Understanding Fund Flow Statement - Detailed Explanations With Clarifications

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CONVERSATION BETWEEN MANU AND VINU

ABOUT FUND FLOW STATEMENT

Manu	Hi Vinu! How are you?
Vinu	I am not fine Manu!
Manu	Why?
Vinu	I think I didn’t take my IPCC Course seriously!
Manu	Common yaar! Wats up?
Vinu	Yesterday I was asked to prepare and present Fund Flow Statement of corporate customer who has approached our Bank for a loan.
Manu	Ok!
Vinu	I had this topic for learning in both Accounting as well as Financial Management papers.
Manu	Ya! I know.
Vinu	But I didn’t give serious look on the topics, because problems would be generally lengthy in nature and I am bit allergic to lengthy problems.
Manu	So?
Vinu	So, I skipped this entire topic and focused on the other topics and somehow sailed through the examinations!
Manu	Acha! You escaped academic examinations but caught red handed in real life examination!
Vinu	True!
Manu	So what are you going to do now?
Vinu	What I’ll do is I’ll learn from you!
Manu	He he...That’s my privilege!
Vinu	Let me ask you a fundamental question!
Manu	Please!
Vinu	When the customer already prepares Financial Statements comprising Statement of Profit and Loss; Balance Sheet Cash Flow Statement Why we have to prepare another statement called Fund Flow Statement to analyse the customer? It’s a waste of time!
Manu	Vinu! Be careful in your words! Then why that particular topic is given so much importance by having it in two examination papers and more importantly why you’re Bank is asking to analyse it?
Vinu	Ok! So it has something to communicate very seriously!
Manu	Yes! Absolutely.
Vinu	But before that, please tell me, why the same topic (Fund Flow Statement) in included in two examination papers?
Manu	Vinu! You should have asked this when you studied. Glad that at least now you have asked.  You had this topic in Accounting paper to learn how to prepare Fund Flow Statement. The same topic was also included in Financial Management to learn how to analyse the Fund Flow Statement.
Vinu	Ok.... Ok...So, two target groups were kept in mind, I believe. How to prepare – As an Accountant How to analyse – As a user of Financial Statement.
Manu	Yup...Shall we move on?
Vinu	Yes Guruji!
Manu	Fund Flow Statement is a statement which will show inflow and outflow of long term funds so that reader of the financial statement will know from where funds have been generated and where they are used!
Vinu	Manu!!!! Please Stop!!!! Don’t teach definitions. Explain with some practical examples yaar!!!
Manu	Ok. Let us go through a Financial Statement tour to understand.
Vinu	I am ready.
Manu	Let’s say you want to start a business with some decent amount. How much you will be investing?
Vinu	One Hundred Crores.
Manu	Great yaar! What you will do with that?
Vinu	I will purchase assets!
Manu	What assets?
Vinu	Long term assets as well as Short term Assets. (Last week you taught me Working Capital J)
Manu	Name some assets which you will be acquiring.
Vinu	Fixed Assets – Rs.80 Crs; Current Assets – Rs.20 Crs.
Manu	Can you prepare your Balance Sheet?
Vinu	Yes! I can. Liabilities Amount (Rs. In Cr.) Assets Amount (Rs. In Cr.) Capital 100.00 Fixed Assets 80.00 Current Assets 20.00 Total 100.00 Total 100.00
Manu	Good! Do you know, now you can prepare your Fund Flow Statement?
Vinu	Is it?
Manu	Yes! What are the sources of funds for you so far?
Vinu	So far, it’s only capital!
Manu	What are your uses of funds?
Vinu	I have two uses. Fixed Assets. Current Assets
Manu	Correct. But in Fund Flow Statement, we will show long term source of funds and long term use of funds. Now, tell me, what are your long term sources and uses.
Vinu	I got your point. I have one long term source whereas out of two uses, one is long term use and the other one is short term use.
Manu	Exactly. If your long term funds are greater than long term use, you will have surplus, and that will be used for funding your current assets.
Vinu	Correct. Shall I prepare Fund Flow Statement with this information?
Manu	Please Vinu.
Vinu	Fund Flow Statement Source of Funds Capital 100.00 Total Source (A) 100.00 Use of Funds Fixed Assets 80.00 Total Use (B) 80.00 Surplus (A-B) 20.00 Correct me, if I am wrong!
Manu	You are correct! Please give the interpretation also.
Vinu	I have brought in Rs.100 Crs as capital of which 80 Crs (80%) has been used for creating fixed assets. I had surplus of 20 Crs (20%) which I have used for creating current assets.
Manu	What does this indicate?
Vinu	This indicates all my current assets were funded by my own money. So I don’t have liquidity pressure, because I need not pay any one in the short run.
Manu	Exactly!
