Chapter- 3B Statement of Changes in Financial Position and Working Capital (Fund

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1 Chapter- 3B Statement of Changes in Financial Position and Working Capital (Fund BSNL, India For Internal Circulation Only 1

2 Statement of Changes in Financial Position and Working Capital (Fund) I. Statement of Changes in Financial Position: Fund may refer to (i) Cash, (ii) Working Capital, or (iii) total financial resources. Fund Flow Statement attempts to analyze the causes for the change in Working Capital only. Similarly, Cash Flow Statement is designed to examine the flows of cash only. Working Capital or cash basis of presenting the financial inflows and outflows appears to be incomplete in the sense that it omits a new major financial and investment activities. In other words, few significant non-current transactions not affecting the Working Capital or Cash Position of the enterprise are not revealed by Fund Flow Statement or cash flow statement, albeit these transactions might have affected considerably the financing mix and position of the enterprise. Issue of equity shares for the purchase of Plant or conversion of Debentures into equity shares are few examples of such transactions. Thus it is felt that a comprehensive statement incorporating the information relating to non-current transactions should be designed and presented along with other published statements. Such statement ahs been termed as Statement of Changes in Financial Position. Definition of the term: actually speaking, the statement of changes in financial position is an extension of fund flow or cash flow statements. It just uses the broader concept of the term fund i.e., fund as equal to total financial resources. As such, a statement of changes in financial position may simply be defined as a statement highlighting the changes in the concern s total financial resources. It attempts to disclose all important aspects of financing and investing activities regardless of whether each or other elements of Working Capital are directly affected. According to International Accounting Standards Committee (IAS No.7), a Statement of Changes in Financial position means a statement which summarizes for the period the resources made available to finance the activities of an enterprise and the uses to BSNL, India For Internal Circulation Only 2

3 which such resources have been put. The Accounting Standard Board set-up by the Institute of Chartered Accountants of India had defined this statement as a statement which summarizes for the period covered by it, the changes in financial position including the sources from which the funds were obtained by the enterprise and the specific uses to which funds were applied. It may be interesting to note that ASB views this statement to signify Fund Flow Statement (i.e., involving changes only in Working Capital), Cash Flow statement (i.e., involving changes only in cash) and Statement of Changes in Financial Position (i.e., involving changes in total financial resources). Importance (usefulness) or objectives : The Statement of Changes in Financial position is more informative and therefore more useful in disclosing the concern s financial and investing activities during the two Balance Sheets dates. Let us quote the opinion of A.P.B. (AICPA Reporting Changes in Financial Position opinion of the Accounting Principles Board No.19, March, 1971 Para 7) that information concerning the financing and investing activities of a business enterprise and the changes in its financial position for a period is essential for financial statement users, particularly owners and creditors in making economic decisions. The A.P.B. has further advocated for preparing and presenting a statement of changes in financial position for a period covered by the profit and loss account. The usefulness of this statement may also be examined on the basis of objectives for which this statement is designed. The basic objectives as narrated by W.B. Meigs are: (i) (ii) (iii) (iv) to provide information on all financing and investing activities to disclose the financial resources (fund) provided by various sources including operations; to highlight upon the uses of these financial resources (fund); to point out the amount and causes of all other changes in financial position This statement has now been considered as a very useful technique and it provides complete and adequate information (though in a summary form) about how activities were financed, how financial resources were collected and applied during a period and how the liquid BSNL, India For Internal Circulation Only 3

4 position was affected. E.A. Spiller holds the view that much of the information about the causes of changes in the assets structure, equity composition, liquidity make up would not be readily available from an analysis of other financial statements. It is also suggested that management may get a lot of help from this statement in making economic decisions. More specially, this statement enables the management to see whether the long-term funds are adequate to finance major fixed assets expansion. Thus this statement is useful to shareholders, investors, creditors and management. Preparation: This statement is prepared on the same principles as were explained in the case of Fund Flow Statement and/or Cash Flow Statement. The only addition to be made is that non-current transactions should also be incorporated in the statement. Thus this statement may be prepared in a form which analyses the sources and uses in two categories of items: (i) (ii) those which affect the Working Capital or Cash Flows; plus those which do not affect the Working Capital or Cash Flows For incorporating second type of items, the following principles should be followed: (a) Increase in assets or decrease in liabilities due to transactions between non-current items should be shown as uses (b) Decrease in assets or increase in liabilities due to transactions between non-current items should be shown as sources. It may be noted that this incorporation of non-current items may be made either in Fund Flow Statement or in Cash Flow Statement. BSNL, India For Internal Circulation Only 4

