The preparation of P & L Alc (also called Income Statement) and of BS and their interrelationship have been discussed in previous units. The P & L A/c summarises items relating to revenue and expenses of a firm during, or over the course of, normally, a year (or a period of time as would be indicated on top of it). The BS lists the firm's assets and liabilities at a point of time; it is, therefore, sometimes said to be "static" and does not show the movement of funds.
The nature of the transactions engaged upon during the period to fiance, the firm's operations are not fully seen in these financial statements, i.e. sources of the funds and the uses to which they have been put are not at once evident from these two financial statements.To answer such limitations, an additional financial statement to provide information on the major financing and investing activities of the firm during the period is also prepared.This is called the Statement of Changes in Financial Position (SCFP). It brings forth the sources from which funds have been obtained and the uses to which they have been applied. This is only an additional statement and does not in any way become a replacement of the P & L A/c and the BS.This lists, and also helps in appreciating, the important aspects of the firm's financing and investing activities regardless of whether cash or other elements of working capital are directly affected. Such aspects include : acquisition of property in exchange of other property or by issuing securities or by raising capital, converting long-term debt or preference shares to ordinary shares, short-term loan obtained and also returned in the same year; etc.
Aspects, brought out by SCFP include : Factors accounting for changes in owners' equity and the assets and liabilities of the firm during the period;
important financing and investment activities during the period;
on adequacy of long-term sources of fundstofinance purchases of fixed assets; on adequacy of working capital;
background of decisions regarding payment, or otherwise, of dividends; on liquidity status of the firm;
regarding funds generated from the firm's operations; etc.
These information are of great interest and value to the financial managers and prospective and current investors.
The term "funds" includes both "cash" and "working capital". Accordingly, SCFP can be prepared on
(a) cash basis;
(b) working capital basis; or
(c) total financial resources basis.
Herein, working capital is intended to denote the difference between current assets and current liabilities (current assets to be generally in excess of current liabilities for liquidity). When prepared on cash basis, it is called Cash Flow Statement. When prepared on working capital basis, it is called Sources and Uses Statement or Funds Flow Statement.
On Cash Basis : (Statement of Changes in Cash)
Cash flow statement lists the various items which effect changes in the cash balance between two consecutive balance sheet dates : whether it be increase or decrease in the cash balance. Payment to creditors decreases the cash balance and receipts from debtors increases the cash balance. These will be included. Purchase on Credit from suppliers and credit sales of goods to customers do not affect cash and these will be excluded from the statement.It must be realised soon that adopting cash balance changes to infer changes in financial position has serious limitations. This is so because several important transactions causing a change in the firm's financial position are by non-cash processes and would stand excluded. Also the on-date financial position may, for this same reason, be wrongly inferred in as much as any delay in making out the due payments would show a better financial position on date than what legally and truly is.
On Working Capital Basis : (Changes in WC)
Working capital (or "funds") is the net of current assets in excess of current liabilities :
WC = CA- CL
In the statement of changes in working capital, all such transactions as affect (increase or decrease) working capital are included; any item which does not affect working capital is excluded. An increase in CA with a just corresponding increase in CL, or balancing decreases in both CA and CL simultaneously, will not affect the WC. Such transactions, not reflected as changes in WC are typically : payment of current liabilities, purchase of inventories on short-term credit, collection of receivables, short-term borrowing, etc. These cause changes in individual accounts, but not in WC. Based on such inclusions and exclusions, it is generally held that the Funds (flow) Statement highlights the changes that have occurred due to the financial operations of the firm between two consecutive balance sheets. It is implicitly believed that the quantum of WC is indicative of the assurance that short-term creditors may feel regarding the solvency of the firm. Stated otherwise :cash means money in hand or at bank; funds means all resources, including cash,with which the firm is able to deal with outsiders.WC may also be viewed as funds available for acquisition of non-current assets (NCA) as well as to repay non-current liabilities (NCL). [See (a) to ( f ) to follow.]Any transaction resulting in increase in WC is a SOURCE of WC; any transaction causing a net decrease in WC is an APPLICATION or USE of WC.
Since total of assets must balance with total of liabilities, we get,
CA + NCA = CL + NCL
It is reflected also as
WC = NCL - NCA.
