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Page13 V UNITIntroduction toAccounting & Financial AnalysisBusiness organizations:Business organizations provide goods and services in order to earn a profit. Goods have form and substance and the seller of goods physically transfers them to the buyer. Soaps, pens, computers, cars and medicines etc. examples for products. Services are work done by one person that benefits another. Examples are hairstyling, writing computer programs etc.Business organizations are of three typesMerchandizing or trading organizations: Buy and sell goods without any processing.Manufacturing organizations: Buy materials, process them into finished products and sell them.Service organizations; Provide services.Meaning of accounting:Accountancy means the complication of accounts in such a way that one is in position to know the state of affairs of the business.Definition of AccountingThe systematic and comprehensive recording of financial transactions pertaining to a business. Accounting also refers to the process of summarizing, analyzing and reporting these transactions. _____R. N. Anthony______Accounting is often called the language of business

Single entry system & Double entry system

Meaning Of Single Entry SystemSingle entry system is an incomplete form of recording financial transactions. It is the system, which does not record two aspects or accounts of all the financial transactions. It is the system, which has no fixed set of rules to record the financial transactions of the business. Single entry system records only one aspect of transaction. Thus, single entry system is not a proper system of recording financial transactions, which fails to present complete information required by the management. Single entry system mainly maintains cash book and personal accounts of debtors and creditors. Single entry system ignores nominal account and real account except cash account. Hence, it is incomplete form of double entry system, which fails to disclose true profit or loss and financial position of a business organization.

Features Of Single Entry SystemThe following are the main features of single entry system:1. No Fixed RulesSingle entry system is not guided by fixed set of accounting rules for determining the amount of profit and preparing the financial statements.2. Incomplete SystemSingle entry system is an incomplete system of accounting, which does not record all the aspects of financial transactions of the business.3. Cash BookSingle entry system maintains cash book for recording cash receipts and payments of the business organization during a given period of time.

Hostile 4. Personal AccountSingle entry system maintains personal accounts of all the debtors and creditors for determining the amount of credit sales and credit purchases during a given period of time.

5. Variations In ApplicationSingle entry system has no fixed set of principles for recording financial transactions and preparing different financial statements. Hence, it has variations in its application from one business to another.

The following are the notable disadvantages of single entry system:

1.Unscientific And UnsystematicThe single entry system is unsystematic and unscientific system of recording financial transactions. It does not have any set of fixed rules and principles for recording and reporting the financial transactions.

2. Incomplete SystemSingle entry system is incomplete system because it does not record the two aspects or accounts of all the financial transactions of the business. It does not maintain any record of the transactions relating to the nominal account and real account except cash account.

3. Lack Of Arithmetical AccuracySingle entry system is not based on the principles of debit and credit. It fails to provide the arithmetical accuracy of the books of accounts. Trial balance can not be prepared under this system to check the arithmetical accuracy of books of accounts.

4. Does Not Reflect True Profit Or LossUnder single entry system, the true amount of profit or loss can not be ascertained because it does not maintain the nominal accounts.

5. Does Not Reflect True Financial PositionThe single entry system does not maintain real accounts except cash book. Therefore, it can not reveal the true financial position of the business.

6. Frauds And ErrorsThe single entry system of book-keeping is incomplete, inaccurate and unscientific. It does not help to check the arithmetical accuracy of the books of accounts. Therefore, there is always a possibility of committing frauds and errors in the books of accounts.

7. Unacceptable For Tax PurposeThe single entry of book keeping has incomplete records of the financial transactions of the business. Hence, the tax office cannot accept the account maintained under this system for the purpose of assessment of tax.

