Case study - Financial Management

Funds Statement showing the increase or decrease in working capital of an ancillary unit near your place of residence      

FUND FLOW STATEMENT

Introduction:

The purpose of measuring trading performance, operational efficiency, profitability and financial position of a concern revealed by Trading, Profit and Loss Account and Balance Sheet. These financial statements are prepared to find out the Gross Profit or Gross Loss, Net Profit or Net Loss and financial soundness of a firm ~ a whole for a particular period of time. From the management point of view, the usefulness of information provided by these income statements functions effectively and efficiently. In the true sense they do not disclose the nature of all transactions. Management, Creditors and Investors etc. want to determine or evaluate the sources and application of funds employed by the firm for the future course of action. Based on these backgrounds, it is essential to analyse the movement of assets, liabilities, funds from operations and capital between the components of two year financial statements. The analysis of financial statements helps to the management by providing additional information in a meaningful manner.

Meaning of Fund

The term "Fund" refers to Cash, to Cash Equivalents or to Working Capital and all financial resources which are used in business. These total resources of a concern are in the form of men, materials, money, plant and equipments and others. In a broader meaning the word "Fund" refers to Working Capital. The Working Capital indicates the difference between current assets and current liabilities. The term working capital may be :

(a) Gross Working Capital and

(b) Net Working Capital.

"Gross Working Capital" represents total of all Current Assets.

"Net Working Capital" refers to excess of Current Assets over Current Liabilities.

In a narrow sense the word "Fund" denotes cash or cash equivalents.

Fund Flow Statement

It is a statement summarizing the significant financial changes in items of financial position which have occurred between the two different balance sheet dates. This statement is prepared on the basis of "Working Capital" concept of funds. Fund flow Statement helps to measure the different sources of funds and application of funds from transactions involved during the course of business.

The fund flow statement also termed as Statement of Sources and Application of Fund, Where Got and Where Gone Out Statement, Inflow of Fund or Outflow of Fund Statement.

Significance / Importance of Fund Flow Statement

Ø It shows the various sources and uses or applications of funds between the two accounting periods.

Ø Fund flow statements assist in determining the shift in amount of current assets investment and current liabilities financing.

Ø It works as a crucial instrument for allocation of resources of a firm. It allows an organization for making plans for optimal allocation of resources.

Ø It highlights the financial power and weak spots of a firm.

Ø It helps the investors to determine about how the company has employed the funds given by them & its financial strength. Based on comparative study of the past with the present, investors can identify & discover potential drains on funds in the future.

Ø It assists the management to take remedial measures in case of deviations between two balance sheet figures.

Ø It helps the investors for effective decisions at the time of their investment proposals.

Ø It also offers detailed information concerning profitability, operational efficiency and financial matters of a firm.

Ø It explains the connection between changes in working capital & net profits. Funds flow statements reveals the quantum of funds produced by operations.

Ø It demonstrates the firms’ capacity to generate long-term financing to meet the investment in long-term assets.

Ø It functions as a guide to the management to prepare its dividend, retention and investment policy, etc.

Ø It helps to assess the financial implications of business transactions associated with operational finance and investment.

Ø It helps the management to predict the requirements of extra capital.

The three statements prepared while making a fund flow analysis are :

A) Statement of changes in Working Capital.

B) Calculation of Funds from Operations

C) Calculation of the Sources and Applications of funds.

A) Statement of changes in Working Capital.

This statement is to explain the net change in Working Capital, as arrived in the Funds Flow Statement. All Current Assets and Current Liabilities are individually listed. Against each account, the figure pertaining to that account at the beginning and at the end of the accounting period is shown. The net change in its position is also shown. The changes taking place with respect to each account should add up to equal the net change in working capital.

Note1: Increase in current assets and decrease in current liabilities – The acquisition of current assets and repayment of current liabilities will result in funds outflow. The funds may be applied to finance an increase in stock, debtors etc. or to reduce the amount owed to trade creditors, bank overdraft, bills payable.

Note2: Decrease in Current Assets and Increase in Current Liabilities: The reduction in current assets e.g. stocks or debtor’s balance will result in release of funds to be applied elsewhere.