5 Working Capital (Fund) Forecasting: Business concerns need two types of capital i.e., Fixed Capital and Working Capital. Fixed Capital is required for the purchase of fixed assets, diversification and expansion of the business, renovation/modernization of plant and machinery etc. Working Capital is needed for short-term purposes i.e. to meet the need for current operations. There are two concepts of Working Capital viz., Gross concept and Net concept. According to Gross concept, Working Capital refers to total investments in current assets. This concept emphasizes the quantitative aspect of the Working Capital. According to net concept, Working Capital refers to the difference between current assets and current liabilities. Thus, this concept lays emphasis upon the qualitative aspect of the Working Capital. For the purpose of present discussion, net concept has been used. It is generally contended that the management of working capital is no less important than the management of fixed assets. Management of Working /Capital involves inter-alia the provision for adequate amount of Working Capital and a proper control over it. It is now well recognized that inadequacy or mismanagement of Working Capital is very costly and most important factor of business failures. If Working /Capital is excessive i.e. no proper control is exercised over it, that would also lead to lower profitability and poor financial position. As such, both inadequate Working Capital as well as excessive Working Capital are dangerous for the health of the business. Thus it becomes imperative that financial management should at least attempt: (i) (ii) to analyze the existing Working Capital for deciding its adequacy or otherwise to forecast the Working Capital requirements needed for running the business more profitably and efficiently But before we attempt to discuss the above points, we must mention the factors which determine the Working Capital requirements of a business concern. BSNL, India For Internal Circulation Only 5

6 Factors determining the Working Capital: The Working Capital requirement is affected by a number of factors some of them might be associated with the business concern and some of them might be related to general economic, monetary and business environment. Financial manager has to consider all of them while determining the level of Working Capital. Of the various factors, the most important ones are as under: (1) Nature of the Business: This is the most important factor affecting the level of Working Capital. The Working Capital requirement differs according to the nature of business. Trading, Banking and financial concerns have a large investments in inventories, Cash Balances etc. and very low investments in fixed assets. On the other hand, public utility concerns have a limited need for Working Capital and have to invest heavily in fixed assets. Among the manufacturing concerns, engineering and oil extracting concerns do not need as much of Working Capital as fixed investments. But concerns like tobacco and construction have to invest substantially in Working Capital. (2) Manufacturing Cycle and Time-lag in Production and Sales: The Working Capital requirement is also affected by the length of the manufacturing cycle as well as time lag in production and sales. If the manufacturing cycle involves a longer period, the need for Working Capital will be more in the form of funds being tied up in inventories of raw materials and works-in-progress. Similarly, where there is more time gap or interval between production and sale, the need for keeping finished goods in stock/inventory will be more and hence Working Capital requirement will also be more. (3) Sales Volume and Turnover of Working Capital: More the sales volume of the concern is, less will be the need for Working Capital because the concern may easily provide for meeting the day-to-day payments out of higher sales BSNL, India For Internal Circulation Only 6

7 proceeds. But the speed of sales also affects the need for Working Capital. A concern having high rate of turnover will need lower amount of capital as compared to a concern having lower and irregular turnover. The Working Capital turnover, which indicates the speed of the use of current assets in effecting the sales, also determines the need for Working capital. More is this turnover ratio, less will be the need for Working Capital. (4) Credit Policy (Terms of Sales and Purchases): Credit terms granted by the concern to its customers as well as credit terms granted by its suppliers will also affect the Working Capital requirements. If the concern has allowed very liberal credit terms to its customers and/or has adopted a slack collection procedures, more funds will be tied in book debts and Working Capital needs will also be high. Where suppliers have granted liberal credit terms to the concern, there will be less need for Working Capital. Not only this, the ratio of Cash and Credit sales or purchases will also affect the level of Working Capital. (5) Production Policy: Production policies followed by the management of the business concern will have an important bearing upon the Working Capital requirements. For example, scheduling has much impact upon the level of inventory. Change in the production procedure like introducing automation will also affect the investment patterns in favour of long-term fixed assets. (6) Seasonal Fluctuations Seasonal and cyclical fluctuations in demand for a product in which a concern is engaged will affect the level of working capital. There are certain industries whose production or sales are effected only in particular season. The production of a product only during a particular season in a way to meet the demand for all seasons may require high volume of Working Capital not only for the purchase of raw materials but also for keeping the BSNL, India For Internal Circulation Only 7