Double entry system:Double entry system is a scientific way of presenting accounts. As such all the business concerns feel it convenient to prepare the accounts under double entry system.Under dual aspect concept the accountant deals with the two aspects of business transaction I. e., (I) receiving aspect and (II) giving aspect, receiving aspect is known as Debit aspect and giving aspect is known as credit aspect. In double entry book keeping system these two aspects are recorded facilitating the preparation of trial balance and the final accounts.The principle under which both debit and credit aspects are recorded is known as the principle of double entry. According to this principle every debit must necessarily have a corresponding credit and vice versa.Features of Double Entry System of Book-keepingThe following are some features or characteristics of double-entry book-keeping.1. Double effecting:It follows the principle of double aspect by debiting and crediting the transaction.2. Equal effect:It assumes that debit must be equal to credit mount i.e. It considers the effect of equal amount.3. Debit and credit:It has two sides i.e. debit and credit. For example, the benefit receive is given the name debit and the benefit giver is given credit.4.Account:It maintains the records of personal, real as well as nominal accounts.5. Arithmetical accuracy:another feature of double entry system of book keeping to check arithmetical accuracy by preparing trial balance.Importance or Advantage of Double Entry Book-Keeping System

The following are the advantages of double-entry book-keeping.1. Complete records of each transaction:Double entry system presents a complete record of transaction. Because it records both the aspect of every transaction, which relates to personal or impersonal.2. Checking of arithmetical accuracy:Arithmetical accuracy can be checked by preparing trial balance from all ledgers concerned.3. Profit or loss:Profit and loss account can easily be prepared. The exact reason for profit and loss can be ascertain.4. Financial position:It provides full particulars of various assets and liabilities of the business, so financial position can be known by preparing balance sheet. A comparative study of the balance sheet for various years shows a firm's progress.5. Frauds and errors:It prevents frauds and errors and makes their detection easier.6. Accepted by court and tax authorities:This system keeps a complete record of financial transaction therefore, it is accepted by court, tax authorities and banking institutions.7. Scientific and systematic:Double entry system of book-keeping is scientific and systematic records of financial transaction.Disadvantage of Double Entry Book Keeping System

1. Expensive:It is an expansive system of book-keeping which is not favorable for small business.2. Complicated:It is complicated system where certain rules and regulations are to be followed.3. Fails:It fails to disclose the error of omission, error of principles, errors of commission, and compensating error

Differences between single entry system & Double entry system

Single-entryDouble-entry

DefinitionSingle-entry system of bookkeeping requires inputting the entry only once in either the credit column or the debit column.Double-entry system requires putting one entry twice, once in the credit column and once in the debit column of another account.

DualityIs not based on the concept of duality.Is based on the concept of duality.

AccountsMaintains simple and personal accounts of debtors, creditors and cashbook.Maintains all personal, real and nominal accounts.

Profit Or LossCannot help in making the companys profit or loss statement.Can help in making the companys profit or loss statement.

SuitabilitySmall businesses where transactions are small and simple.Big businesses and corporations that deal with complex transactions and huge inventories.

Trial BalanceCannot prepare trial balanceCan prepare trial balance

Tax PurposeIs not acceptable for tax purposes.Is acceptable for tax purposes.

Financial PositionCannot ascertain the true financial position of the business.Can ascertain financial position of the business.

AdvantagesSimple, less-expensive, easier to manage, provides general view of earnings and expenditure.Complete data is available, provides an arithmetic check on bookkeeping, helps track debits and credits, can help ascertain the financial position of the business, makes it easier to produce year-end accounts.

DisadvantagesIncomplete data, are not able to provide a check against clerical error, does not record all transactions, does not provide a detailed record of assets, theft and loss cannot be detected.Expensive, harder to understand, requires hiring external staff and time-consuming.

