31 Statement of changes in working capital and Statement of sources and application of funds

Deepika Gautam

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LEARNING OBJECTIVES:

 

After going through the module, students may be able to gain ample knowledge regarding the meaning of working capital, statement of changes in working capital, the format and the reasons for its preparation. Moreover, knowledge can also be gathered about the statement of sources and application of funds, its format and the users who use up the statement.

 

INTRODUCTION:

 

A business is incorporated with the main aim to earn the profits and perform the operations for a longer period of time. With this aim, the business transacts with the outside world either to gather the funds or to sell its products. For carrying out the business smoothly, every enterprise requires an adequate amount of finance, and continuous generation of funds is also required, so that the growth is not hampered in between and the firm never faces the situation of financial crunch. Cash is considered the life blood of an organisation, and needed for the non interrupted flow of the firm, and continuous efforts are made to acquire the funds through different sources and judiciously using them for its operations. This inflow and outflow of funds is also recorded in the form of statement of change, which depict the changes in the balance of funds.

 

The statement recording the inflow and outflow of funds is termed as a Fund Flow Statement, the statement recording the changes in cash balances is termed as Cash Flow Statement and the statement revealing the changes in the current natured accounts between two consecutive balance sheet dates is termed as Statement of changes in Working Capital.

 

MEANING OF WORKING CAPITAL:

 

Organisations need funds for long term as well as short term purposes. That part of capital which is required for fulfilling the short term needs or the day to day workings/ operations of an enterprise is termed as working capital. Example: payment of salaries, paying off short term loans, purchase of raw material etc. In other words the difference between company’s current assets and current liabilities is termed as working capital.

 

In the words of Shubin, “Working Capital is the amount of funds necessary to cover the cost of operating the enterprise.” Every firm tries to maintain the adequate balance of the working capital because both excess and insufficient balance of working capital can prove harmful for the organisations. For this purpose, a proper record of the inflow (increase) and outflow (decrease) of working capital is kept and record of the changes in the working capital of the firm is kept in the form of Statement of Changes in Working Capital.

 

STATEMENT OF CHANGES IN WORKING CAPITAL:

 

Statement of changes in working capital is the overall change (increase or decrease) in current assets and current liabilities or a consolidated form which reveals the changes in the amount of net working capital i.e. changes in current assets and current liabilities, which makes clear that whether there is an increase in the working capital or a decrease in the working capital.

 

For the preparation of statement of changes in working capital, following are the rules:

 

Increase in Current Assets LEADS TO Increase in Working Capital
Increase in Current Liabilities LEADS TO Decrease in Working Capital
Decrease in Current Assets LEADS TO Decrease in Working Capital
Decrease in Current Liabilities LEADS TO Increase in Working Capital

 

It should be noted that a change in the current assets without any change in the current liabilities will result in a change in the amount of working capital. On the other hand, a change in the current liabilities without any identical change in the current assets will result in a change in the amount of working capital.

Example: The owner makes an additional investment of Rs 120000 in the company. As a result of which the current assets will increase by Rs 120000, but there will be no increase in the current liabilities. As a result the company’s working capital increases by Rs 120000.

 

 

FORMAT OF STATEMENT OF CHANGES IN WORKING CAPITAL:

 

Preparing a statement of changes in working capital, means a comparative evaluation of the values of current assets and current liabilities of a company presented in the two consecutive balance sheet dates. Such a comparison helps the management to look up at the sources which lead to an increase in the working capital, and the areas that result in the decrease in working capital.

Current Assets: These are those assets which can be converted into cash within a short period of time (normally one accounting year). Examples of Current Assets are:

 

1.      Cash in hand and bank balances

2.      Bills Receivables

3.     Sundry debtors

4.      Accrued Incomes

5.      Prepaid Expenses

6.      Short term loans and advances

7.      Inventories

Current Liabilities: These are liabilities, which are known to be paid in the ordinary course of business, in a short period of time, usually one accounting year. Examples of Current Liabilities are:

 

1.      Bills Payable

2.      Dividends Payable

3.      Sundry Creditors

4.      Outstanding Expenses

5.      Bank Overdraft

6.      Provision for Bad and Doubtful Debts

7.      Short term loans and advances

 

QUICK REVISION

 

▪  The statement recording the inflow and outflow of funds is termed as a Fund Flow Statement.

