UNIT - 3

FINANCIAL STATEMENT ANALYSIS

The term Financial analysis, also known as analysis and interpretation of financial
statements is a process of evaluating the relationship between component parts of a
financialstatement to obtain a better understanding of a firms position and performance.
According

to

Myers,

Financial

statement

analysis

is

largely

study

of

relationshipsamong the various financial factors in business as disclosed by a single set

of statementsand a study of the trend of these factors as shown in a series of
statements.
Objectives of Financial Statement Analysis
1) To ascertain the profitability and efficiency of the business operations.
2) To estimate the earning capacity of the firm.
3) To judge the short-term and long-term solvency of the company.
4) To ascertain the debt capacity of the organization.
5) To decide on the future prospects of the concern.
6) To find out the efficiency in the utilization of assets.
7) To facilitate inter-firm comparison.
8) To aid intra-firm comparison.
9) To facilitate leverage analysis.
10) To help prospective investors in their investment decision.

Steps involved in Financial Statement Analysis

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1. Determine the scope and objective for financial statement analysis

One must have clear idea about the purpose and extent of analysis that is need to be
carried out.
2. Study and comprehend the contents of financial statements
3. Collection of relevant information
Sufficient number of years of financial statements should be collected. Additional
Information or data, if needed should also be gathered.
4. Re arrange the data
The available data should be properly rearranged or regrouped. so that they can be
made suitable for analysis.
5. Analysis of collected data using analytical tools
Now one can apply appropriate tool to analyse the data. tools like Comparative
statements, common-size statements, trends, calculate ratios, etc.can be applied
6. Interpretation
The facts revealed by the analysis should be properly interpreted, taking into account
Relevant quantitative and qualitative factors.
7. Presentation in suitable form
The interpretation drawn from the analysis should be presented in a form which serves
the purpose for which the financial statements are analyzed.
Types of Financial Analysis
On the basis of Material used :
1. External Analysis: Analysis is done on the basis of published financial statements.
This type of analysis is done by outsiders like creditors,suppliers,investors and

32

government agencies who do not have access toInternal accounting records of the
company.
2. Internal Analysis: Analysis is done on the basis of internal and unpublished
records.It is done by persons like executives and other authorized officials, who have
access to internal accountingRecords of the firm is called internal analysis.
On the basis of Modus Operandi:
1. Horizontal Analysis: Here, every item in the financial statement is analyzed over a
numberof years, order to ascertain its trend. Comparative statements and Trend
percentages arethe two tools used in this type of analysis.
2. Vertical Analysis: It refers to the study of relationship between various items in a
specificyears financial statement. Common size financial statements and financial
ratios are the twotools used in this analytical mode.
Limitations of Financial Statement Analysis
1) Financial statements do not take into account qualitative factors like credit
Worthiness, quality of human resources, reputation, etc.
2) They ignore changes in price level.
3) The assumption that past happenings may get reflected in the future may not hold
good.
4) Interpretation is based on personal judgment of the analyst, which may be biased.
5) Window dressing, which is the major drawback of financial statements will have an
impact onthe analysis.
Tools and Techniques for Analysis of Financial Statements
The following are the most important tools are used for analysis,

33

1) Common size statements

2) Comparative statements
3) Trend analysis
4) Ratio analysis
5) Fund Flow analysis
6) Cash Flow analysis
7) Cost-Volume Profit Analysis

RATIO ANALYSIS
Meaning of Ratio Analysis
According to accounting parlance Ratio may be defined as a numerical relationship
between two relatedaccounting figures and is calculated by dividing one by another.
Ratio analysis is a technique used for analysis and interpretation of financial statements
It helps us to analyze and understand the financial affairs and the strength and
weakness ofa firm. Extent and quality of analysis and interpretation depends on the use
of apt type of ratio and on the talent of the caliber analyst.
Importance or Uses of Ratio Analysis

Ratio analysis Helps in understanding the general efficiency of the management.

Measures the liquidity and solvency position of firm.
Facilitates management in decision making.
Helps prospective investors in arriving at an investment decision.
Aids management to initiate corrective action.
Supplies management with inputs to aid in their forecasting and planning.
Ratio analysis Facilitates inter-firm comparison.
Ratio analysis helps in effective control over the business through the measuring
of actual performancesand comparing it with the planned performance..
34

Supplies required information to the interest parties like owners, crs, govt etc..
It brings to light financial strength and weakness of a firm.