Hostile

Accounting conceptsThe Business Entity ConceptThe business entity concept provides that the accounting for a business or organization be kept separate from the personal affairs of its owner, or from any other business or organization. This means that the owner of a business should not place any personal assets on the business balance sheet. The balance sheet of the business must reflect the financial position of the business alone.Dual Aspect Concept:Under dual aspect concept the accountant deals with the two aspects of business transaction I. e., (I) receiving aspect and (II) giving aspect, receiving aspect is known as Debit aspect and giving aspect is known as credit aspect.The Continuing Concern ConceptIt is assumed that the business will continue for a long time. With this assumption fixed assets are recorded in the books at their original cost. Keeping this assumption in view, prepaid expenses are not treated as the expenses of the year in which they are incurred. It is assumed that the business derives benefit out of it in the years to come.The Principle of ConservatismThe principle of conservatism provides that accounting for a business should be fair and reasonable. Accountants are required in their work to make evaluations and estimates, to deliver opinions, and to select procedures. They should do so in a way that neither overstates nor understates the affairs of the business or the results of operation.The Objectivity PrincipleThe objectivity principle states that accounting will be recorded on the basis of objective evidence. Objective evidence means that different people looking at the evidence will arrive at the same values for the transaction. Simply put, this means that accounting entries will be based on fact and not on personal opinion or feelings.The Revenue Recognition Convention or Accrual ConceptThe revenue recognition convention provides that revenue be taken into the accounts (recognized) at the time the transaction is completed. Usually, this just means recording revenue when the bill for it is sent to the customer. If it is a cash transaction, the revenue is recorded when the sale is completed and the cash received. If this is not done, the earnings statements of the company will be incorrect and the readers of the financial statement misinformed.The Matching PrincipleThe matching principle is an extension of the revenue recognition convention. The matching principle states that each expense item related to revenue earned must be recorded in the same accounting period as the revenue it helped to earn. If this is not done, the financial statements will not measure the results of operations fairly.The Cost PrincipleUsually all the transactions will be recorded at cost in the books. However, at the end of every year the accountant shows the reduced value of the assets, after providing for depreciation. This approach preferred because it is difficult and time consuming to ascertain the market values.The Consistency PrincipleThe consistency principle requires accountants to apply the same methods and procedures from period to period. When they change a method from one period to another they must explain the change clearly on the financial statements.The consistency principle prevents people from changing methods for the sole purpose of manipulating figures on the financial statements.Hostile The Materiality PrincipleThe materiality principle requires accountants to use generally accepted accounting principles except when to do so would be expensive or difficult, and where it makes no real difference if the rules are ignored. If a rule is temporarily ignored, the net income of the company must not be significantly affected, nor should the reader's ability to judge the financial statements be impaired.The Full Disclosure PrincipleThe full disclosure principle states that any and all information that affects the full understanding of a company's financial statements must be include with the financial statements.Accounting period concept: Accounting period is the period followed by a business concern for maintaining accounts to know profit or loss. Usually, one year will be the accounting period starting from 1st April to 31st march.Branches of accountingAccounting has three branches and each branch of accounting is inter - related with other branch. No one branch is perfect without other branch of accounting. Every branch of accounting works only if other branch of account will perform best.Financial AccountingFinancial accounting is the old branch of accounting which is related to make profit and loss account and balance sheet after maintaining daily record of business transactions. Profit and loss shows net profit or net loss for a specific period and balance sheet shows the financial position on the specific date.Cost AccountingCost accounting is that branch of accounting which is related to calculate of total cost or per unit cost of goods or services. Its aim is to reduce cost of production and increase businessmans profitability. In other words , it is used in an organization for controlling the cost .Management AccountingManagement accounting is that branch of accounting which is related to use accounting information for determination of policies and other business decisions . It uses the accounting information for analysis the efficiency of different department of an organization.

