows, crucial for liquidity management.
     • Capital Expenditure Budget: Plans for long-term investments in assets.
   • Master Budget: A comprehensive budget that integrates all functional budgets into a single, cohesive plan, including a budgeted income statement, balance sheet, and cash flow statement.
3. Based on Flexibility:
   • Fixed Budget: Prepared for a single level of activity. It does not change even if the actual activity level differs. Useful for control but can be unfair if actual activity varies significantly.
   • Flexible Budget: Prepared for different levels of activity. It adjusts budgeted costs based on the actual volume of output. More effective for control and performance evaluation when activity levels fluctuate.
4. Based on Method of Preparation:
   • Incremental Budgeting: Uses the previous period's budget or actual results as a base and adjusts for expected changes (inflation, volume changes). It's simple but can perpetuate inefficiencies.
   • Zero-Based Budgeting (ZBB): Starts from scratch (zero base) for every budget period. Each activity or expenditure must be justified. It's time-consuming but helps eliminate wasteful spending and reallocate resources effectively.

The Budgetary Control Process

This is a cyclical process:

1. Budget Preparation: Setting objectives and preparing detailed budgets for all functions.
2. Establishing Responsibilities: Assigning responsibility for budget preparation and implementation.
3. Budget Implementation: Communicating the approved budgets to all relevant managers.
4. Performance Measurement: Recording actual results achieved during the budget period.
5. Performance Comparison: Comparing actual results with budgeted figures to identify variances (differences).
6. Variance Analysis: Investigating the causes of significant variances.
7. Corrective Action: Taking appropriate actions to address unfavorable variances and leverage favorable ones.
8. Feedback and Revision: Using the insights gained to improve future budgeting and control processes.

Variance Analysis

Variance analysis is a critical part of budgetary control. It involves identifying and analyzing the differences between budgeted and actual results. Variances can be favorable (F) or unfavorable (U).

Example: Sales Variance
Budgeted Sales: $1,00,000
Actual Sales: $90,000
Variance: $10,000 Unfavorable (U)

Example: Material Cost Variance
Budgeted Material Cost: $50,000
Actual Material Cost: $55,000
Variance: $5,000 Unfavorable (U)

Understanding the causes of variances (e.g., changes in price, volume, efficiency) is crucial for effective management.

Marginal Costing and Break-Even Analysis

Marginal Costing is a costing technique where all costs are classified into fixed and variable costs. The 'marginal cost' is the cost of producing one additional unit of output. In marginal costing, only variable costs are charged against the contribution margin, while fixed costs are deducted from the total contribution to arrive at profit.

Break-Even Analysis (BEA), also known as Cost-Volume-Profit (CVP) analysis, is a technique used to determine the point at which total revenue equals total costs, resulting in zero profit. This point is called the break-even point (BEP).

Key Concepts in Marginal Costing

• Variable Costs: Costs that vary directly with the volume of production or sales (e.g., direct materials, direct labour, variable overheads).
• Fixed Costs: Costs that remain constant in total, regardless of the volume of production or sales, within a relevant range (e.g., rent, salaries, depreciation).
• Contribution Margin: The difference between sales revenue and variable costs. It represents the amount available to cover fixed costs and contribute to profit.
  Formula: Contribution = Sales Revenue - Variable Costs
• Profit: Calculated by deducting fixed costs from the total contribution margin.
  Formula: Profit = Contribution Margin - Fixed Costs

Break-Even Point (BEP)

The break-even point can be expressed in terms of units or sales revenue.

1. Break-Even Point in Units: The number of units that must be sold to cover all costs.
   Formula: BEP (Units) = Fixed Costs / Contribution Margin per Unit
2. Break-Even Point in Sales Revenue: The amount of sales revenue required to cover all costs.
   Formula: BEP (Sales) = Fixed Costs / Contribution Margin Ratio
   Where: Contribution Margin Ratio (CMR) = Contribution Margin / Sales Revenue = (Sales - Variable Costs) / Sales

Margin of Safety

The Margin of Safety (MOS) represents the difference between actual or budgeted sales and the break-even sales. It indicates the extent to which sales can decline before the company starts incurring losses. A higher margin of safety is desirable.

Formulas:

• MOS (Units) = Actual/Budgeted Sales Units - BEP (Units)
• MOS (Sales) = Actual/Budgeted Sales Revenue - BEP (Sales Revenue)
• MOS Ratio = (MOS / Actual/Budgeted Sales) * 100
• Alternatively, MOS Ratio = Profit / Contribution Margin Ratio

Applications of Break-Even Analysis

BEA is a powerful tool for management decision-making:

• Pricing Decisions: Helps in setting prices by understanding the impact on the BEP and profitability.
• Make or Buy Decisions: Used to compare the costs of manufacturing a component internally versus purchasing it from an external supplier.
• Product Mix Decisions: Analyzing the BEP for different products to determine the optimal sales mix.
• Fixed vs. Variable Cost Decisions: Evaluating the trade-offs between investing in fixed assets (higher fixed costs, lower variable costs) versus variable cost structures.
• Profit Planning: Forecasting profits at different sales volumes and setting sales targets to achieve desired profit levels.

Example Scenario for Marginal Costing and BEP

A company provides the following data:

• Selling Price per unit: $50
• Variable Cost per unit: $30
• Total Fixed Costs: $2,00,000
• Current Sales Volume: 15,000 units

Calculations:

• Contribution Margin per Unit = Selling Price - Variable Cost = $50 - $30 = $20
• Contribution Margin Ratio (CMR) = $20 / $50 = 0.4 or 40%
• Fixed Costs = $2,00,000
• BEP (Units) = Fixed Costs / Contribution Margin per Unit = $2,00,000 / $20 = 10,000 units
• BEP (Sales Revenue) = Fixed Costs / CMR = $2,00,000 / 0.4 = $5,00,000
• Current Profit:
  • Total Contribution = Contribution per Unit * Actual Sales Units = $20 * 15,000 = $3,00,000
  • Profit = Total Contribution - Fixed Costs = $3,00,000 - $2,00,000 = $1,00,000
• Margin of Safety:
  • MOS (Units) = Actual Sales Units - BEP (Units) = 15,000 - 10,000 = 5,000 units
  • MOS (Sales) = Actual Sales Revenue - BEP (Sales Revenue) = ($50 * 15,000) - $5,00,000 = $7,50,000 - $5,00,000 = $2,50,000
  • MOS Ratio = ($2,50,000 / $7,50,000) * 100 = 33.33%