Limitation of Ratio Analysis

Differences in the definition of ratios make their calculations and interpretation

Ambiguous.
Financialstatements form the basis for calculation of Ratios. Such statements
sufferfrom several limitations. Ratios derived from them are also suffer from

suchlimitations.
Ratios ignore Changes in price level, which render the interpretation of ratios

invalid.
It is difficult to find out a proper basis for comparison.
Ratios just provide quantitative input, and its analysis and interpretation is subject
to the personal bias and competence of the analyst.
Ratios reflect the postmortem analysis of the past affairs of the firm.and the past

need not necessarily be anindicator of the future.

Financial statements are subject to serious limitation called window-dressing.

ratios are calculated from such statements. Hence users of such ratios while

making a decision should be careful.

While preparing financial statements, different firms follow different accounting
Policies.Hence, interpretation made by comparing these ratios will not depict a
real picture.
Calculation of a single ratio may not give out the end result required and hence
one may be required to calculate several ratios. Toomany ratios can make
decision making process confusing and time consuming.

Classification and Analysis of Ratios

Ratios can be classified in several ways depending upon the purpose of analysis. It

35

Should be noted that the basic rates are same, but the way they are classified varies
withthe objective of the analysis. Generally, an organization will be analyzed for the
following:
1) Profitability: -analysis of the profit can made from point of view of amount of
sales,capital employed in the business, and the value of assets applied in business. Is
the company is earning a normal profit etc..
2) Liquidity: -test the whether the business is having enough liquid cash to meet its
payment obligation.
3) Solvency: -this measures the companies ability to meet its long term payment
obligations. Will the company have sufficient capacity to service its long-term
borrowings
4) Asset usage: -optimum utilization of assets both fixed and current, can also be found
out.
5) Capital Gearing: -this studies the proportion between the owned funds and
borrowed funds.
6) Status in the stock market :- the companys position in the stock market. The rating
of share and other securities of the firm can also be made known.
lows.
The following are the ways in which Ratios can be classified:
(A) Profitability ratios: under this category we have variety of ratios analyzing the
profit earned by a business unit after taking in to consideration items like sales,
cost of sales operating and non operating expenses etc. the following are the
various types of profitability ratios:-

36

1. Return on investment or overall profitability ratio: it measures the

sufficiency or otherwise of the profit earned in relation to capital employed.
This is calculated using the below given formula:
R.O.I= operating profit X 100
Capital employed
2. Return on Equity or equity share holders fund:This ratio gives the details
of

amount of profit available for equity share holders in relation to their

amount of investment. This is calculated using the below given formula:

R.O.E = Net profit after interest, tax and preference dividend X100
Equity share holders fund
3. Gross profit ratio : this ratio indicates the difference between sales and
direct cost it also explains the relationship between sales and gross profit
earned. This is calculated using the below given formula:
Gross profit X100
Net sales
4. Net profit ratio: this measures the managements efficiency in operating the
business successfully from owners point of view. The higher the ratio the
better it is.This is calculated using the below given formula
Net profitX 100
Net Sales
5. Operating Ratio: this ratio indicates the relationship between total operating
expenses and sales. This is calculated using the below given formula
Cost of sales + operating expenses
Net sales

37

X 100

6. Operating profit ratio : this shows the operational efficiency of the firm and
the management efficiency in carrying out the day to day operations of the
firm. Operating ratio
7. Expenses ratio: this shows the relationship between various expenses done
in connection to business and the amount of sales: This is calculated using
the below given formula:
Particular expenses X 100
Net sales
8. E.P.S or Earnings per share : it reflects the capacity of the concern to pay
dividend to equity share holders. it is helpful in determining the market price
of the equity share. This is calculated using the below given formula:
Net profit after tax and preference dividend X 100
Number of equity shares
9. Interest cover or fixed charge cover:this ratio brings to light the relationship
between profit before interest, tax and fixed interest charges. . This is
calculated using the below given formula:
Profit before interest and tax

X 100

Fixed interest charges

(B). Turn over Ratios or Activity Ratios

These ratios high light the operational efficiency of the firm. The ratios of this
category are calculated with reference to sales or cost of sales and expressed in
number of times. Following are the various types of turn over ratios:1.Inventory or Stock turnover ratio: this is calculated to ascertain the efficiency of
inventory management in terms of capital investment. it shows the relationship between
the cost of goods sold and the amount of average inventory.