B) Calculation of Funds from Operations

During the course of trading activity, a company generates revenue mainly in the form of sale proceeds and pays for costs. The difference between these two items will be the amount of funds generated by the trading operations.

C) Calculation of the Sources and Applications of funds.

1) Sources:

It includes:

Funds raised from Shares, Debentures and Long-term Loans:

The Long-term funds are injected into the business during the year by issue of any shares and debentures and by raising long-term loans. In any premium is collected that is also form part of funds raised from the above said sources of finance.

Sale off fixed assets and Long-term investments:

Any amount generated from sale of fixed assets or long-term investments is a source of funds. While preparation of funds flow statement the gross sale proceeds from sale is taken as source of funds.

2) Application:

The use of funds in an organization takes place in the following forms:

Repayment of Preference Capital or Debentures or Long-term Debit:

This represents the application of organisation’s funds released from business through redemption of preference shares or debentures, repayment of long-term loans previously made by the organization. Any reduction in equity capital is also taken as application of funds.

Purchase of fixed assets or long-term investments:

The funds used to purchase long-term assets are usually the most significant application of funds during the year. This group includes capital expenditure on land, buildings, plant and machinery, furniture and fittings, vehicles and long-term investments outside the business.

Distribution of dividends and payment of taxes:

The dividend to the shareholders and tax paid during the year is the application of funds for the firm.

Loss from operations:

Losses made in the trading activities use up the funds. If costs exceed revenue, a cash outflow will be experienced.

Key criteria followed by K.L Warehouse

One of the key criteria to consider in evaluating potential or existing suppliers is financial health.  Unless a suppler has staying power, all of its other fine qualities won’t mean much.  Here we look to the supplier’s financial statements for some answers.  Four easily obtainable ratios are probably sufficient to evaluate a supplier’s financial health adequately:  (1) profit margin, (2) inventory turnover, (3) quick ratio and (4) debt-to-equity.

The profit margin (return on sales) should be used in evaluating a supplier the same way it was used to evaluate the manager’s own company.  It should be compared with other companies in the industry to evaluate the supplier’s relative operating efficiency.  More important, however, is to look at the trend of this ratio.  Even if the current year’s profit margin is within industry norms, a declining ratio could indicate that the supplier is facing serious competition or even a financial crisis.

The inventory turnover ratio can be used to determine whether the supplier’s inventories are moving, on the one hand, and whether its inventory levels may be too low, on the other.  A key is to consider the industry average.  A low turnover could indicate that inventory is not moving, leading to a future liquidity crisis.  An exceptionally high turnover could indicate that the supplier is maintaining very low inventory levels, which could mean that goods will not be available when a manager orders them. 

The quick and debt-to-equity ratios are used extensively by short-term creditors and long-term creditors, respectively, to assess a debtor’s liquidity and debt structure.  Although we are not concerned with being paid on time by the supplier, we want reasonable assurance that the supplier can discharge his financial obligations, both short-term as well as long-term, and will not be forced into bankruptcy.  As noted earlier, the current ratio provides only a rough measure of the supplier’s short-term debt paying ability.  The quick ratio is a better test and usually is just as easily obtainable from the supplier’s balance sheet.  Cash and cash equivalents (marketable securities), plus receivables, are frequently listed separately among the current assets.  For this purpose, we would be satisfied with a quick ratio of 1.0 or higher, or at least equal to the industry norm.

The debt-to-equity ratio provides an indication of how heavily the supplier is in debt, relative to the amount of capital provided by the owners.  The higher the ratio, the more concerned one should be about the long-term welfare of the supplier.  As a customer, we probably wouldn’t be too concerned as long as the supplier’s D/E ratio is less than 100 percent, which would indicate equal amounts of debt and equity capital.

Looking at this measure alone, one might conclude that the supplier will soon be facing a serious financial crisis.  However, the inventory turnover ratio was only slightly below the industry average and does not show a definite trend.  Still, the inventory has been turning over only once every 80 days or so.  This relatively low turnover ratio appears to be due primarily to a higher-than-average level of inventory as a percent of total assets.  This could be viewed as favorable from our standpoint as customer, since high inventory levels should result in fewer back orders.  However, high levels of slow moving inventories reduce the liquidity of a company’s current assets and working capital.