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Users of accounting informationAccounting information is useful in making a number of decisions that affect the income or wealth of individuals and organizations. Examples of decisions that are based on accounting information include the following.1. Decide when to buy, hold or sell an equity investment2. Assess the stewardship or accountability of management3. Assess the ability of the enterprise to pay and provide other benefits tom its employees.4. Assess the security for amounts lent to the enterprise5. Determine taxation policies6. Determine distributable profits and dividends7. Prepare and use national income statistics8. Regulate the activities of enterprisesUsers of accounting informationUsers of financial information may be both internal and external to the organization.Internal users(Primary Users)of accounting information include the following:1. Owners Stockholders of corporations need financial information to help them make decisions on what to do with their investments (shares of stock), i.e. hold, sell, or buy more.2. ManagementIn small businesses, management may include the owners. In huge organizations, however, management is usually made up of hired professionals who are entrusted with overall responsibility of operating the business or a part of the business. They act as agents of the owners.Themanagers, whether owner or hired, regularly face economic decisions How much supplies will we purchase? Do we have enough cash? How much did we make last year? Did we meet our targets? All those, and many other decisions, require analysis of accounting information.3. EmployeesEmployees are interested in the companys profitability and stability. They are after the ability of the company to pay salaries and provide employee benefits. They may also be interested in the companys financial position and performance to assess the possibility of company expansion and career opportunities.External users (Secondary Users) of accounting information include the following: 1. LendersLenders of funds such as banks and other financial institutions are interested in the companys ability to pay liabilities upon maturity (solvency).2. Trade creditors or suppliersLike lenders, trade creditors or suppliers are interested in the companys ability to pay obligations when they become due. They are nonetheless especially interested in the company'sliquidity-- its ability to payshort-termobligations.3. GovernmentGoverning bodies of the state, especially the tax authorities, are interested in an entity's financial information for taxation and regulatory purposes. Taxes are computed based on the results of operations and other tax bases. In general, the state would like to know how much the taxpayer is making to determine the tax due thereon.4.CustomersWhen there is a long-term involvement or contract between the company and its customers, the customers may be interested in the companys ability to continue existence and its stability of operations. This need is also heightened in cases where the customers depend upon the entity.For example, a distributor (reseller), the customer in this case, is dependent upon the manufacturing company from which it purchases the items it resells.5. General PublicAnyone outside the company such as researchers, students, analysts and others are interested in the financial statements of a company for some valid reason.Internal users refer to managers who use accounting information in making decisions related to the company's operations.External users, on the other hand, are not involved in the operations of the company but hold some financial interest. The external users may be classified further into users withdirectfinancial interest the owners, investors, lenders and creditors, and users withindirectfinancial interest government, employees, customers and the others.Accounting cycleAccounting cycle is a step-by-step process of recording, classification and summarization of economic transactions of a business. It generates useful financial information in the form offinancial statementsincluding income statement, balance sheet, cash flow statement and statement of changes in equity.Thetime period principlerequires that a business should prepare its financial statements on periodic basis. Therefore accounting cycle is followed once during each accounting period. Accounting Cycle starts from the recording of individual transactions and ends on the preparation of financial statements and closing entries.Major Steps in Accounting Cycle

Journal entriesTherecordingoffinancialdata(taken usually from ajournal voucher) pertaining tobusiness transactionsin ajournalsuch that thedebitsequalcredits. Journal entriesprovideanaudit trailand ameansof analyzing the effects of thetransactionson anorganization'sfinancial position. See alsojournalizing.

LedgerCollectionof an entiregroupof similaraccountsindouble-entry bookkeeping. Alsocalledbook of finalentry, a ledgerrecordsclassifiedand summarizedfinancial informationfromjournals(the 'booksof first entry') asdebitsandcredits, and shows theircurrentbalances. Inmanualaccounting systems, a ledger is usually a loose leafbinderwith a separate page for eachledger account. In computerizedsystems, it consists of interlinkeddigitalfiles, but follows the sameaccounting principlesas the manual system.

Structure of ledgerDateParticularsJ.RAmountDateParticularsJ.RAmount

2005Dec. 17Cash A/C1,2002005Dec. 17Purchases A/C2,000

Trial balanceTrial Balance is a list of closing balances of ledger accounts on a certain date and is the first step towards the preparation of financial statements. It is usually prepared at the end of an accounting period to assist in the drafting of financial statements. Ledger balances are segregated into debit balances and credit balances. Asset and expense accounts appear on the debit side of the trial balance whereas liabilities, capital and income accounts appear on the credit side. If all accounting entries are recorded correctly and all the ledger balances are accurately extracted, the total of all debit balances appearing in the trial balance must equal to the sum of all credit balances.Purpose of a Trial Balance Trial Balance acts as the first step in the preparation of financial statements. It is a working paper that accountants use as a basis while preparing financial statements. Trial balance ensures that for every debit entry recorded, a corresponding credit entry has been recorded in the books in accordance with the double entry concept of accounting. If the totals of the trial balance do not agree, the differences may be investigated and resolved before financial statements are prepared. Rectifying basic accounting errors can be a much lengthy task after the financial statements have been prepared because of the changes that would be required to correct the financial statements. Trial balance ensures that the account balances are accurately extracted from accounting ledgers. Trail balance assists in the identification and rectification of errors.TRADING AND PROFIT AND LOSS ACCOUNT