38

Cost of goods sold

Average inventory
Cost of goods sold = Sales - Gross profit
Where average inventory is given by opening stock + closing stock
2
2.Stock velocity or stock turn over period:

this is related to the time taken for

rotation of stock. It refers to speed with which the raw material is converted in to finished
products and finished products in to cash or sales. This is calculated using the below
given formula:
Days or Months in a year
Stock turnover ratio
3. debtorturn over ratio : this measures the number of times the receivables are
rotated in a year in terms of sales. it also indicates the efficiency of credit collection and
credit policy of the firm. This is calculated using the below given formula:

Net credit sales

Average receivables
Average receivables = opening receivables + closing receivables
2
4. Debtor Velocity or debt collection period:this indicates the number of days taken
by the firm to collect its amount of debtors. The shorter the period the better it is. This
shows the promptness of the collection department in getting the dues from the
customers.This is calculated using the below given formula:
Days or months in a year
Debtor turnover ratio

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5. creditor turnover ratio : this indicates the number of times the payables rotate in a
year, it states the relationship between net purchases for the entire year and total
payables.This is calculated using the below given formula:
Net credit purchases
Average accounts payable
6.creditor velocity or average payment period: this ratio shows how promptly the firm
settles the dues to the creditor. The lower number of days indicates the prompt payment
schedule maintained by the firm.This is calculated using the below given formula:
Days or months in a year
Creditor turnover ratio
7.working capital turnover ratio:this measures the effective utilization of working
capital. this ratio establishes relationship between sales or cost of sales and working
capital. Working capital = current assets current liabilities. .This is calculated using the
below given formula:
Sales or cost of sales
Net working capital
8.Fixed asset turnover ratio: this determines the efficiency of utilization of fixed
assets and profitability of a business concern.the higher the ratio the more efficient the
Firm is. This is calculated using the below given formula:
.

Cost of sales
Net fixed assets

9.Capitalturn over ratio : managerial efficiency is calculated by establishing the

relationship between cost of sales or sales with the amount of capital invested in the
business. This is calculated using the below given formula
Sales or cost of sales
Capital employed
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Capital employed = shareholders funds + long term loans

( C )Solvency or financial ratios or Balance sheet ratios
These are calculated using items taken from Balance sheet. This measures the short
term and long term solvency of a firm. This is useful to bankers, creditors, investors etc.
This again can be divided in to two types. They are short term solvency ratios and long
term solvency ratios.
Short term solvency ratios:under this type we have the following ratios:
1. Current ratio:this a ratio of current assets to current liabilities. Comparison between
current assets to current liabilities is made to find out the short term solvency of the
firm. the ideal ratio is 2:1 for this we use the formula
Current assets
Current Liabilities
2. Liquid ratio :this ratio is also called as Acid test ratio or quick ratio.the ideal ratio is
1: 1. Current assets other than stock and prepaid expenses are Quick assets.
Quick assets
Current liabilities.
3. Cash position ratio: this ratio is caculated when liquidity is highly restricted in
terms of cash and cash equivalents.this ratio measures liquidity in terms of cash and
near cash items short term current liabilities.the ideal ratio is 0.75 : 1
Cash + Bank balance + marketable securities
Current liabilities
Long- term solvency ratios:

41

1. Fixed asset ratio:this ratio measures the relationship between fixed assets and
long term funds. The objective is to ascertain the proportion of long term funds
invested in fixed assets.
Fixed asset ratio =

fixed assets
Long term funds

2. Debt equity ratio: :this ratio measures the long term solvency of the firm.
External equity
Internal equity
Another formula for this ratio is given by

total long term debt

Total long term funds

3. Proprietary ratio: this ratio compares the owners funds to total tangible
assets.
Share holders funds
Total tangible assets
4. Capital gearing ratio: it analyses the capital structure of the company. thisratio
measures the relationship between fixed interest and dividend bearing funds and
equity share holders funds.
Long term loans + debentures + preference share capital
Equity share holders funds

From the following Balance sheet and Profit and loss account as on 31.12.1997
youare required to calculate the below given ratios :

1.
2.
3.
4.
5.
6.
7.
8.
9.