Vinu	Wow! I am understanding Fund Flow Statement.
Manu	Wait. Let’s dig deeper.
Vinu	Ok.
Manu	What was your total current asset?
Vinu	It is Rs.20 Crs.
Manu	Can you give break up?
Vinu	May be Raw Material of Rs.15 Crs and Cash and Bank Balance of Rs.5 Crs
Manu	Ok. Expand your balance sheet with this information.
Vinu	Ok. Let me do that. Liabilities Amount (Rs. In Cr.) Assets Amount (Rs. In Cr.) Capital 100.00 Fixed Assets 80.00 Current Assets: Raw Material 15.00 Cash and Bank 5.00 Total 100.00 Total 100.00
Manu	Good! Now what you will do with your Raw Material and Cash Balances?
Vinu	I will use them for production, incur manufacturing and other expenses.
Manu	Ok. Let us assume, you are using Rs.13 Crs worth of RMs and Rs.4 Crs Cash balances for Production.
Vinu	So, my total cost of production will be Rs.17 Crs.
Manu	Let’s say, you sell all your production for Rs.20 Crs.
Vinu	Ok. So, my sales is Rs.20 Crs, Cost is Rs.17 Crs and profit is Rs.3 Crs.
Manu	Correct. Can you prepare your Profit and Loss statement now?
Vinu	Sure. Income Statement Income 20.00 Less: Expenses 17.00 Profit 3.00
Manu	Will all your sales be in cash?
Vinu	No way! Now days, we don’t get payments even for credit sales on time. Then where is the question of all cash sales. We can assume 60% as Credit Sales and 40% as Cash.
Manu	So your credit sales are going to be reflected as Debtors.
Vinu	Yes.  Rs.12 Crs (60% of Rs.20 Crs) will be reflecting as Debtors and my cash balance will go up by Rs.8 Crs.(40% of Rs.20 Crs).
Manu	When you give credit sales, you can also ask for credit purchase right?
Vinu	Yes. I can. But as per Balance Sheet, all my purchases are by cash only. Probably the next purchases, I’ll make it through credit.
Manu	Good! You are sharp now. You cannot talk about credit purchases now, because you have already made purchases through cash.
Vinu	Ya!
Manu	Now can you prepare your Balance Sheet?
Vinu	Yes. I will have some new entries like retained profits, debtors, change in Raw Material and Cash Balances.
Manu	Before that, arrive at your cash balance:
Vinu	Opening Balance 5.00 Less: Used for Manufacturing Expenses 4.00 Add: Cash Sales 8.00 Closing Balance 9.00
Manu	Good! Go ahead with Balance Sheet!
Vinu	Liabilities Amount (Rs. In Cr.) Assets Amount (Rs. In Cr.) Capital 100.00 Fixed Assets 80.00 Current Assets: P&L (Retained Profits) 3.00 Raw Material 2.00 Debtors 12.00 Cash and Bank 9.00 Total 103.00 Total 103.00
Manu	Good!
Vinu	But Manu, where are we going? You said, you will help me preparing Fund Flow and Analysing it. But you are taking me through Accounting!
Manu	Don’t worry! I am doing this with an intention. Now can you prepare your fund flow statement?
Vinu	Now? Let me try. Total Sources now are Capital Retained Profits. I have a doubt now. Whether retained profits are long term funds? Is it not distributable to owners as dividend and is it not short term?
Manu	For that, tell me, whether Capital is long term fund or short term fund?
Vinu	Obviously, it is long term fund. It has to be paid back only in the event of winding up.
Manu	If Capital is long term fund, which is owners’ funds, then Retained Profits is also long term funds, because it is also payable to owners only.
Vinu	Correct. Retained Profits are owner funds and they are long term funds.
Manu	Your focus should be on profits generated and not on retained profits. Because, once profit is generated, it becomes long term funds and any usage out of it will become long term use.
Vinu	Correct! In our case, my focus should be on Profits generated which is Rs.3 Crs and it is a source. Total Sources are Capital b)Funds from Operations.
Manu	Kudos for that correction.
Vinu	Now shall I prepare the fund flow statement?
Manu	Please!
Vinu	Source of Funds Capital 100.00 Funds from Operations 3.00 Total Source (A) 103.00 Use of Funds Fixed Assets 80.00 Total Use (B) 80.00 Surplus (A-B) 23.00
Manu	You have surplus of Rs.23 Crs. It can be used for?
Vinu	It has been used for funding current assets like this: Raw Materials 2.00 Debtors 12.00 Cash and Bank 9.00 Total 23.00
Manu	Correct. Now let us assume we have completed one full year of operations and we get into the next year.
Vinu	Ok.
Manu	Now only the real drama starts! You now become so enthusiastic in your business operations, want to expand your business, raise more funds and want to be more vibrant.