This alternate definition of WC is, though, less popular. Since the word "Working",somehow or the other, is affined with "current" rather than with "non-current".
Referring again to the equation WC = CA CL, the following are typically easily understood, these being a few general occurrences of financial transactions in a firm :
(a) Issue of equity shares : CA (as cash) increases with a corresponding increase in Non-current Liability (NCL). CL is not increased. Hence, WC increases.
CA ?, NCL ?, WC ?
(b) Purchase of land increases NCA and decreases CA (by cash outflow).There is no change in CL. Hence, WC deceases. However, CA may remain unchanged too.
C A & , N C A ? , W C & ; (or) N C A ? , WC&
(c) Repaying a long-term loan through receiving a bank overdraft, decreases NCL by increasing CL - with no change in current assets. Hence, WC .decreases,Redemption of debentures or preference shares causes a decrease in NCL with an equal decrease in WC.
(d) Repaying a bank overdraft through receiving cash by issue of shares or debentures decreases the CL through increase in NCL with no change in current assets. Hence, WC increases,
(e) When inventory is purchased on credit, both CA and CL increase equally.WC does not change.
CA ? , CL ? equally
(f) When creditors are paid, CL and CA both decrease equally. WC is not affected.
CL & , CA J equally
(g) When plant, building or land is sold for purpose of getting cash, decrease of NCA results in increase of WC.
N C A & , WC?
(h) [cf. (a)] If equity shares are issued to purchase equipment, then NCL and NCA increase eq~ially and WC is not affected.
(k) [cf. (c)] If equipment is sold to repay long-term debt, there is equal decrease in both NCL and NCA and WC is not affected.
It may be noted in the above nine illustrations that out of the five ingredients, WC,the transaction (and only either two or three can be mentioned). Whenever CA or CL alone is affected [unlike in (e) and (01, then, either NCL or NCA too would be affected simultaneously [see (a) to (d)]. In the same vein, one may realise if one form of NCA is converted to another form of NCA (say, to sell a building and to purchase a machinery out of the sale proceeds) or if one form of NCL is converted to another form of NCL (say, converting a debenture into an equity), one of the forms increases with an equal decrease in the other in each case and there is no change in WC [see (h) and (k)]. Issue af equity shares or debentures (NCL) towards purchase of buildings, plant, or machinery (NCA) does not affect WC [(h) and (k) again].
SCFP on WC basis greatly helps in long-range financial planning. However, certain drawbacks must be recognised in this basis as herein. Increases in inventories and accounts receivable are treated as equivalent to increase in cash though inventories have to be transformed over a further duration of manufacture and processing before they can become sources of cash by sales. And, conversely, accrued expenses and accounts payable are treated in par with bank overdrafts,though the former may be payable sooner than the latter.
Such delays between recognising as WC and corresponding ready cash availability thereupon could well embarrass in meeting short-term commitments though a reasonable financial position, profitability and solvency in the long-term future may seem assured.
For this reason, though SCFP on WC basis is good enough for long-range projections, yet, for short-range financial planning, the cash basis serves the firm better. Cash flow statement, if prepared, say, on a monthly basis, would help to identify periods when excess cash can be used to pay off trade creditors, bank loans, interests due and dividends, and periods of cash shortage when overdrafts may have to be arranged for. Thus, even with the limitations indicated under section "On Cash Basis : (Statement of Changes in Cash)", cash flow statement can be innovatively helpfully employed (used).
On Total Financial Resources Basis
Given the advantages and shortcomings of both the cash basis and WC basis of preparing SCFP, some significant omissions in them relate to instances of transactions which do not affect net working capital but are yet significant in decision-making by the public as well as the owners and investors regarding the potential and capabilities of the firm. Such instances have been indicated after (e),(0, (h) and (k) of section under "On Working Capital Basis : (Changes in WC)".
Thus, to consider important aspects of financial and investing activities regardless of whether cash or other elements of WC are directly affected is the purpose for preparing SCFP on total financial resources basis.Such a statement would summarise the sources from which the funds have been obtained and the uses to which they have been put in two categories :
(a) those which affect working capital [(a) to (d) and (g)], and
(b) those which do not affect working capital [(e), (0, (h) and (k)].