Current ratio
Quick ratio
Fixed asset ratio
Debt equity ratio
Proprietary ratio
Stock turn over ratio
Fixed asset turn over ratio
Return on capital employed
Debtor turn over ratio
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10. Creditor turn over ratio

11. Netprofit ratio
12. Operating ratio.

Balance sheet as on 31.12..1997

Liabilities
Issued capital:

Rs
40,00,000

Assets
Building

Rs
30,00,000

40,000 shares of Rs.100 each

Reseves
Creditors
Profit&loss a/c
6% Debentures
Total

18,00,000
26,00,000
6,00,000
6,00,000
96,00,000

Plant
Stock
Drs
Bank

16,00,000
29,69,000
14,20,000
6,20,000
96,00,000

Profit & Loss Account

Particulars
To Opening stock
To purchases
To Diorect expenses
To Gross profit C/d
To administration expenses
To selling and distribution

Rs.
19,90,000
1,09,05,000
2,85,000
68,00,000
1,99,80,000
30,00,000
6,00,000

Particulars
By sales
By closing stock

Rs.
1,70,00,000
29,80,000

By gross profit b/d

By non operating income

1,99,80,000
68,00,000
1,80,000

expenses
To financial expenses
To non-operaring expenses
To net profit

3,00,000
80,000
30,00,000
69,80,000
1. Current ratio :current assets
Current liabilities
=

50,00,000
26,00,000
= 1.92

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69,80,000

Current assets = stock + debtors + Bank = 29,60,000 + 14,20,000 + 6,20,000 =

50,00,000
Creditor = 26,00,000
2. Quick ratio = quick assets
Current liabilities
=

20,40,000
26,00,000

= 0.78
3. Fixed asset ratio =
fixed asset
Long term funds
46,00,000
70,00,0000
= 0.66
Fixed assets = building + plant = 30,00,000 + 16,00,000 = 46,00,000
Long term funds = share capital + reserves + Profit & loss a/c + debentures
= 40, 00,0,00 +18, 00,000 + 6,00,000 + 6,00,000
= 70, 00,000
4. Debt- equity ratio = long term debt
Share holders fund
= 6, 00,000
64, 00,000
= 0.094
Long term debt = debenture = 6, 00,000
Share holder fund = share capital + reserves + Profit & loss a/c
= 40, 00,0,00 +18, 00,000 + 6, 00,000
= 64, 00,000
5. Proprietary ratio = share holders fund
Total tangible assets
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= 64,00,000
96,00,000
= 0.67
6. Stock turn over ration = cost of sales
Average stock
Cost of sales = sales gross profit = 1,70,00,000 68,00,000
= 1,02,00,000
Average stock = opening stock + closing stock
2
19,90,000 + 29,80,000
2
= 24,85,000
Stock turn over ratio =

1,02,00,000
24,85,000
== 4.10 times.

7. Fixed asset turn over ratio =

cost of sales
Fixed assets

Cost of sales = 1,02,00,000

Fixed assets = building + plant = 30,00,000 + 16,00,000
= 46,00,000
Fixed asset turn overratio =1,02,00,000
46,00,000
= 2.22 times
8. Return on capital employed = profit before interest and taxX 100
Capital employed

Profit before interest and tax = net profit + non operating expenses +
45

Interest Non- operating income

= 30,00,000 + 80,000 + 3,00,000 - 1,80,000

= 32,00,000
Capital employed = share capital + reserves + Profit & loss a/c + debentures
= 40, 00,0,00 +18, 00,000 + 6,00,000 + 6,00,000
= 70, 00,000
Return on capital employed =32,00,000X 100
70, 00,000
= 45.71%
9. Debtor turn over ratio = credit sales
Average debtors
= 1,70,00,000
14,20,000
= 11.97 times
10. Debt collection period = days or months in a year
Debtor turn over ratio
,

= 12 months

11.97
= 1.00 month

11. Creditor turn over ration = credit purchases

Accounts payable
= 1,09,05,000
26,00,000
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= 4.19 times

12. Creditor payment period = days or months in a year

Creditor turn over ratio
= 12 months
4.19
= 2.86 months
13. Net profit ratio = net profit X 100
Net sales
= 30,00,000
X 100
1,70,00,000
= 17.64%
14. Operating ratio = cost of sales + Adm. expenses + selling expenses X 100
Sales
= 1,02,00,000 + 30,00,000 + 6,00,000 X 100
1,70,00,000
= 81.17%