Vinu	Me? Ok! I’ll leave it to your imagination!
Manu	Let’s say you want to purchase another Plant and Machinery at a cost of Rs.50 Crs so you can improve your sales by another Rs.50 Crs per year and profit by another Rs.5 Crs.
Vinu	It sounds very illogical. When I have not even stabilised with my current operations, why are you saying I should expand?
Manu	Vinu. It all happens in Industry. Do you know one thing? Fund flow will throw all illogical financial stuffs done by the business entities!!!
Vinu	Is it so? Then I am ready to expand more J
Manu	You are going to bring in fresh capital of Rs.10 Crs for this Plant and Machinery.
Vinu	But that’s only Rs.10 Crs. My requirement is Rs.50 Crs?
Manu	Don’t worry. You have some cash balance too. For the balance arrange some short term funds.
Vinu	I had cash balance of Rs.9 Crs. I am also going to raise Rs.10 Crs capital. So funds have to be arranged for Rs.31 Crs. But I have a question. Can i use short term borrowings for acquiring Plant and Machinery?
Manu	No! But short term borrowing is going to give you cash and you may use that and find some long term funds later as a substitute.
Vinu	It’s a Criminal Mistake!
Manu	Don’t worry. Let us go ahead! Please prepare your Balance Sheet first.
Vinu	Liabilities Amount (Rs. In Cr.) Assets Amount (Rs. In Cr.) Capital 100.00 Fixed Assets 130.00 Additional Capital 10.00 Current Assets: P&L (Retained Profits) 3.00 Raw Material 2.00 Short Term Borrowing 31.00 Debtors 12.00 Cash and Bank - Total 144.00 Total 144.00
Manu	Now you have to procure raw materials for this year sales. Your last year sales were Rs.20 Crs. For that your RM was Rs.13 Crs and other expenses were Rs.4 Crs.
Vinu	Correct!
Manu	Current year also you will repeat the same plus additional sales.
Vinu	Correct!
Manu	Can you tabulate that for understanding?
Vinu	Will do that: Particulars With Existing Capacity With New Capacity Total Sales 20.00 50.00 70.00 RM Consumption 13.00 38.00 (51.00) Other Expenses 4.00 7.00 (11.00) Profit 3.00 5.00 8.00
Manu	So it means, you are going to consume Rs.51 Crs worth of Raw Materials.
Vinu	Yes!
Manu	Do you have Raw Materials with you?
Vinu	My Balance Sheet says, i have Rs.2 Crs worth Raw Materials. But my requirement is Rs.51 Crs worth Raw Materials.
Manu	So, you have to purchase RM worth Rs.49 Crs. But you don’t have cash balance. You have to be dependent on your cash sales for purchase of RM. So, ascertain cash inflows from sales.
Vinu	I don’t have any information on that!
Manu	Then take this shock! Your Credit sales are going to increase to remain competitive in the market. Your total sales are Rs.70 Crs of which 80% is going to be on credit
Vinu	So, I will have debtors of Rs.56 Crs. Already I had debtors of Rs.12 Crs
Manu	So your total debtors will be Rs.68 Crs. But find out your cash sales.
Vinu	Cash sales will be Rs.70 Crs x 20% = Rs.14 Crs
Manu	So please prepare cash statement to know cash generation.
Vinu	Opening Balance - Add: Cash Sales (20% of Rs.70 Crs) 14.00 Cash Generation 14.00
Manu	Make use of cash generated to purchase goods and calculate how much should be purchased on credit
Vinu	Raw Materials requirement 51.00 Less: RM Stock available 2.00 Raw Materials to be purchased 49.00 Less: Cash Purchases with cash generated 14.00 Raw Material purchases to be made in Credit 35.00
Manu	So now you have exhausted all your cash balances!
Vinu	Yes Yes Yes! Alas! I also have other expenses for Rs.11 Crs! How will I pay them?
Manu	Those expenses will remain as Liabilities till they are paid off.
Vinu	True. That too current liability because of its operative nature. But why do you create all these mess?
Manu	Only then you will understand the real purpose of Fund Flow Statement. I am taking you through a real business scenario!
Vinu	Ok!
Manu	Now let us reconcile to prepare Balance Sheet. Will you have RM Stock?
Vinu	No. As per working, we consumed all RM Stock.
Manu	Will you have debtors?
Vinu	Yes. Rs.68 Crs
Manu	Will you have Cash Balance?
Vinu	No! All are consumed.
Manu	Correct! Now please prepare your Balance Sheet.