8 inventory of finished goods. Sugar industry is an example. Cyclical fluctuations in general economy also will affect the level of working capital. An upward swing in the general economy may lead to increased sales resulting into increased investment in inventory and book debts and vice-versa too. (7) Operating Efficiency: It is also contended that a business concern can minimize its need for Working Capital by efficiently controlling its operating costs i.e. utilizing the resources optimally. Such efficiency in operations will ensure improvement in the use of Working capital and also acceleration in the pace of cash cycle. Profitability will also improve which will help in relieving the pressure on Working capital. (8) Growth and Expansion Although the relationship between Growth and Working Capital needs is not well recognized, it is felt that frowing concerns require more Working Capital than those which are static. As a concern grows, larger amount of Working Capital will be required. (9) Price level changes and Adjustments thereto When the prices are rising in general, higher investment in Working capital is required, because the same level of current assets would need increased investment due to rises in prices. But if the concern is able to revise the prices of its product upward, it may not be compelled to increase the level of Working Capital in the period of rising price levels. But all the concerns may not feel the impact of price level changes upon Working Capital level to the same extent and magnitude. BSNL, India For Internal Circulation Only 8

9 Techniques of Forecasting Working Capital: Generally the following techniques may be used in forecasting the Working Capital for any future period: 1. Operating Cycle method 2. Estimating current assets and current liabilities method 3. Cash Forecasting method 4. Projected Balance Sheet method 5. Profit and loss adjustment method 1. Operating Cycle method: Under this method working capital is determined by (a) total operating expenses for the year, and (b) Number of operating cycles during the year. Total operating expenses will include all expenses (excluding non-cash like depreciation) on raw materials, labour and overheads. While estimating these expenses, it is necessary to adjust for the changes in product-mix, introduction of new product, changes in price-level etc. Number of operating cycles is calculated dividing 365 days of the year by the duration of operating cycles. The duration of operating cycle is the number of days involved in the various stages of the operating cycle (i.e. Cash-Raw materials Finished goods Debtors Cash) as reduced by the credit period allowed by the creditors. The duration of operating cycle in terms of days for various stages may be calculated as under: (i) Materials Storage Period (days) = Average Stock of Materials Daily Average consumption Average Stock Materials = Opening Stock + Closing Stock 2 Daily Average Consumption = Consumption for the year 365 BSNL, India For Internal Circulation Only 9

10 (ii) Conversion period (days) = Average Stock of Semi-finished goods Average daily factory cost Average stock of semi-finished goods = Opening stock + closing stock 2 Average daily factory cost = Total factory Cost 365 Note: Conversion period is sometimes called as production cycle period (iii) Finished goods storage period (days) = Average stock of finished goods Average daily cost of sales Average stock of finished goods = Opening stock + closing stock 2 Average daily cost of sales = Total cost of sales for the year 365 (iv) Average Collection period (Days) = Average Debtors & B/R Net credit sales per day = Average Debtors & B/R x 365 Total credit sales for the year BSNL, India For Internal Circulation Only 10

11 Average Debtors + B/R = Open Drs. & B/R + Clos. Drs. & B/R 2 Net Credit sales per day = Total Credit sales for the year 365 (v) Average payment period (days) = Average Creditors & B/P Net Credit Purchases per day Or = Average Crs. & B/P x 365 Total credit purchases for the year Average Crs. & B/P = Open Crs. & B/P + Clos. Crs. & B/P 2 Net Credit purchases per day = Total credit purchases for the year 365 Note: In order to calculate the duration of operating cycle in number of days, add from (i) to (iv) and deduct (v) (vi) No. of Operating Cycles: 365 Duration of Operating Cycle Working Capital : Total Operating Expenses No. of operating cycles To this amount of working capital, we have to add something for contingencies. BSNL, India For Internal Circulation Only 11

