Importance and Usefulness
The SCFP is used for two principal purposes: (i) as a means of analyzing what has happened in the past and (ii) as a mean of planning and decision making for future.
As a tool of historical analysis, the statement highlights not only the magnitude and direction of change in the net working capital during the period of two-successive balance sheets but also the factors responsible for it. The information shown in the SCFP is relevant to those making economic decisions. It helps to provide answers to some of the important financial questions related to the company such as.
1. Where did the profit go?
2. Why are dividends not larger?
3. How was it possible to distribute dividends in excess of current earnings or in the presence of a net loss for the period?
4. Why have the net current assets gone down although till net income has gone up?
5. How is it that the net current assets have risen even though there has been a net loss for the period?
6. Why must money be borrowed to finance purchases of new plant and equipment when the cash flow (the sum of the net income and depreciation) is in excess of the required amount?
7. How has the expansion in plant and equipment been financed?
8. What happened to the proceeds of the sale of plant and equipment resulting from a contraction or operations?
9. How was the retirement of debt accomplished?
10. What became of the assets derived from an increase in outstanding share capital?
11. What became of the proceeds of the debt is issue?
12. How was the increase in working capital financed?
These questions apart, the SCFP also enables the management to ascertain whether the magnitude and type of commitment Pertaining to various sources of raising funds are in conformity with the type of commitment required for their corresponding uses. To be specific, it enables the management to see whether the long-term funds are adequate to finance major fixed assets expansion. A situation in which short-term sources (bank overdraft, temporary loans, etc.) constitute the hulk of sources for long-term purposes may not be desirable. Such a pattern of financing likely to cause problems for the firm to meet its current liabilities in future. Besides, the SCFP also indicates the extent of reliance on external resources vis-a-vis the internal sources in the use of funds. Thus, the SCFP clearly highlights the firm's financing and investment activities funds. Thus, the SCFP clearly highlights the firm's financing and investment activities.
Moreover, the SCFP is of almost significance for working capital management decisions also. By listing all transactions of sources and uses of working capital, it provides the management with a net figure of changes in working capital during the two consecutive balance sheet dates. In case change in WC is significant, the management to make in depth investigation/ analysis into its undesired increase or decrease in WC entails cost. The former clearly involves higher interest cost. Besides interest costs, there are chances of inventory accumulations, looking up of receivables, maintaining excessive cash balances, and so on. The latter situation is still more dangerous in terms of its serious consequences to the smooth functioning and running of the business, Clearly, the SCFP provides a measure of sound working capital management.
The SCFP, when prepared on a projected basis, has immense potential/utility as a tool of financial planning. It shows the effect of various financing and investment decisions on WC in future. If the implementation of the decision, results in excessive or inadequate WC, steps may he taken to improve the situation or review the decisions. For instance, if the WC position is expected to deteriorate, funds may be raised by borrowing or issuing new equity shares: If the required amount is not to be raised, plans for acquisition or assets may be postponed or alternative operative plans can be developed to ensure that the desired future level of business operations, expansion and so on, are achieved. Thus, the SCFP enables the management to revise/review its investments, operations and financing activities so as to conform to the desired financial inflow and outflow of resources, Above all the long-term lenders of funds can use the statement as a means of estimating the firm's ability to service its debts.