For reason of providing a complete disclosure on the financial and investment activities of the firm during the interval between two consecutive balance sheets,the total financial resources basis is the most preferable. Auditor's comments appended to P & L A/c and BS attend to these disclosures.
The nature of the transactions engaged upon during the period to fiance, the firm's operations are not fully seen in these financial statements, i.e. sources of the funds and the uses to which they have been put are not at once evident from these two financial statements.To answer such limitations, an additional financial statement to provide information on the major financing and investing activities of the firm during the period is also prepared.This is called the Statement of Changes in Financial Position (SCFP). It brings forth the sources from which funds have been obtained and the uses to which they have been applied. This is only an additional statement and does not in any way become a replacement of the P & L A/c and the BS.This lists, and also helps in appreciating, the important aspects of the firm's financing and investing activities regardless of whether cash or other elements of working capital are directly affected. Such aspects include : acquisition of property in exchange of other property or by issuing securities or by raising capital, converting long-term debt or preference shares to ordinary shares, short-term loan obtained and also returned in the same year; etc.
Aspects, brought out by SCFP include : Factors accounting for changes in owners' equity and the assets and liabilities of the firm during the period;
important financing and investment activities during the period;
on adequacy of long-term sources of fundstofinance purchases of fixed assets; on adequacy of working capital;
background of decisions regarding payment, or otherwise, of dividends; on liquidity status of the firm;
regarding funds generated from the firm's operations; etc.
These information are of great interest and value to the financial managers and prospective and current investors.
The term "funds" includes both "cash" and "working capital". Accordingly, SCFP can be prepared on
(a) cash basis;
(b) working capital basis; or
(c) total financial resources basis.
Herein, working capital is intended to denote the difference between current assets and current liabilities (current assets to be generally in excess of current liabilities for liquidity). When prepared on cash basis, it is called Cash Flow Statement. When prepared on working capital basis, it is called Sources and Uses Statement or Funds Flow Statement.
On Cash Basis : (Statement of Changes in Cash)
Cash flow statement lists the various items which effect changes in the cash balance between two consecutive balance sheet dates : whether it be increase or decrease in the cash balance. Payment to creditors decreases the cash balance and receipts from debtors increases the cash balance. These will be included. Purchase on Credit from suppliers and credit sales of goods to customers do not affect cash and these will be excluded from the statement.It must be realised soon that adopting cash balance changes to infer changes in financial position has serious limitations. This is so because several important transactions causing a change in the firm's financial position are by non-cash processes and would stand excluded. Also the on-date financial position may, for this same reason, be wrongly inferred in as much as any delay in making out the due payments would show a better financial position on date than what legally and truly is.
On Working Capital Basis : (Changes in WC)
Working capital (or "funds") is the net of current assets in excess of current liabilities :
WC = CA- CL
In the statement of changes in working capital, all such transactions as affect (increase or decrease) working capital are included; any item which does not affect working capital is excluded. An increase in CA with a just corresponding increase in CL, or balancing decreases in both CA and CL simultaneously, will not affect the WC. Such transactions, not reflected as changes in WC are typically : payment of current liabilities, purchase of inventories on short-term credit, collection of receivables, short-term borrowing, etc. These cause changes in individual accounts, but not in WC. Based on such inclusions and exclusions, it is generally held that the Funds (flow) Statement highlights the changes that have occurred due to the financial operations of the firm between two consecutive balance sheets. It is implicitly believed that the quantum of WC is indicative of the assurance that short-term creditors may feel regarding the solvency of the firm. Stated otherwise :cash means money in hand or at bank; funds means all resources, including cash,with which the firm is able to deal with outsiders.WC may also be viewed as funds available for acquisition of non-current assets (NCA) as well as to repay non-current liabilities (NCL). [See (a) to ( f ) to follow.]Any transaction resulting in increase in WC is a SOURCE of WC; any transaction causing a net decrease in WC is an APPLICATION or USE of WC.
Since total of assets must balance with total of liabilities, we get,
CA + NCA = CL + NCL
It is reflected also as
WC = NCL - NCA.
This alternate definition of WC is, though, less popular. Since the word "Working",somehow or the other, is affined with "current" rather than with "non-current".
