Financial Statements and Firm Value 125The uses of funds are:- Cash loss, i.e., loss before providing for all non-cash expenses
- Capital expenditure
- Investment in other companies
- Dividends paid
- Redemption of term loans and repayment of other liabilities
- Liquidation of other liability (current and non-current)
- Acquisition of other assets (current and non-current)
The funds flow statement has two portions—one that tracks the movement of funds in the long-term
account comprising non-current assets and non-current liabilities, and the other tracks the movement of
funds in the short-term account, i.e., amongst current assets and current liabilities. Ideally, there should be a
surplus in the long-term account which is used as margin money towards working capital. A deficit in the
long-term account may mean that the management has diverted short-term funds to long-term uses, which
is a bad practice. Of course, it could be temporary. For instance, a company may be awaiting the proceeds of
a sale of debenture or term loan. In the interim some short-term sources may be tapped to bridge the gap.
A company should match long-term sources and long-term uses. For instance, capital expenditure may be
financed by equity or long-term debt or some combination. Funds flow analysis throws light on major
corporate financial policies like dividend policy, capital investment, financing mix, etc. The funds-flow
statement should be coupled with other techniques like ratio analysis to make meaningful judgment about
the company’s performance.
The prediction of business failure on the basis of financial ratios has its limitations in the sense that the
choice of ratios is not based on some theory of financial failure and hence the model cannot be generalized.
Consequently, some researchers have developed cash based funds flow model since financial value is
dependent on future cash flow.^2 In other words these studies have tried to find out if the pattern of a firm’s
cash inflows and outflows can differentiate between financially successful and failing firms. In these models
each component of funds flow (e.g., inventory or accounts receivable) is expressed as fraction of total net
flow (= inflows = outflows) to determine the percentage of each component to the total. The mean and standard
deviation of funds flow components of failed and non-failed firms are compared to see if there is any pattern.
The standard deviation of failed firms is usually substantially larger than non-failed firms. These studies
have found that funds flow components provide a reliable signal for discriminating between failed and non-
failed firms.
Cash Flow Statement
A funds flow statement is a broader concept than the cash flow statement in the sense that it reflects changes
in all accounts including cash. A cash flow statement tries to explain the change in cash position between
two balance sheet dates. Thus, an increase in plant and machinery will be recorded as a use in funds flow
statement but may not be recorded in cash flow statement if it does not involve a cash outlay during the
(^2) Gentry, James, Paul Newbold, and David Whitford (1987). ‘Fundflow Components, Financial Ratios and Bankruptcy’,
Journal of Business Finance and Accounting, Vol. 14, No. 4.