Final Accounts of sole Traders:show the calculation of profit earned or the loss incurred during the period and the financial position of the business at the end of the period. Final accounts usually prepared from a trial balance.

1. Trading Account: deals with trading (buying and selling). The account shows the calculation of profit earned on goods sold.

Gross Profit = Sales Cost of Goods SoldCost of goods sold = opening stock + purchases + carriage inwards - closing stock

Drawings of goods for personal use is deducted from purchasesCarriage inwards is added to the purchases

2. Profit and Loss Account: shows the calculation of final or true profit. This is the profit after all running expenses and any other items of income. Net Profit = Gross profit + other incomes - Expenses

3. Balance Sheet: is a statement of the financial position of the business on a certain date. It shows what the business owns, and amounts owing to the business- the assets and what the business owes, the liabilities and the capital Proforma of balance sheet

List of some common Expenses, Income, Assets and Liabilities

EXPENSES.Carriage inwards, carriage outwardsPurchases, wages and salaries,Rent and insurance, electricity charges, advertising charges, bank charges,Discount allowed, bad debts,Depreciation of fixed assets,Provision for bad debts, office expenses,Provision for discount on debtorsGeneral expenses, motor expenses,Motor vehicle expensesRepairs to building or machineryInterest on loan

FIXED ASSETSPlant and MachineryLand and BuildingsPremisesEquipmentFurniture and FittingsFixtures and FittingsLawn MoverComputersMotor van/Motor vehicleMotor carCURRENT LIABILITYCreditors for goodsCreditors for expenses: Eg. Rent owing, Salary accrued Wages unpaid General expenses unpaid Commission outstandingBank overdraft[ all unpaid amounts]

INCOMES:Sales, discount received,Commission receivedInterest received, rent received,profit on sale of old fixed assetsCURRENT ASSETSCash in handCash at bankDebtorsClosing stockPrepaid rent, insurance, ratesLONG TERM LIABILITIESLoan from bankMortgage loansDebenture

Ratio analysis:Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. By computing ratios it is easy to understand the financial position of the firm.What is ratio?Ratio is simply a number expressed in terms of another. It refers to the numerical or quantitative relationship between two variables which are comparable.Importance of ratios:1. Liquidity Portion:The liquidity portion of a firm would be satisfactory if it is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short maturing debt usually within a year as well as the principal. This ability is reflected in the liquidity ratios of a firm.2. Long term SolvencyRatio analysis is equally useful for assessing the long term financial viability of a firm. The long term solvency is measured by the leverage or capital structure and profitability ratio which focus on earning power and operating efficiency. Ratio analysis reveals the strength and weakness of a firm.3. Operating efficiencyRatio Analysis throws light on the degree of efficiency in the management and utilization of its assets. It would be recalled that the various activity ratios measures this kind of operational efficiency.4. Overall profitabilityThe management is constantly concerned about the over all profitability of the enterprises they are concerned about the ability of the firm to meet its short term as well as long term obligation to its creditors to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm.5. Inter firm comparisonAn inter firm comparison would demonstrate the relative portion vis--vis its competitors. If the results are at variance either with the industry average or with those of the competitors the firm can seal to identify the probable reasons and in the light take remedial measures.6. Ratios serve as an instrument of management control7. They facilitate and help in forecasting future events8. They help management in exercising effective decisions9. They help management take corrective actionsLimitations of ratios:Ratio analysis despite its wide applications, is not free from limitations1) Accounting ratios are retrospective: The ratios are computed based on the past data or previous performance. They may not necessarily hold good in the future and may not be helpful in making projections into future.2) Accounting methods, policies and procedures are not common3) Inflationary tendencies cannot be highlighted: in times of inflation the accounting data of several years cannot be compared. Any analysis of such data based on ratios cannot be meaningful4) Concepts of ratios are not the same5) Qualitative factors cannot be considered: factors such as managerial abilities cannot be considered here.6) Ratio by itself has no utility: ratios to be meaningful have to be read along with other Ratios. Any single ratio is meaning less by itself. 7) Ratios can be manipulated: during festival season there will be good turnover of stocks when compared to the earlier periods. It is necessary to consider the average inventories to present a fair view of the business activity.Current Assets and Current Liabilities listed:Current assets: cash hand, cash at bank, bills receivable, sundry debtors, marketable/temporary investments, advances(short term), closing inventory of finished goods/work in progress/raw materials, prepaid expenses, accrued income.Current liabilities: bank overdraft, sundry creditors, bills payable, outstanding expenses, dividends payable, tax payable, provision for taxation, provision for dividends, unearned income