The quick ratio of .5 times is substantially below the industry average -- and the general benchmark -- of 1.0 times.  Since we are a customer in this case, we are not concerned about being paid by this company; but we might wonder about the company’s ability to discharge its short-term debts as they come due.  On the other hand, the debt-to-equity ratio of .6 times indicates that the company is not highly leveraged and still has a fair amount of financial flexibility.  The company can probably obtain additional long-term funds to make up for near-term shortfalls.  So, while the first three ratios indicate that our potential supplier may be facing a liquidity squeeze, the last indicates that the company’s total debt position is relatively solid.  On balance, if this were one of a limited number of potential suppliers of critical materials, we would find little difficulty in establishing long-term commitments.

                                                   K-L Warehouse, Inc. Financial Statements

The Income Statement

For the year ended December 31:

(In Rupees)	2013	2012	2011	2010
Net Sales	6,039,750	5,452,010	4,558,060	3,362,910
Cost of Goods	3,573,070	3,135,730	2,616,710	1,903,480
Gross Profit	2,466,680	2,316,280	1,941,350	1,459,430
Selling, General and Administrative  Expenses (including depreciation)	2,221,540	1,849,100	1,434,860	1,076,990
Income from Operations	245,140	467,180	506,490	382,440
Other Income (expenses):
Interest and other income	14,470	19,510	27,250	14,410
Interest Expense	(10,180)	(13,990)	(12,320)	(13,570)
Income Before Income Taxes	249,430	472,700	521,420	383,280
Income Tax Provision	102,000	181,990	198,600	162,080
Net Income	147,430	290,710	322,820	221,200

(As a Percentage of Sales)
Net Sales	100.0%	100.0%	100.0%	100.0%
Cost of Goods	59.2	57.5	57.4	56.6
Gross Profit	40.8	42.5	42.6	43.4
Selling, General and Administrative   Expenses (including depreciation)	36.8	33.9	31.5	32.0
Income from Operations	4.0	8.6	11.1	11.4
Other Income (expenses):   Interest and other income	.3	.4	.6	.4
Interest Expense	(.2)	(.3)	(.3)	(.4)
Income Before Income Taxes	4.1	8.7	11.4	11.4
Income Tax Provision	1.7	3.4	4.3	4.8
Net Income	2.4%	5.3%	7.1%	6.6%

 
 (Cont.)  K-L Warehouse, Inc. Financial Statements

The Balance Sheet

(In Rupees)	2013	2012	2011	2010
Assets
Current Assets:
Cash and Cash Equivalents	272,640	82,540	321,390	281,750
Receivables	12,090	3,480	7,550	2,740
Inventory	738,630	857,090	668,200	464,440
Prepaid Expenses	54,880	54,030	39,670	33,630
Total Current Assets	1,078,240	997,140	1,036,810	782,560
Property, Plant & Equipment (at cost):
Land and Buildings	531,270	383,350	312,670	151,140
Fixtures and equipment	476,460	411,230	251,920	219,740
Leasehold improvements	16,460	15,120	12,340	9,080
Construction in progress	----	46,370	32,800	6,740
Less Accumulated Depreciation	(248,430)	(183,890)	(135,020)	(99,470)
Property, Plant & Equipment, net	775,760	672,180	474,710	287,230
Total Assets	1,854,000	1,669,320	1,511,520	1,069,790
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts Payable	377,970	244,150	259,040	212,223
Advance Payment on Orders	4,460	2,030	3,500	4,530
Income Taxes Payable	70,800	53,020	103,970	53,940
Other Current Obligations	154,510	139,950	148,790	117,900
Total Current Liabilities	607,740	439,150	515,300	388,600
Long-Term Debt	78,000	84,130	76,740	86,670
Stockholders’ Equity:
Common Stock; 20.1M, 20.1M &20.0M     Shares, respectively, at par	2,010	2,010	2,000	2,000
Additional Capital, net	311,360	307,810	293,080	223,080
Retained Earnings	983,810	875,160	624,400	341,666
Less Treasury Stock, at cost	(128,920)	(38,940)	----	----
Total Stockholders’ Equity	1,168,260	1,146,040	919,480	566,740
Total Liabilities and Equity	1,854,000	1,669,320	1,511,520	1,069,790