Vinu	Liabilities Amount (Rs. In Cr.) Assets Amount (Rs. In Cr.) Capital 100.00 Fixed Assets 130.00 Additional Capital 10.00 Current Assets: P&L (3 Crs + 8 Crs) 11.00 Raw Material Nil Bank Overdraft 31.00 Debtors 68.00 Sundry Creditors 35.00 Cash and Bank - Expenses Payable 11.00 Total 198.00 Total 198.00
Manu	Can you reproduce two years balance sheet and Income statement in one place?
Vinu	Ya! BALANCE SHEET Liabilities Amount (C.Y.) Amount (P.Y.) Assets Amount (C.Y.) Amount (P.Y.) Capital 100.00 100.00 Fixed Assets 130.00 80.00 Additional Capital 10.00 - Current Assets: P&L (3 Crs + 8 Crs) 11.00 3.00 Raw Material Nil 2.00 Current Liability: Debtors 68.00 12.00 Bank Overdraft 31.00 - Cash and Bank - 9.00 Sundry Creditors 35.00 - - - Expenses Payable 11.00 - - - Total 198.00 103.00 Total 198.00 103.00 INCOME STATMENT Particulars Total Sales 70.00 RM Consumption (51.00) Other Expenses (11.00) Profit 8.00
Manu	In this entire exercise, we have not touched on Depreciation. Let us not touch on that now.
Vinu	Ok.
Manu	Now, try preparing the Fund Flow Statement. What are long term sources for this company now?
Vinu	Additional Capital of Rs.10 Crs when compared with Previous Year and Funds from Operations Rs.8 Crs
Manu	So your total long term funds is Rs.18 Crs
Vinu	Yes.
Manu	What are your long term uses?
Vinu	It is Rs.50 Crs of Plant and Machinery when compared with previous year.
Manu	Here comes the catch. Go ahead and prepare your Fund Flow Statement.
Vinu	Source of Funds Capital 10.00 Funds from Operations 8.00 Total Source (A) 18.00 Use of Funds Fixed Assets 50.00 Total Use (B) 50.00 Deficit (A-B) (32.00)
Manu	Now, what does your fund flow communicate?
Vinu	Its communicating something very basic, but very serious. I had long term source of Rs.18 Crs Whereas My long term use was Rs.50 Crs I had a deficit of Rs.32 Crs
Manu	It means you have used some other funds for creating long term assets.
Vinu	Yes
Manu	Which Funds?
Vinu	I have used the funds meant for Working Capital purposes.
Manu	Yes. You have committed the crime of using short term funds for long term purposes.
Vinu	Yes. I understand. But I am struck here. Can you elaborate this?
Manu	Ya.  Previous year your working capital requirement was Rs.23 Crs and that was funded fully by own funds. But current year, your Gross Working capital fund requirement was Rs.68 Crs.  (i.e, Current Assets). But against this you had current liability of Rs.77 Crs. You had negative working capital.
Vinu	What does that mean?
Manu	It means, you have to pay Rs.77 Crs in the short term as your liability, where as you have only Rs.68 Crs as resource available to pay that! You have used short term funds to the tune of Rs.9 Crs for creating long term assets. This will have serious bearing on the operations of the company.
Vinu	But why?
Manu	Your short term funds were locked in long term assets. Those who have lent you in short term will ask for repayment in the short term. At that point, you should have short term assets (resources) to pay short term lenders. But now your funds were locked in long term assets and you cannot dispose those assets soon. So, short term lenders will take you for a ride. That would be a disastrous ride, sometimes even leading to winding up of the company, if they are not paid as agreed!!!
Vinu	Getting your point! Let me tabulate that: Particulars Previous Year Current Year Current Assets 23.00 68.00 Less: Current Liability - 77.00 Working Capital 23.00 (9.00) Reduction in Working Capital 32.00 I have used this reduction in Working Capital to fund Fixed Asset creation. I think this is the amount revealed by Fund Flow Statement.
Manu	Exactly! Fund Flow Statement (FFS) shows how irrational you are! You have attempted to create long term asset to the tune of Rs.50 Crs by arranging long term funds of just Rs.18 Crs and relying predominantly on short term funds of Rs.32 Crs. FFS shows you want to run business with others funds, especially funds which can put lots of pressure on liquidity of your business. FFS shows solvency of your business is always under pressure and threat! FFS shows you wanted to create assets even before you stabilise in your operations! FFS shows you are very poor in Working Capital Management! Your FFS shows, you have cheated your banker, because you have availed cash credit but in turn used it for creating fixed assets!
Vinu	My God! Whether Fund Flow is such a dangerous monster?
Manu	Yes! If you’re activities are monstrous, illogical, detrimental, you have to be cautious about this guy – Mr. Fund Flow Statement. He is there to reveal what you do!
Vinu	Thanks Manu! Now I understand why banks are so serious about this statement and why it is considered as critical topic in two examination papers. Thanks a lot!

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