# What are Funds from Operations? Finding/Calculating Funds from Operations - Direct, Adjusted Profit/Loss a/c, Add Back Methods

## What are Funds From Operations?

Operations imply the regular activities carried on by the organisation.

### Capital accumulated through profits

All the nominal accounts representing the incomes and expenses relating to the operations of the business are closes at the end of the accounting period by transfer to the profit and loss account. Profit and loss account has a credit balance when there are profits and is closed by transfer to the capital account.

The transfer of profit to the capital account would result in the capital account being credited and thereby increasing the existing credit balance in that account which indicates an increase in capital.

Thus, we say that operations result in profits which increase capital.

The opposing idea that operations result in losses which decreases capital is equivalently true.

### Funds from operations = working capital accumulated through profits

There are many transactions taking place in the day to day business operations, which in most cases affects nominal accounts.

Transactions involving nominal accounts can be considered to be cross transactions when they are related to expenses and incomes. All transactions involving expenses and incomes being cross transactions would bring about a change in working capital (fund).

Since, assessing the impact of each and every such transaction on working capital, would involve a laborious work and would not be of much use in analysing working capital changes or funds flow we consider the consolidated view of all such transactions.

Funds from operations represent the change in working capital (fund) brought about by the business operations or transactions involving nominal accounts which represent expenses and incomes.

### Funds from Operations = Net Profit

Where there are no transactions representing appropriations, adjustments, losses, gains in the transactions involving nominal accounts, funds from operations would be nothing but the Net Profit as revealed by the profit and loss account.

Though this is theoretically possible, it would not be so in most cases as we find losses like depreciation in most cases.

By Net Profit we mean the net balance as revealed by the profit and loss account which may be a profit/loss.

## Finding/Calculating Funds from Operations - Methods available

Net profit can be taken to be the funds from operations only when there are no transactions involving nominal accounts which represent losses, gains, appropriations and adjustments or if the net profit is a figure that is not affected by such transactions.

However, in most cases, the net profit is a figure that is affected at least by transactions involving nominal accounts that represent losses and gains.

In most cases, net profit is a figure arrived at after deducting depreciation. The transaction for recording depreciation, not being a cross transaction does not bring about a change in working capital (fund). If we have to take the figure of net profit as the funds from operations, then it should have been arrived at without its influence.

Therefore, we ascertain the funds from operations by making proper adjustments to the figure of net profit based on the transactions that should not have affected it, if it is to be considered as the funds from operations.

Such adjustment involves writing back the affect of transactions which represents losses, gains, appropriations and adjustments.

### Methods for Calculating/Finding Funds From Operations

There are three methods available for finding the funds from operations
• Direct Method
• Adjusted Profit and Loss Account Method

#### Which method to use?

We can use any method of our choice for ascertaining the Funds from Operations.

To use the Direct Method, we should be knowing the figure of Gross Profit.

The other two methods are the similar. The difference is in the way, the information is presented. It would be useful to know both the methods.

## Direct Method for calculating Funds from Operations

Direct method involves redrawing/making up the profit and loss account with postings that represent incomes and expenses excluding the posting that represent losses, gains, appropriations and adjustments.

To use this method, we at least need to have the information relating to gross profit, incomes and expenses.

### Problem

From the information provided in the following profit and loss account, find out the Funds from Operations
Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
3,42,000
1,24,000
76,000
1,32,000
87,000
39,000
91,000
42,000
1,25,000
75,000
50,000
40,000
5,25,000
By Gross Profit
By Commission
By Miscellaneous Income
By Profit on Sale of Asset
12,50,000
2,80,000
1,54,000
64,000
16,84,000  16,84,000

### Finding/Calculating Funds from Operations

Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Funds From Operations
3,42,000
1,24,000
76,000
42,000
11,00,000
By Gross Profit
By Commission
By Miscellaneous Income
12,50,000
2,80,000
1,54,000
16,84,000  16,84,000

The funds from operations would be carried down to the Profit and Loss appropriation account. The affect of the other transactions relating to losses, gains, appropriations and adjustments is dealt with through this account.

