Financial Statements 2
Funds Flow/Cash Flow Statement
Funds means cash and funds flow statement is prepared on this basis is in the form of cash flow statement. In other words, cash flow statement is nothing but the summary of Cash Book or Receipt & Payment Statement.
However, as a wider concept, ‘Funds’ is used as Resources, i.e. to consider all the assets and liabilities in which funds are blocked.
So, whereas Cash Flow Statement considers movement of cash from one period to another and Funds Flow Statement shows the movement of all the resources whether cash or non cash assets and liabilities.
Funds Flow Statement determines the financial consequences of the business operations. A business may earn profit from year to year still its liquidity position may deteriorate every year, which may take the business to the point of closure.
The basic financial management principle is that the long term requirements of funds should be met out of long term sources of funds. Short term requirements of funds can be met out of long term sources of funds, however under no circumstances, long term requirements of funds should be met out of short term sources of funds.
Funds flow statement prepared on estimated basis for the future period enables the firm to plan its financial resources properly. The firm can know, how much can be raised internally and how much has to be arranged externally.
The basic principles are as follows:
- Increase in Assets means outflows of funds
- Decrease in Assets means inflow of funds
- Increase in Liabilities means inflow of funds
- Decrease in Liabilities means outflow of funds.
In a T-form Account, the left side is for Sources and right side is for Application.
Sources:
- Issue of Shares
- Issue of Debentures
- Receipt of Term Loans
- Receipts of Fixed Deposits/Loans
- Sales of Fixed Assets
- Sale of other investments
- Other Non Operating Income
- Decrease in Working Capital
- Operating Profit
Operating profit/Loss is calculated as follows:
Net profit/Loss + Depreciation on Fixed Assets + Preliminary Expenses W/off + Goodwill written off + Loss on sale of Fixed Assets + Loss on sale of Investments + Abnormal expenses + non- operating expenses – Profit on sale of fixed assets – profit on sale of investments – abnormal income- non- operating income
Applications:
- Redemption of Shares
- Redemption of Debentures
- Term Loan repayments
- Purchase of Fixed Assets
- Purchase of Investments
- Repayment of Deposits/Loans
- Non- Operating Expenses
- Operating Loss
- Dividends
- Increase in Working Capital
Changes in Working Capital:
- Increase in current assets increases working capital
- Increase in current liabilities decreases working capital
- Decrease in current assets decreases working capital
- Decrease in current liabilities increases working capital
Cash Flow Statement:
The principles on the basis of which the Cash Flow statement is prepared are similar to those used for preparing the Funds Flow Statement.
The Cash Flow Statement is a form of Receipt and Payment Statement. In a summarized way, the Cash Flow Statement can be shown as follows:
Opening Cash Balance
Add: Sources of Cash Inflow
Less: Application of Cash
Closing Cash Balance
CAPITAL BUDGETING
What is Cash Flow and how do we compute it? Following Items constitute the cash outflow:
(i) Cost of new equipment
(ii) Cost of demolition of old equipment
(iii) Cost of preparing the site and installation cost of new equipment
(iv) If the cost of new equipment is not paid in single payment and is to be paid over a number of years and if the cost is paid by term borrowing, the interest cost will also be an outflow
Following factors constitute Cash Inflow:
(i) Scrap value of old equipment
(ii) Additional production units of new equipment would increase the gross revenue
(iii) Tax liability on increased cash inflow would reduce the actual inflow
Time Value of Money:
How much petrol one was able to buy 2 years before for Rs.100/-, probably 3 Liters and the same Rs.100/- would get you just about 2 liters today. The value of Rs.100/- is reduced to such an extent. In case of capital expenditures, the decision is to be taken today and flow of funds, inflow or outflow, may happen in the future months or years. The question arises whether the value of flow arising in future is the same in terms of today. For example, if a proposal involves cash inflow of Rs.10,000/- after one year, the value of Rs.10,000/- received after one year is less than Rs.10,000/- if received today. The reasons for this could be as follows:
a) There is always an element of uncertainty attached with future cash flows
b) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today
c) There may be investment opportunities available if the amount is received today which cannot be exploited if the equivalent sum is received after one year.
For example, if you are given an option to take Rs.10,000/- either today, against any of the services provided by you, or after one year, you will most obviously choose to take it today because you can invest the same amount in equity market or in Bank deposit etc and earn money on the same. If you get Rs.10,000 after one year, the real value of the same in terms of today would not be Rs.10,000 but something less than that. This concept is called Time Value of Money.
In the capital budgeting decisions, if there has to be a meaningful comparison between the cash outflows and cash inflows which may arise in future at different points of time whereas the evaluation is to be done as on today, both the future cash outflows and cash inflows are required to be expressed in terms of today.
There are two techniques available for this:
(a) Compounding: In this technique, the interest is compounded and becomes part of initial principal at the end of compounding period. For example, If Ram invests Rs.10,000 in fixed deposit carrying interest @10% pa compounded annually, at the end of first year, Rs.10,000 will become Rs.11,000 and will become Rs.12,100 at the end of second year. Thus the values of today’s Rs.10,000 if received after two years becomes Rs.12,100.
We can calculate it with the help of an equation:
A= P x (1+R)^n
A= Amount at the end of period
P= Amount of principal at the beginning of the period
R= Rate of Interest
n= Number of years
So, for the above example, we can calculate the “A” as follows:
A = 10000 x (1+0.10)^2
= 10000 x 1.21
= 12,100
(b) Discounting: This technique is exactly opposite to that involved in Compounding. This technique finds out the value of Rs.1 if received or spent after n years, provided that the rate of interest can be earned on investment. The present value can be calculated with the help of following equation:
P = A/(1+R)^n
P = 10000/ (1+0.10)^2
P = 8,264.46
In other words, if Ram invests Rs.8,26.46 today in the investment carrying interest of 10% pa, he may be able to receive Rs.10,000 after two years or the present value of Rs.10,000 if received after two years is only Rs.8,264.46 as on today if investment opportunities are available to earn the interest of 10% p.a.
Internal Rate of Return:
Internal rate of Return (IRR) is the rate at which the discounted cash inflows match with discounted cash outflows. This is the maximum rate of interest at which the Company will be able to pay towards the interest on amounts borrowed for investing in the projects, without loosing anything. Thus we can call it “Break even rate” of borrowing for the company.
IRR indicates that discounting rate at which Net Present Value (NPV) is zero.