  K-L Warehouse, Inc. Financial Statements

Statement of Cash Flows

(Major component totals only)

For the year ended December 31:

(In Rupees)

Net Cash flow	2013	2012	2011	2010
Net cash flows from operating activities	512,020	95,200	255,600	217,030
Net cash flows from investing activities	(175,410)	(250,560)	(226,690)	(52,310)
Net cash flows from financing activities	(146,510)	( 83,490)	10,730	(43,290)
Net increase (decrease) In cash and cash equivalents	190,100	(238,850)	39,640	121,430

Following are the summarized Balance Sheet of K.LWarehouse As on 31^st December 2012 and 2013.

Liabilities	2012	2013	Assets	2012	2013
Share capital	1,00,000	1,25,000	Goodwill	-	2,500
General Reserve	25,000	30,000	Buildings	1,00,000	95,000
P & L A/c	15,250	15,300	Plant	75,000	84,500
Bank Loan (Long-term)	35,000	67,600	Stock	50,000	37,000
Creditor	75,000	-	Debtors	40,000	32,100
Provision for Tax	15,000	17,500	Bank	-	4,000
			Cash	250	300
	2,65,250	2,55,400		2,65,250	2,55,400

Additional Information:

(i) Dividend of Rs. 11,500 was paid.

(ii) Depreciation written off on plant Rs. 7,000 and on buildings Rs. 5,000.

(iii) Provision for tax was made during the year Rs. 16,500.

Increase and decrease in working capital:

Schedule of changes in working capital (Rs.)

Particulars	2012	2013	Increases	Decreases
Current Assets Cash Bank Debtor Stock	250 - 40,000 50,000 ------------------- 90,250 --------------------	300 4,000 32,100 37,000 ------------------ 73,400 -------------------	50 4,000 - -	- 7,900 13,000 -

Funds Flow Statement

Sources	Rs.	Particulars	Rs.
Funds from operations Issue of Shares Bank Loan	45,050 25,000 32,600	Purchase of Plant Income tax paid Dividend Paid Goodwill Paid Net Increase in Working capital	16,500 14,000 11,500 2,500 58,150
	1,02,650		1,02,650

Working Notes:

Share Capital A/c

Particulars	Rs.	Particulars	Rs.
To Balance c/d	1,25,000	By Balance b/d By Bank A/c	1,00,000 25,000
	1,25,000		1,25,000

General Reserve A/c

Particulars	Rs.	Particulars	Rs.
To Balance c/d	30,0000	By Balance b/d By P & L A/c	25,000 5,000
	30,0000		30,0000

Provision for Taxation A/c

Particulars	Rs.	Particulars	Rs.
To Bank A/c To Balance c/d	14,0000 17,500	By balance b/d By P & L A/c	15,000 16,500
	31,500		31,500

Bank Loan A/c

Particulars	Rs.	Particulars	Rs.
To Balance c/d	67,600	By Balance b/d By Bank A/c	35,000 32,600
	67,600		67,600

Land and Building A/c

Particulars	Rs.	Particulars	Rs.
To Balance c/d	1,00,000	To Depreciation a/c By balance c/d	5,000 95,000
	1,00,000		1,00,000

Conclusion:

Compiling, analyzing, and understanding financial statements provides business owners one of the most important tools for reducing the considerable risk involved in starting and growing a business.  The comparison of financial ratios to industry standards is, perhaps, one of the best uses of financial information, as it allows the business owner to compare the performance of his or her business with other like businesses.

In addition to providing information to owners critical for their own decision making, the accuracy of financial statements will impact the business’ tax obligations and opportunities to obtain equity and/or debt financing.   Careful record keeping leads to accurate financial statements, thereby reducing the business’ tax burden.  Business owners have the opportunity to compare their financial ratios with industry standards before applying for loans, thereby giving them the opportunity to correct any problems that could lead to the rejection of their business loan application or equity offering.