▪  The statement recording the changes in cash balances is termed as Cash Flow Statement.

▪    The statement revealing the changes in the current natured accounts between two consecutive balance sheet dates is termed as Statement of changes in Working Capital.

▪  Statement of changes in working capital is the overall change (increase or decrease) in current assets and current liabilities, which makes clear that whether there is an increase in the working capital or a decrease in the working capital.

▪   Change in the current liabilities without any identical change in the current assets will result in a change in the amount of working capital and vice verse.

▪   Analysing the Statement of changes in working capital helps the management to look up at the sources which lead to an increase in the working capital, and the areas that result in the decrease in working capital.

In order to understand the technique of preparing a statement of changes in working capital, one hypothetical example has been explained under:

 

EXAMPLE 1:

 

The Balance Sheet of Sharma Ltd. is presented for two consecutive years. Prepare Statement of Changes in Working Capital.

 

Balance Sheet

 

LIABILITIES AMOUNT AMOUNT ASSETS AMOUNT AMOUNT
(2013) (2014) (2013) (2014)
Creditors 56000 84000 Cash in Hand 16000 15000
Bills Payable 21000 17000 Cash at Bank 11000 9000

By looking at the above example it can be interpreted that:

 

1)      The respective amounts of cash in hand and cash at bank have decreased from 2013 to 2014, leading to a decrease in the amount of working capital.

 

2)      Whereas the debtors, stock and bills receivable have increased, means an increase in the current assets, which led to an increase in the working capital as well.

 

3)      Creditors (current liability in nature) have shown an increase in amount of RS 28000, which have resulted into a decrease in the working capital by Rs 28000, because an increase in current liability means an equivalent decrease in the working capital.

 

4)      Bills Payable (current liability in nature) have shown a decrease by Rs 4000, which has led to an increase in working capital by the same amount, as a decrease in current liability means an increase in working capital.

 

5)      The respective working capitals for the year 2013 (Rs 408000) and 2014 (Rs 459000) have resulted into a net increase in working capital by Rs 51000. It is considered as a positive sign because an increase is seen in the working capital of the firm as compared to the previous year i.e. the firm was able to generate more funds effectively.

 

Example 1 explained the situation when the firm experienced a net increase in the working capital. But this may not be the situation all the time. Sometimes a company may face a situation where thenet working capital shows a decrease. A decrease in net working capital means that the financial health of the company is deteriorating at a fast pace, and it is facing the shortage of cash for capital expenditures. This may be considered as a red flag and lead to the decrease in sales of the company, ultimately affecting the image, growth and competition facing capacity of the firm.

 

REASONS FOR THE PREPARATION OF STATEMENT OF CHANGE IN WORKING CAPITAL:

 

A change in the working capital reveals whether the change is a good one (increase) or a bad change (decrease). Accountants prepare statement of changes in working capital because:

 

1)      It helps in comparing the figures relating to the current period with that of the previous year, hence revealing its growth.

 

2)      Analysis about the change in the current assets and liabilities is made easy, also the management is provided with a base to set the policies.

 

3)      Helps management to look upon the areas which need improvement.

 

4)      Preparation of fund flow statement is made easy, by preparing a statement of changes in working capital. And unfolding the directions of inflows and outflows of funds.

 

QUICK REVISION

 

▪Statement of changes in working capital leads to the preparation of fund flow statement.

▪The management is made aware about the increase/ decrease in working capital from the statement.

▪It reveals how effectively an organisation is carrying out its operations.