UNIT 6
FUNDS FLOW ANALYSIS
Definition of Fund
Fund means working capital. If current assets of company is more than current liability
of business, it is called working capital and working capitals other name is Fund.
Fund = Working capital = Current assets Current liability

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Definition of Fund Definition of

Flow of fund means movement of fund. I take the example of air; we can feel its
movement or flow of air. Same thing is happen with fund, due to the activity of business
fund is transfer from one asset to another assets. If fixed assets are converted into
current asset or fixed liability is converted into current liabilities, these are the flow of
fund. But if current assets are changed with current assets or current assets are
changed into current liabilities, then, there is no flow of fund because there is no change
working capital. Suppose, we get the money from debtor, this is not flow of fund
because, working capital is not changed. Both items of current assets and when current
assets change into current assets, there will not be change in working capital.
Flow of Fund = Fixed asset changes into current asset or current asset changes into
fixed assets
Definition of fund flow statement
Fund flow statement is a statement which shows the inflow and out flow of funds
between two dates of balance sheet. So, it is known as the statement of changes in
financial position. We all know that balance sheet shows our financial position and
inflow and outflow of fund affects it. So, in company level business, it is very necessary
to prepare fund flow statement to know what the sources are and what are applications
of fund between two dates of balance sheet. Generally, it is prepare after getting two
year balance sheet.According to Prof. Anthony, The funds flow statement describes the
sources from which additional funds were derived and the use of which these funds
were put.
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Funds flow
To facilitate fund flow analysis, accounts shown in Balance Sheet can be classified as
shown below:
Accounts shown in Balance Sheet
1. Current Accounts
a. Current Assets: Eg: Cash, Debtors, Stock,
b. Current Liabilities: Eg: Creditors, Bills, Payable, etc.,

2. Non-CurrentAccounts :
a. Fixed Assets : Eg: Machinery, Land & Building
b. Fixed Liabilities: Eg: Equity Capital, Preference Capital

Flow of fund takes place only when a transaction involves one currentAccount and one
non-current account. For example, purchase of building which is non-currentAccount,
for cash which is a current account.Transaction between two current accounts for
example, cash paid to suppliers ortwo non-current accounts like issue of shares as
consideration for purchase of building,does not result in flow of funds.Transaction taking
place between Current Accounts and Non-Current Accounts onlywill generate
funds.Thus, flow of funds can be represented as follows:
Current Accounts -------- Non-Transaction leading to flow of funds-------- Current
Accounts
Steps involved in the Preparation of Fund Flow Statement
The followingsteps areinvolved in the preparation of Fund Flow Statement:
1) Preparation of Schedule of changes in Working Capital.
49

2) Preparation of accounts for non-current items.

3) Calculation of funds from operation through the Preparation of Adjusted Profit and
Loss account.
4) Preparation of Fund Flow Statement.
Step 1.Preparation of Schedule of changes in Working Capital:
Making of statement of Changes of Working Capital
For making of fund flow statement. It is very necessary to make statement of changes of
working capital. Because net increase in working capital is use of fund and net decrease
in working capital is source of fund. So, it is duty of accountant to make statement of
changes of working capital. Making of statement of changes working capital is very easy
and simple. We take two balance sheets, one is current year balance sheet and other is
previous year balance sheet. Then we separate current assets and current liabilities. If
current assets are more than previous year current assets, it means increase in working
capital. If current assets are less than previous year current assets, it means decrease
in working capital. Because, relationship between current assets and working capital is
positive and if any changes in current assets, working capital will change in same
direction. If current liabilities are more than previous year current liabilities, it means
decrease in working capital. If current liabilities are less than previous year current
liabilities, it means increase in working capital. Relationship between working capital
and current liabilities are inverse.
Schedule of changes in Working Capital
Particulars

Previous
Year

Current
Year

Increase Rs.

Xxxxxx

Xxxx

Current Assets:
Cash

Xxx

50

Decrease Rs.

Bank

Xxx

Xxxxxx

Bills Receivable

Xxx

Xxxxxx

Xxxx

Debtors

Xxx

Xxxxxx

xxxxx

Total Current Assets.