Referring again to the equation WC = CA CL, the following are typically easily understood, these being a few general occurrences of financial transactions in a firm :
(a) Issue of equity shares : CA (as cash) increases with a corresponding increase in Non-current Liability (NCL). CL is not increased. Hence, WC increases.
CA ?, NCL ?, WC ?
(b) Purchase of land increases NCA and decreases CA (by cash outflow).There is no change in CL. Hence, WC deceases. However, CA may remain unchanged too.
C A & , N C A ? , W C & ; (or) N C A ? , WC&
(c) Repaying a long-term loan through receiving a bank overdraft, decreases NCL by increasing CL - with no change in current assets. Hence, WC .decreases,Redemption of debentures or preference shares causes a decrease in NCL with an equal decrease in WC.
(d) Repaying a bank overdraft through receiving cash by issue of shares or debentures decreases the CL through increase in NCL with no change in current assets. Hence, WC increases,
(e) When inventory is purchased on credit, both CA and CL increase equally.WC does not change.
CA ? , CL ? equally
(f) When creditors are paid, CL and CA both decrease equally. WC is not affected.
CL & , CA J equally
(g) When plant, building or land is sold for purpose of getting cash, decrease of NCA results in increase of WC.
N C A & , WC?
(h) [cf. (a)] If equity shares are issued to purchase equipment, then NCL and NCA increase eq~ially and WC is not affected.
(k) [cf. (c)] If equipment is sold to repay long-term debt, there is equal decrease in both NCL and NCA and WC is not affected.
It may be noted in the above nine illustrations that out of the five ingredients, WC,the transaction (and only either two or three can be mentioned). Whenever CA or CL alone is affected [unlike in (e) and (01, then, either NCL or NCA too would be affected simultaneously [see (a) to (d)]. In the same vein, one may realise if one form of NCA is converted to another form of NCA (say, to sell a building and to purchase a machinery out of the sale proceeds) or if one form of NCL is converted to another form of NCL (say, converting a debenture into an equity), one of the forms increases with an equal decrease in the other in each case and there is no change in WC [see (h) and (k)]. Issue af equity shares or debentures (NCL) towards purchase of buildings, plant, or machinery (NCA) does not affect WC [(h) and (k) again].
SCFP on WC basis greatly helps in long-range financial planning. However, certain drawbacks must be recognised in this basis as herein. Increases in inventories and accounts receivable are treated as equivalent to increase in cash though inventories have to be transformed over a further duration of manufacture and processing before they can become sources of cash by sales. And, conversely, accrued expenses and accounts payable are treated in par with bank overdrafts,though the former may be payable sooner than the latter.
Such delays between recognising as WC and corresponding ready cash availability thereupon could well embarrass in meeting short-term commitments though a reasonable financial position, profitability and solvency in the long-term future may seem assured.
For this reason, though SCFP on WC basis is good enough for long-range projections, yet, for short-range financial planning, the cash basis serves the firm better. Cash flow statement, if prepared, say, on a monthly basis, would help to identify periods when excess cash can be used to pay off trade creditors, bank loans, interests due and dividends, and periods of cash shortage when overdrafts may have to be arranged for. Thus, even with the limitations indicated under section "On Cash Basis : (Statement of Changes in Cash)", cash flow statement can be innovatively helpfully employed (used).
On Total Financial Resources Basis
Given the advantages and shortcomings of both the cash basis and WC basis of preparing SCFP, some significant omissions in them relate to instances of transactions which do not affect net working capital but are yet significant in decision-making by the public as well as the owners and investors regarding the potential and capabilities of the firm. Such instances have been indicated after (e),(0, (h) and (k) of section under "On Working Capital Basis : (Changes in WC)".
Thus, to consider important aspects of financial and investing activities regardless of whether cash or other elements of WC are directly affected is the purpose for preparing SCFP on total financial resources basis.Such a statement would summarise the sources from which the funds have been obtained and the uses to which they have been put in two categories :
(a) those which affect working capital [(a) to (d) and (g)], and
(b) those which do not affect working capital [(e), (0, (h) and (k)].
For reason of providing a complete disclosure on the financial and investment activities of the firm during the interval between two consecutive balance sheets,the total financial resources basis is the most preferable. Auditor's comments appended to P & L A/c and BS attend to these disclosures.
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