 

 

STATEMENT OF SOURCES AND APPLICATION OF FUNDS:

 

According to ICAI, “Fund refers to amount set aside for a general or specific purpose, whether represented by specifically earmarked assets or not.” Organisations try to maintain a balance between the various sources of funds and the application of those funds. Maintaining balance would sound much easy when a proper record of the sources and application of funds is kept. This recorded statement would help the management in deciding whether they are investing in the right place or not and take decisions accordingly. This consolidated record is termed as Statement of Source and Application of Funds.

 

The source and application of funds statement shows the total sources/areas of new funds that are raised by an enterprise between two balance sheet dates, and also tells where the funds are actually used up/ applied between two balance sheet dates. It tells exactly where the money is coming from, and where it is being utilised, and reveals whether the management was competent in making sound investment decisions or not.

 

The statement contains two sections:

 

1.      THE SOURCE: from where the inflow of money took place

2.      THE APPLICATION: where the money was used up

1.      SOURCE OF FUND :

 

Inflow of fund may arise from many sources. It may arise either from An Increase in Liabilities, or Decrease in Assets.

 

Examples of sources of funds include:

 

An increase in equity share capital, increase in reserves, decrease in value of fund asset, proceeds of loan raised, proceeds of shares that were issued, net income after tax, repayments received on loans etc.

 

2.      APPLICATION OF FUND :

 

Application means utilisation of fund, or where the money is being used up. It may arise either from A Decrease in Liabilities, or Increase in Assets.

 

Examples of application of funds include:

 

Losses to be faced by the firm, purchase of fixed assets, granting loans, repayment of loans etc.

 

FORMAT OF STATEMENT OF SOURCES AND APPLICATION OF FUNDS:

 

The statement can be prepared either in vertical form, or horizontal form. The companies prepare this statement and include it in their final accounts, which can be further used by the interested parties. It must be kept in mind that both the sides should tally, at the end of the accounting year. Tallying would mean that the funds sourced from different sources is being utilised fully by the organisation.

 

 

Statement of Sources and Application of Funds as at _____

 

SOURCES OF FUNDS AMOUNT APPLICATIONS OF FUNDS AMOUNT
Share Holder’s Funds: Fixed Assets:
Share Capital Purchase of Land
Reserve and Surplus Purchase of Machinery
Loan Funds: Investments in Mutual Funds
Secured Loans Repayment to Creditors
Unsecured Loans Start Up Costs
Proceeds of Shares Repair of Building
TOTAL TOTAL

 

 

NOTE: The above format is just an extract of the full length statement. Organisations keep a full record of each and every source and application of funds.

 

Let us understand the statement of sources and application of funds with the help of a hypothetical example:

 

Example 2:

 

Statement of sources and application of fund as at ___

 

Sources of Fund Amount Application of Fund Amount
Share Capital: Legal Fees 5000
Preference share capital 20000 Licenses and Permits 15000
Equity share capital 40000 60000 Leasing Costs 15000
Loan: Inventory 25000
Secured loans 70000 70000 Purchase of Land and Building 60000
Repayment of debts 10000
TOTAL SOURCES 130000 TOTAL APPLICATION 130000

 

 

By looking at the Example 2 it can be interpreted that:

 

1)      It can be seen clearly that the company raises funds of Rs 60000 by the way of preference share capital and equity share capital. And borrows Rs 70000 by the way of secured loans. A total amount of Rs 130000 was raised from different sources of funds.

 

2)      Application of funds means the areas where the raised funds are used up. The company here uses up Rs 20000 raised by the means of preference share capital, for paying off legal fee and licenses of Rs 5000 and 15000 respectively.

 

3)      Rs 40000 that was raised by issuing equity shares, is used up for paying the leasing costs and buying inventory for Rs 15000 and 25000 respectively.

 

4)      Funds borrowed as a form of secured loans, are used up for purchasing land and building (Rs 60000) and for repaying the debts due on the company with Rs 10000.

 

5)      It can be noticed that the sum total of sources, equals the sum total of its application. Depicting that the company is using up the funds raised by it to the full capacity.