Xxxxx

Xxxxxxx

Bills Payable Creditors

Xxxxxx

Xxxxxx

Bank Overdraft

Xxxxxxx

Xxxxxxx

Xxxxx

Xxxxxxx

TotalCurrent liabilities.

xxxxxx

Xxxxxxxx

Net Working

xxxxx

Xxxxx

Current liabilities

Capital (CA-CL)
Net Increase or
decrease
Total

51

xxxx

Following rulesare followed for preparing the schedule

Particulars
.Increase in Current asset during Increase

Impact on working capital

-----------

current year
2.Decrease in Current asset

--------

Decrease

during current year

3. Increase in Current liabilities

Increase

----------

Increase

--------

during current year

4. Decrease in Currentliabilities
during current year

2) Opening of accounts for non-current items

Opening of accounts are required , to ascertain the sources or application of
Funds regarding items for which additional informationis given
3) Preparation of Adjusted Profit and Loss A/c
This is prepared to ascertain Funds from operation or Loss from operation.
A fund from operation is the only internal source of funds. The net profit, earned by
the business is known as the internal source. But such net profit shown by Profit and
LossA/c should be adjusted for Non-fund and Non-operating items.Non-fund items are
those income and expenses charged to Profit and Loss A/c thatdoes not involve any
outflow of fund for example, writing back of Provision for tax,Depreciation, Transfer to
General Reserve, etc. Non-operating items are those income and expenses charged to
Profit and Loss A/cwhich are not directly related to business operations of the company.

52

for examples: Refund oftax, profit on sale of asset, Dividend received, Loss on sale of
asset, etcThe balancing figure in the Adjusted Profit and Loss A/c is either, Funds
fromFunds from operation or Loss from operation.
Following is the format for Adjusted Profit and Loss A/c:
Dr

Adjusted Profit and Loss A/c

Particulars

Cr

Particulars

To Depreciation

Amount
Xxx
By Net Profit of last year

Amount
Xxxx

To Goodwill, Patent, Preliminary

Xxxx

Xxxxx

expenses written off

By writing back of excess provision

year

To Transfer to reserves

Xxxx

By Refund of income tax

Xxxxxxx

To interim dividend paid

Xxxxx

By Appreciation in the value of fixed

Xxxxxx

To Proposed Dividend (if

Xxxxx

asset

taken as non-current item)

To Provision for tax (if taken as

Xxxx

non-current item)
To Loss on sale of asset

Xxxx

To Net profit of current year (or)

Xxxxxx

To funds lost in operation

xxxxxx

By Dividend received

Xxxxxx

By profit on sale of asset

Xxxxxxx

By Funds from operation

xxxxxx

4) Preparation of Fund Flow Statement

This is prepared by displaying sources of funds on one side, and application of
53

funds on another along with the data generated in the above three steps. Following is
the format of Fund Flow Statement:
Fund Flow Statement as on ..
Sources of Funds

Amount

Application of Funds

Rs.

Amount
Rs.

Funds from operation

Xxx

Funds lost in operation

Xxxxx

Issue of shares/debentures

Xxxxx

Redemption of Preference shares,

Xxxxxx

Sale of fixed asset/investment

Xxxxx

Debenture

Long term loans taken

Decrease in Working Capital

Purchase of fixed asset/investment

Xxxxxx

Xxxxx

Repayment of long term loans

Xxxxx

xxxxx

Payment of tax

Xxxxx

Payment of dividend

Xxxxx

Increase in Working Capital

xxxxx

Difference between Fund Flow Statement and Balance Sheet

Fund Flow Statement

Balance Sheet

It shows the changes in financial position

It shows the financial position as on a

between two dates

It is a post balance sheet exercise
legally it is not obligation toprepare Fund

particular date
It is the end-result of accounting operations
Companies Act makes preparation of

Flow Statement
It is a statement showing of changes in

Balance Sheet obligatory

It is a statement which displays assets

assets and liabilities

It helps management in financial

andliabilities
Analysis of Balance Sheet reveals the

analysis and in decision making

soundness or otherwise of a firm

54

This is no prescribed form

Company Balance Sheet should beprepared in

for Fund Flow Statement

Sides of this statement are titled as

accordance to legal requirement.

