The information below will help you to understand a set of financial statements. However, it is not really needed for making day-to-day commercial trading decisions. That said, this first video may be worth watching as it highlights the importance of cash flow.
The statements we are considering, unlike the Income Statement and Statement of Financial Position, are not part of an organisation’s accounts – they are prepared to highlight differences that have occurred over time, between the dates of 2 Statements of Financial Position.
The images below are taken from the spreadsheet model for Big Air Toys and any changes you make in the spreadsheet will be reflected in these statements – click on the relevant tabs.
The Source and Use (Application) of Funds statement contains the difference in value for every balance sheet element between two periods. Each difference is either a “Source” of funds or a “Use” of funds. The methodology is to lay the balance sheets side by side and next to them have a “Source” and “Use” column, where the differences are entered. It can be confusing! The table below will help:
Once the Sources and Uses have been identified, the Cash Reconciliation Statement can be prepared. It uses the cash balance for period 1 as the opening balance and the cash balance for period 2 as the closing balance. Cash Out items are taken from the Use column of the Sources and Funds statement, Cash In items from the Sources column. For example from our scenario (figures may be different depending on changes that have been made):
Sometimes a cursory glance at the statement will reveal anomalies. A particular concern is the type of funding used during trading. The golden rule of matching is that short-term funding is for short-term uses (e.g. to fund a marketing campaign) and long-term funding is for long-term uses (eg fixed assets). When a firm is growing, it is usual for some of its working capital to be provided by long-term funds.
At first glance. it may seem that WCR is a short-term investment because it is made up of current assets, which will become cash within a year, and current liabilities, which will decrease the firm’s cash holdings within a year. But, the answer is not that simple. Although these assets and liabilities are classified as current, or short-term, they will be replaced by new current assets and new current liabilities as the operating cycle repeats.
As long as the firm stays in business, working capital requirement will remain in its (managerial) balance sheet and, hence, is more permanent than transient in nature. Hence, working capital requirement is essentially a long-term investment. Under a matching strategy, it should be financed with long-term funds. It is a different matter if the firm is shrinking. If capital is tied up in accounts receivable (in other words, your customers funding their businesses with your money) there may be insufficient to invest in the fixed assets required for production or for funding R&D.
Corporate cash flow is an alternative approach and emphasises changes in Working Capital Requirement. Here is an example from the scenario, year 1.
The change in working capital requirement (WCR) is:
(accounts receivable + inventories + prepayments)
(accounts payable + accruals)
To finish this section, here is a link to a page of models and checklists for financial statements under IFRS