12 2. Estimation of Current Assets and Current Liabilities: This is the traditional method of forecasting the working capital requirements. Since the working capital is the excess of current assets over current liabilities, its requirements can easily be forecasted by making the estimates of the amount of each component of current assets and current liabilities. Again, such estimates can either be made at total value of each component or at cash cost of each component. The procedures for estimating the components may be explained as under: (i) Stock of /Raw Materials: For having a smooth production, raw materials are to be kept in the store. The average amount of such stock of raw materials would depend upon the quantity of raw materials required for production during a particular period as well as upon the average time taken in obtaining fresh delivery. Of course, adjustments for seasonal factors and contingencies like delay in supply are to be made for ascertaining the quantity of raw materials to be kept in stock. Such quantity when multiplied by the price will give the amount of stock of raw materials. In the form of formula: Stock of Raw Materials = P x U x P r P = Period for which stock required U = Units of production during that period P r = Price of materials per unit (ii) Stock of Works-in-progress : Raw materials, wages and overheads are included in the cost of Works-in-progress. (If wages and overheads accrue evenly during the period production is in process, then only half of the wages and overheads for that period shall be taken for determining the cost of works-in-progress. Similarly, when it is mentioned that raw materials are in process, then cost of works-in-progress will consist of only raw BSNL, India For Internal Circulation Only 12

13 materials.) In order to determine the stock of works in progress, we must find out the time period for which the inputs will be in the process of production. This is also known as conversion period. When we multiply the units in process during the said period by the cost of works-in-progress per unit, we find the stock of works in progress. (iii) Finished goods stock: Finished goods are not immediately sold; these are to be kept in go downs or warehouses for certain period. This period is an important factor in determining the amount to be locked up in finished goods stock. On the basis of year s production, the amount of finished goods for the storage period may easily be calculated. (iv) Sundry Debtors: The amount of capital locked up in sundry debtors may be computed on the basis of credit sales, period of credit allowed/time lag in collecting the payments. Again, such amount of Debtors may be determined either at sales value or at cost. In the former case, amount of credit sales is taken into account, while in the later case cost of credit sales (i.e. units sold on credit multiplied by cost per unit) is considered. Calculations may be done as under: Debtors at sales value = U x SP x P U = Units of credit sales during the credit period SP = selling price per unit P = credit period Debtors at Cost = U x C x P C = Cost per unit (v) Cash and Bank Balances: These are estimated on the basis of past experience and the problem / question generally mentions about them. (vi) Sundry Creditors: This is estimated on the basis of credit purchases and the time lag in payments to creditors / credit period allowed by suppliers of raw materials. BSNL, India For Internal Circulation Only 13

14 (vii) Outstanding expenses (i.e. wages, salaries, etc.) : These are ascertained having considered the time lag in payment of various types of expenses. 3. Cash Forecasting Method: This method is very much related to cash budgeting and it attempts to estimate the cash surplus or deficiency For this purpose, receipts and payments expected to flow during the future period are estimated and their difference will disclose the surplus or deficiency. 4. Projected Balance Sheet Method: Under this method, various items of assets and liabilities (both long term as well as current) are estimated after taking into account the transactions expected for the future period. On the basis of these assets and liabilities, a projected Balance Sheet is prepared and then working capital estimate is made by deducting current liabilities from the current assets. 5. Profit and Loss Adjustment Method: According to this method, estimated profit is calculated first on the basis of transactions likely to take place in the future. Working capital magnitude is ascertained by making necessary adjustments for cash inflow and outflow in the estimated profit. In fact, this method attempts to convert profit on cash basis. Questions:- 1. What is the Statement of Changes in Financial Position? 2. What are the objectives of Statement of Changes in Financial Position? BSNL, India For Internal Circulation Only 14

15 3. How is the Statement of Changes in Financial Position prepared? 4. What are the concepts of Working Capital? 5. What are the factors that determine Working Capital? 6. What are the techniques of forecasting Working Capital? BSNL, India For Internal Circulation Only 15

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