### Deriving Net Profit from Funds from Operations

The Funds from Operations are brought down from the Profit and Loss account to the Profit and Loss appropriation a/c and the postings relating to losses, gains, appropriations and adjustments are made in that account for ascertaining the net profit.
Dr Profit and Loss Appropriation a/c Cr
Particulars Amount Particulars Amount
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit (unappropriated)
1,32,000
87,000
39,000
91,000
50,000
40,000
7,25,000
By Funds from Operations
By Profit on Sale of Asset
11,00,000
64,000
11,64,000  11,64,000
To General Reserve
To Special Reserve
To Net Profit
1,25,000
75,000
5,25,000
By Net Profit (unappropriated)
7,25,000
7,25,000  7,25,000

We first consider the postings representing losses, gains and thus obtain the net profit before appropriations and adjustments. Next we consider the postings representing appropriations and adjustments thereby obtaining the net profit transferred to the capital account.

We generally come across a consolidated view of the above account wherein information relating to losses and appropriations are mixed up and information relating to adjustments and gains are mixed up instead of being dealt with separately.

Dr Profit and Loss Appropriation a/c Cr
Particulars Amount Particulars Amount
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000
By Funds from Operations
By Profit on Sale of Asset
11,00,000
64,000
11,64,000  11,64,000

### Profit and Loss Appropriation account in Financial Accounting and Financial Management

The Profit and Loss account in financial accounting is posted with transactions representing expenses, losses, incomes and gains. whereas in financial management (in finding funds from operations) it is posted with transactions representing incomes and expenses only.

The Profit and Loss appropriation account in financial accounting is posted with transactions representing appropriations and adjustments only. Whereas in financial management (in finding funds from operations) it is posted with transactions representing losses, gains, appropriations and adjustments.

### Why call this the Direct Method?

Since we prepare the account starting with the gross profit, (just like in the case of the Profit/Loss account), this method is called the Direct Method.

### Clubbing both the accounts may give a better idea

Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Funds From Operations
3,42,000
1,24,000
76,000
42,000
11,00,000
By Gross Profit
By Commission
By Miscellaneous Income
12,50,000
2,80,000
1,54,000
16,84,000  16,84,000
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit (unappropriated)
1,32,000
87,000
39,000
91,000
50,000
40,000
7,25,000
By Funds from Operations
By Profit on Sale of Asset
11,00,000
64,000
11,64,000  11,64,000
To General Reserve
To Special Reserve
To Net Profit
1,25,000
75,000
5,25,000
By Net Profit (unappropriated)
7,25,000
7,25,000  7,25,000

## Adjusted Profit and Loss Account method for calculating Funds from Operations

Under this method, we make up an account by name Adjusted Profit and Loss a/c posting the Net Profit along with all the postings representing losses, gains, appropriations and adjustments.

This account is the same as the second part of the account prepared in the direct method. We start with posting the net profit and obtain the funds from operations as a balancing figure. Whereas in the direct method we start with the funds from operations and obtain the net profit as the balancing figure.

### Problem

From the information provided in the following profit and loss account, find out the Funds from Operations
Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
3,42,000
1,24,000
76,000
1,32,000
87,000
39,000
91,000
42,000
1,25,000
75,000
50,000
40,000
5,25,000
By Gross Profit
By Commission
By Miscellaneous Income
By Profit on Sale of Asset
12,50,000
2,80,000
1,54,000
64,000
16,84,000  16,84,000

### Finding/Calculating Funds from Operations

Dr Profit and Loss Adjustment a/c Cr
Particulars Amount Particulars Amount
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000
By Funds from Operations
By Profit on Sale of Asset
11,00,000
64,000
11,64,000  11,64,000

### Why call it Adjusted Profit and Loss a/c method?

Since we arrive at funds from operations by adjusting all the losses, incomes, appropriations and adjustments that have affected the net profit as revealed by the profit and loss account we call this the adjusted profit and loss account method.

## Add Back method for calculating Funds from Operations

Except for the way the information is presented, this method is similar to the adjusted profit and loss account method. Under this method, we make up a statement that starts with Net Profit and make adjustments relating to the transactions of incomes, losses, appropriations and adjustments that have affected the net profit to arrive at the funds from operations.

The current period Net Profit may have to be ascertained from the ledger account to which the Net Profit is transferred (Capital a/c, Profit and Loss Appropriation a/c, Retained Earnings a/c etc).