Sides of this statement are titled as Assets

Source ofFunds and Application of

andLiabilities

Funds
Importance or uses of Fund Flow Statement
1) It brings to light how and from what sources funds were raised and utilized.
2) It shows the consequences of business operations, thus enabling management to
take remedial measures.
3) It depicts the reasons for changes in working capital.
4) It helps in working capital management.
5) Sources of funds reveal how the firm has funded its development projects in the
past, whether and to what extent from internal and external sources.
6) Analysis of Application of funds reveals how the resources were used in the
past. This can act as a guide while planning future funds deployment.
7) It gives a general idea about the overall financial management of the business.
8) Acts as a guideline for efficient use of scarce resources.
9) Helps banks and financial situations to assess the credit worthiness and repaying
capacity of the firm.
10) Aids management in formulating financial policies in areas like dividend declaration,
creating reserves, etc.
Limitations of Fund Flow Statement
1) It is not original in nature and is only a re-arrangement of data given in financial

55

statements.
2) When both aspects of a transaction involve current account, they are ignored in
this statement.
3) When both aspects of a transaction involve non-current account, they are not
considered in this statement.
4) It depicts the past position and not the future.
5) It is not a ideal tool for financial analysis.
6) Changes in cash position are more important that working capital.
Cash Flow Statement
Cash flow statements report a companys inflows and outflows of cash. This is important because
a company needs to have enough cash on hand to pay its expenses and purchase assets. While an
income statement can tell you whether a company made a profit, a cash flow statement can tell
you whether the company generated cash. The purpose of the Cash flow statements is to
highlight the major activities that directly and indirectly impact cash flows and hence affect the
overall cash balance. A Cash Flow Statement is one which is prepared from income statement
and balance sheet, showing sources and uses of cash. It reveals the inflow and outflow of cash
during a particular period, and explains reasons for changes in cash position between two
balance sheet dates.
Importance or uses of Cash Flow Statement
1. It indicates the reasons for low cash balance despite huge profits or huge cash balance inspite
of low profits.
2.By comparing the actual cash flow statement with that of the projected one, it helps
management in identifying the variation, and thus provide a basis for remedial measures.
3. It reveals the liquidity position of the firm, by indicating the source of cash and its uses.
4.Provides a basis for effective cash management by matching cash receipts and payments.
5. It is an essential tool for short term planning.

56

6. It helps in taking loans from banks by indicating the repayment capacity of the firm through
cash flow statement.
7. A projected cash flow statement aids in planning for the investment of surplus or meeting the
deficit.
8. It explains the reasons for changes in cash position between two balance sheet
dates.
Distinction between Cash Flow and Fund Flow Statements
Cash Flow Statement

Fund Flow Statement

It deals with cash and bank only

It deals with working capital, of which cash and bank are

constituent parts.

Shows the causes for changes in

Shows the causes for changes in

cash position.

working capital position

Records cash receipts and

Records increase or decrease in

payments.

working capital

Inflow of cash will definitely

Inflow of funds need not necessarily

result in inflow of funds.

mean inflow of cash

It starts with opening cash

There are no such opening and

balance and ends with closing

closing balance of funds

cash balance.
Improved cash position

Improved working capital position

indicate improved working

need not necessarily mean sound

capital position.

cash position.

Useful for short-term financing

Useful for Long - term financing

57

Limitations of Cash Flow Statement

1. There is a lack of clarity in the precise definition of cash. Controversies exist over inclusion of
items like cheque, stamps, postal orders, demand drafts, etc., in cash.
2. Since near cash items are excluded from cash flow statement, it does not reveal The true
liquidity position of the firm.
3. Further, cash flow statements exclude non-cash items of expenses and incomes Example,
depreciation and writing back of provision. Therefore, they cannot provide a comprehensive
picture of a firms financial position.
4. A fund flow statement, based on the concept of funds, ie., working capital,presents a more
complete picture than cash flow statement.
Steps for preparing Cash Flow Statement
1. Compute Cash Trading Profit by adding non cash and non-operating incomes from Net
Profit [i.e. Current year profit Previous year profit].
2. Calculate Cash from Operations by adding decrease in current assets and increase in current
liabilities and deducting increase in current assets and decrease in current Liabilities. The above
two step can be done in the form of a statement, a specimen of which is given below:
CASH FROM OPERATIONS
Particulars

Rs.

Net Profit [current year profit previous year

profit]
Add: Non-cash and non-operating expenses:Depreciation
Goodwill written off
Patents, Pre-liminary expenses, written off

58

Rs.

Discount on issue of shares, etc., written off

Loss on sale of fixed assets
Transfer of Reserves
Proposed Dividends
Provision for Taxation
Less: Non-cash and non-operating incomes:
Writing back of excess provision
Profit on sale of fixed assets
Refund of income tax
Dividend and Rent received
CASH TRADING PROFIT
Add: Decrease in current assets
Increase in current liabilities
Less: Increase in current assets
Decrease in current liabilities
CASH FROM OPERATIONS
CASH FLOW STATEMENT ( in account form )
Sources of Cash

Rs.