Noncurrent assets and Noncurrent liabilities listed:Noncurrent or fixed assets: good will, patents, trademarks and copy rights, land and buildings, plant and machinery, furniture and fittings, long term investments, preliminary expenses, discount on issue of shares and debentures, other deferred revenue expenditure such as advertisingNoncurrent or long term liabilities and owners equity/share holders funds: Equity share capital, preference share capital, share premium, shares forfeited, reserve fund or general reserve, works men compensation fund, capital reserve, depreciation fund or provision for depreciation, debentures, long term loansTypes of Ratios: Based on their nature the ratios can broadly be classified into 4 categories. 1) Liquidity Ratios 2) Activity Ratios3) Capital Structure Ratios or Leverage Ratios or Solvency ratios.4) Profitability Ratios

1) Liquidity Ratios:This expresses the ability of the firm to need its short term commitments as and when they become due. Creditors are interested to know whether the firm will be in a position to meet its commitments on time or not. If the firm is not in a position to meet its short term commitment then it cannot continue in business for long despite its strong capital base. Liquidity ratios help in identifying the danger signals for the firm in advance. Apart from the firm itself all the financing companies offering short-term finances are interested in these ratios.

Liquidity ratios can be classified into two typesCurrent ratio: This is the ratio between current assets and current liabilities. The firm is said to be comfortable in its liquidity position if the current ratio is 2:1. The current assetsinclude cashin hand, cash at bank, debtors, bills receivable, prepaid expenses and so onThe current liabilities include creditors , bills payable , bank overdraft less than one year period, outstanding expenses , Income receive in advance , all provisions , dividends payable and so onThe current ratio is also called working capital ratio. It is because it is related to the working capital of the firm.Quick ratio or liquid ratio or acid test ratio: It measures the firms ability to convert its current assets quickly into cash inorder to meet its current liabilities. It is the ratio between quick assets and quick liabilities.2) Profitability ratios: Profitability ratios throw light on how well the firm is organizing its activities in a profitable manner. The owners expect reasonable rate of return on their investment. The firm should generate enough profits not only to meet the expectations of the owners, but also to finance the expansion activities. The following are the various profitability ratiosa) Gross profit ratio: Gross profit ratio is the ratio between gross profit to sales during a given period it is expressed in terms of percentage. Gross profit is the difference between the net sales and the cost of goods sold.b) Net profit ratio: Net profit ratio is the ratio between net profit after taxes and net sales. It indicates what portion of sales is left to the owners after operating expenses.c) Operating ratio: Operating ratio is the ratio between cost of goods sold plus operating expenses and the net sales. This is expressed as a percentage to net sales. The higher the operating ratio the lower is the profitability and vice versa.d) Return on investment (ROI): return on investment is one of the very important parameters affecting business plan. The profitability of the firm is measured in terms of return on investment. The term investment may refer to total assets, capital employed or owners equity. Its classified into return on capital employed & return on equitye) Earnings per share: EPS is the relationship between net profits and the number of shares outstanding at the end of the given period. This can be compared with previous years to provide a basis for assessing the companys performance.f) Dividend yield: Yield refers to the amount of total return the investor will receive for a given period of time for the amount of his investment.g) Price earnings ratio: This is the share price divided by the earnings per share.3) Solvency Ratios:Solvency ratio is also called capital structure ratios or leverage ratios. It is defined as the financial ratio, which focuses on the long term solvency of the firm. The long term solvency of the firm is always reflected in its ability to meet its long term commitments such as payment of interest periodically without fail.The following are the most commonly used capital structure ratiosa) Debt equity ratio: Debt equity ratio is the ratio between outsiders funds (debt) and insiders fund (equity). This is used to measure the firms obligations to creditors in relation to the owners funds. It is measure of solvency. The yardstick for this ratio is 1:1.b) Interest coverage ratio: interest coverage ratio is calculated to judge the firms capacity to pay the interest on debt it borrows. It gives an idea of the extent the firms earnings may contract before it is unable to pay interest payments out of current earnings.c) Ratios of proprietors funds to total assets: This establishes the relationship between proprietors funds and the total assets. Here the total assets include the tangible fixed assets plus current assets. As a guideline the ratio of around 0.5:1 or 50% is considered as the minimum desirable.

