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MANU

UNDERSTAND FUND FLOW STATEMENT

THROUGH CASUAL CONVERSATION BETWEEN

MANU AND VINU

VINU

 

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

  1. Statement of Profit and Loss;
  2. Balance Sheet
  3. 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.

  1. Fixed Assets.
  2. 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

  1. Capital
  2. 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

  1. 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!

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

  1. Statement of Profit and Loss;
  2. Balance Sheet
  3. 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.

  1. Fixed Assets.
  2. 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

  1. Capital
  2. 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

  1. 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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ACCOUNTING BASICS A COMPLETE STUDY

A - Z Guide for learning the Basics of Accountancy

 

Course Description

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Welcome to one of the comprehensive ever course on Accounting Basics.

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