 

 

USERS TO THE STATEMENT OF SOURCES AND APPLICATION OF FUNDS:

 

This statement serves as a communication tool with the outside world, depicting that from where the business is generating funds and in which areas is using up those funds. Moreover, the statement provides with the exact demarcation of where and how much portion of the raised fund is being used. The statement is used up by the following users:

 

1)      Analysts: for analysing the utilisation of the funds by the company in an accounting year.

 

2)      Management: to make decisions as to from where to finance in the future, and where to invest, keeping in mind the figures in the statement.

 

3)      Banks and other Financial Institutions: for analysing the financial position of the firm, and taking correct decision towards the true financial needs of the firm in the form of loans.

 

4)      Government: for making sure that the organisation is conducting the business in a fair manner, and to see that it is using the funds exactly where needed. And to keep a check on its operational working.

 

QUICK REVISION

 

▪The statement of sources and application of funds tells exactly where the money is coming from, and where it is being utilised.

▪It reveals whether the management was competent in making sound investment decisions or not.

▪Inflow of fund may arise either from An Increase in Liabilities, or Decrease in Assets.

▪Application of funds may arise either from A Decrease in Liabilities, or Increase in Assets.

▪The statement is used up by different users for their own separate purposes. Such as by the analysts, management, government and financial institutions.

 

 

SUMMARY:

 

Every business is set up with the main aim to earn the profits and perform the operations for a longer period of time. With this aim, the business transacts with the outside world either to gather the funds or to sell its products. For carrying out the business smoothly, every enterprise requires an adequate amount of finance, and continuous generation of funds is also required, so that the growth is not hampered in between and the firm never faces the situation of financial crunch.

 

Firms deal with the current assets and current liabilities throughout its working life, makes efforts to maintain a balance between them so that the current assets are always in a positive balance. The difference between the current assets and current liabilities is termed as Working Capital. And the statement so formed to keep a record of the changes in the working capital of the business in an accounting year, is termed as Statement of Changes in Working Capital. Change means, the net increase or net decrease in the amount of working capital. It becomes an important part of the financial statements of the company and reveals the changes in the working capital (current assets and liabilities) for an accounting year.

 

Moreover, the funds collected by the firm from different sources, and applies to different uses is also recorded in the form of “Statement of sources and application of funds”. Which clearly points out the exact areas where and how much the generated funds are used up by the company. It helps the management in framing policies and keeping a check on the unwanted use of funds (if any). Both the statements form an important portion in the financial report, and provide additional information to the users of the reports, which is not disclosed in the final accounts. Both the statements serves as a complementing, consolidated set of information which helps the investors to take decisions before investing, financial institutions before granting loans and government to keep a check on the working of the business enterprises.

you can view video on Statement of changes in working capital and Statement of sources and application of funds

Few suggested readings to learn more:

 

  • Khan & Jain, “Management Accounting”
  • V.K. Goyal, “Financial Accounting”, Excel Books, New Delhi

 

Points to be Ponder

 

  1. Every business is set up with the main aim to earn the profits and perform the operations for a longer period of time.
  2. With this aim, the business transacts with the outside world either to gather the funds or to sell its products.
  3. For carrying out the business smoothly, every enterprise requires an adequate amount of finance, and continuous generation of funds is also required, so that the growth is not hampered in between and the firm never faces the situation of financial crunch.
  4. Firms deal with the current assets and current liabilities throughout its working life, makes efforts to maintain a balance between them so that the current assets are always in a positive balance.
  5. The difference between the current assets and current liabilities is termed as Working Capital.
  6. The statement so formed to keep a record of the changes in the working capital of the business in an accounting year, is termed as Statement of Changes in Working Capital.
  7. It becomes an important part of the financial statements of the company and reveals the changes in the working capital (current assets and liabilities) for an accounting year.
  8. The funds collected by the firm from different sources, and applies to different uses is also recorded in the form of “Statement of sources and application of funds”.