Where there are no further transactions affecting the account to which the net profit/loss is transferred, the current period net profit would be equal to the difference between the closing and opening balances in that account. A negative difference indicates that a net loss has been transferred to that account during the current period.

losses and appropriations that have been taken into consideration in calculating the above figure of net profit.

• From that sum we DEDUCT

incomes and adjustments which have been taken into consideration in calculating the above figure of net profit.

### Problem

From the information provided in the following profit and loss account, find out the Funds from Operations
Dr Profit and Loss a/c Cr
Particulars Amount Particulars Amount
To Salaries and Wages
To Rent and Rates
To Interest
To Provision for Taxes
To Depreciation on Machinery
To Depreciation on Furniture
To Loss on Sale of Motor Car
To General Reserve
To Special Reserve
To Goodwill Written off
To Discounts on issue of Shares
To Net Profit
3,42,000
1,24,000
76,000
1,32,000
87,000
39,000
91,000
42,000
1,25,000
75,000
50,000
40,000
5,25,000
By Gross Profit
By Commission
By Miscellaneous Income
By Profit on Sale of Asset
12,50,000
2,80,000
1,54,000
64,000
16,84,000  16,84,000

### Finding/Calculating Funds from Operations

Statement for Calculation of Funds from Operations
Particulars Amount Amount
Profit and Appropriation a/c:
Closing Balance
Less: Opening Balance

–
Current Period Profit
Add: Losses/Appropriations debited to Profit/Loss a/c
1) Provision for Taxes
2) Depreciation on Machinery
3) Depreciation on Furniture
4) Loss on Sale of Motor Car
5) General Reserve
6) Special Reserve
7) Goodwill Written off
8) Discounts on issue of Shares/Debentures

1,32,000
87,000
39,000
91,000
1,25,000
75,000
50,000
40,000
5,25,000

6,39,000
Less: Gains and Adjustments credited to Profit/Loss a/c
1) Profit on Sale of Asset

64,000
11,64,000
64,000
Funds From Operations 11,00,000

### Why call it the Add Back method?

Since we find the Funds from Operations by starting with the net profit, and adding back the losses and appropriations which have been taken into consideration in calculating the net profit earlier, this method is called the Add Back Method.

## Is Funds From Operations a Source/Inflow or Application/Outflow

Funds from operations implies capital accumulated through profits from operations.

The Profit/Loss account shows a credit balance when there are profits and a debit balance when there are losses. The P/L account is closed by transferring its balance to either the Capital account or the Profit and Loss appropriation account, both of which are non-current liabilities.

For the purpose of the below explanation, assume that the profit and loss account is closed by transfer to the capital account and the capital account has a credit balance.

### When there are profits

A transfer of net profit from profit and loss account to the Capital account will result in the capital account being credited and the profit and loss account being debited.

Capital account generally has a credit balance and any further credit to it would result in an increase in the balance in that account.

Dr Capital a/c Cr
Particulars Amount Particulars Amount
To Balance c/d
8,05,000

By Balance b/d
By Net Profit
2,80,000
5,25,000
8,05,000  8,05,000
By Balance b/d 8,05,000

Capital would appear in the balance sheet as below

Balance Sheet of M/s ___ as on ___
Liabilities 31st March Assets 31st March
2009 2010 2009 2010
Capital
2,80,000
8,05,000
...
...
...

Capital account being a non-current account, an increase in its balance indicates an inflow of working capital (fund).

When there are profits, the funds from operations would amount to an inflow/source of funds.

### When there are losses

A transfer of net loss from the profit and loss account to the Capital account will result in the capital account being debited and the profit and loss account being credited.

Capital account generally has a credit balance and a debit to it would result in a decrease in the balance in that account.

Dr Capital a/c Cr
Particulars Amount Particulars Amount
To Net Loss
To Balance c/d
65,000
2,15,000
By Balance b/d
2,80,000

2,80,000  2,80,000
By Balance b/d 2,15,000

Capital would appear in the balance sheet as below

Balance Sheet of M/s ___ as on ___
Liabilities 31st March Assets 31st March
2009 2010 2009 2010
Capital
2,80,000
2,15,000
...
...
...

Capital account being a non-current account, a decrease in its balance indicates an outflow of working capital (fund).

When there are losses, the funds from operations would amount to an outflow/application of funds.

 ... 111213 ...