Application of Cash

Opening cash and Bank balance

Redemption of Preference Shares

Issue of shares

Cash lost in operation

Cash from operation

Purchase of assets

Loan taken

Repayment of Debentures, loans

Sale of assets

Dividend paid

Interest, Dividend received

Closing cash and Bank balance

59

Rs.

CASH FLOW STATEMENT( in statement form )

Particulars
Opening cash and Bank balance
Add: Sources of cash

Rs.

Cash from operations

Xxxx

Issue of shares

Xxxx

Loan taken

Xxxx

Sale of assets

Xxxxx

Interest, Dividend received

Xxxxx
Total sources of cash

Rs.

Xxxxxx (A)

Less: Application of cash

Cash lost in operations

Xxxx

Purchase of assets

Xxxx

Redemption of preference shares

Xxxx

Repayment of debentures, loans

Xxxx

Dividend paid

xxxx
Total application of cash

Closing cash and Bank balance

Prepare funds flow statement from the following balance sheet
Particulars
Assets:
Cash
Drs
stock
Machinery
Land
Building
Liabilities
Creditors
Mrs.Rams loan
Loan from bank
Capital

1.1.2000

31.12.2000

10,000
30,000
35,000
80,000
40,000
35,000
2,30,000

7,000
50,000
25,000
55,000
10,000
60,000
2,47,000

40,000
25,000
40,000
1,25,000

44,000
----50,000
1,53,000

60

Xxxxx(B)
Xxxxx C=A-B

2,30,000

2,47,000

Duing the year machine costing Rs.10,000(accumulated depreciationRs.3000) was sold for
Rs.5,000. The balance of provision for depreciation against machinery as on 1.1.2000 was
Rs.25,000 and on 31.12.2000 Rs.40,000. Net perfit for the year 2000 amounted to Rs.45,000.
Prepare cash flow statement.

Solution:

CASH FLOW STATEMENT FOR THE YEAR ENDED 31-12-2000

Inflow of cash
Cash balance 1.1.2000
Sales of machine
Loan from party
Cash from operation

Rs
20,000
5,000
10,000
59,000

Out flow of cash

Purchase of land
Purchase of building
Repayment of loan
Drawing
Cash balance

84,000

Rs
10,000
25,000
25,000
17,000
7,000
84,000

Workings:MACHINERY ACCOUNT
Particulars
To balance b/d
To balance c/d

Rs
1,05,000
10,000
1,05,000

Particulars
By machinery disposal

Rs
95,000
1,05,000

PROVISION FOR DEPRECIATION

Particulars
To machinery disposal a/c
To balance c/d

Rs
3,000
40,000
43,000

Particulars
1.1.2000 By Balance b/d
31.12.2000 By p&L a/c (bal.fig)

Rs
25,000
18,000
43,000

MACHINE DISPOSAL ACCOUNT

Particulars
To Machinery a/c
To Cash
To p&L a/c

Rs
10,000
5,000
2,000
10,000

Particulars
Provision for depreciation

Rs
10,000
10,000

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CASH FROM OPERATION

PARTICULARS
Net profit for the year
Add: Non- cash charges depreciation

RS.
45,000
18,000

Loss on sale of machinery

2,000
65,000
10,000

Add : Decrease in stock

Increase in creditors

4,000
79,000
20,000
59,000

Less: increase in Drs.

Cash from operation

Example
From the following balance sheet prepare a cash flow statement:

BALANCE SHEET
Liability
Equity share capital
General Reserve
P&La/c
Creditors
Outstanding expenses
Provision for Tax
Provision for bad debt

1985
20,000
2,800
3,200
1,600
240
3,200
80
31,120

1986
20,000
3,600
2,600
1,080
160
3,600
120
31,160

Asset
Goodwill
Land
Building
Investments
Stock
B/R
Bank

1985
2,400
8,000
7,400
2,000
6,000
4,000
1,320
31,120

Additional Information:
1. Piece of land is sold for Rs.800
2. Depreciate building by Rs.1,400
3. Provision for tax has been made for Rs.3,800 during the year.

62

1986
2,400
7,200
7,200
2,200
4,680
4,440
3,040
31,160

63