FUNDS FLOW ANALYSISMeaning of funds:By the term funds we generally mean cash. But from the point of view of accountant and finance managers funds means working capital or net working capital. Net working capital or working capital:Net working capital refers to excess of current assets over current liabilities. The current assets are those assets which get convert into cash through business operation within one year. The current liabilities refer to those liabilities which are to be cleared within one year.The net working capital can either be positive value or negative1) Net working capital = current assets current liabilities2) Gross working capital = sum of current assets3) Positive net working capital = current assets > current liabilities4) Negative working capital = current assets < current liabilitiesFunds flow:The funds flow statement Fund flow statement also referred to as statement of source and application of funds provides insight into the movement of funds and helps to understand the changes in the structure of assets, liabilities and equity capital. The information required for the preparation of funds flow statement is drawn from the basic financial statements such as the Balance Sheet and Profit and loss account. Funds Flow Statement can be prepared on total resource basis, working capital basis and cash basis. The most commonly accepted form of fund flow is the one prepared on working capital basis.It reflects the movement of working capital that is the funds flow statement presents the increase or decrease in the working capital. The transactions which result in increase of working capital will be treated as sources of funds and the transactions which result in decrease of working capital will be treated as application of funds.Objectives of funds flow statements:The funds flow statement is prepared to identify different sources and application of funds.in other words it explains the sources of rising funds and how the same has been utilized. The funds flow statements answers the following specific questions.1) How could the firm pay dividends at a higher rate despite declining profits in the year2) How does the firm have more working capital, when the profits have declined drastically 3) Is the firm solvent or not?4) How has the company financed its fixed assets5) Why does the company find it difficult to pay dividends though it has made good profits

Steps in preparation of funds flow statements:1) Preparation of statement showing changes in working capitalPreparation of statement showing changes in working capitala) Increase in current assets will result in increase of working capitalb) Decrease in current assets will result in decrease of working capitalc) Increase in current liabilities will result in decrease of working capitald) Decrease in current liabilities will result in increase of working capital2) Calculation of funds from operations3) Preparation of funds flow statements

Advantages of fund flow are as follows: management of various companies are able to review their cash budget with the aid of fund flow statements Helps in the evaluation of alternative finance and investments plan Investors are able to measure as to how the company has utilized the funds supplied by them and its financial strengths with the aid of funds statements. It serves as an effective tool to the management of economic analysis It explains the relationship between the changes in the working capital and net profits. Help in the planning process of a company It is an effective tool in the allocation of resources Helps the management of companies to forecast in advance the requirements of additional capital and plan its capital issue accordingly. Helps in determining how the profits of a company have been invested: whether invested in fixed assets or in inventories or ploughed back.

Preparation of funds flow statementFunds flow statement