In 1952, renowned American economist Prof. Morris Copeland developed the Flow of Funds (FOF) theory as a supplement to the national income accounting followed earlier.
The national income fell short in illustrating the financial transactions corresponding to the economic activities that took place within an entire economy.
In such, the introduction of the flow of funds accounts heralded a new era in macroeconomic accounting.
What is the Flow of Funds?
The flow of funds is essentially a financial report or account that illustrates fund inflow and outflow in an economy across different sectors operating within it on a whom-to-whom basis.
Where national income accounting fell short was it did not enumerate any list of funds that came into an economy and how the amount was used.
This system of macroeconomic accounting addresses the problems adequately by showing sector-wise fund inflow and sector-wise usage of such funds.
The flow of funds follows a double-entry bookkeeping system. The central bank of an economy publishes the flow of fund data sourced from these accounts periodically.
Flow of Fund Matrix
The flow of funds matrix is the form in which FOF of an economy is represented. It primarily shows six economic sectors. These are –
- Household sector – this sector involves Non-profit organizations within an economy.
- Financial institutions.
- Non-financial corporations – this sector includes, inter alia, insurance companies, mutual funds, pension funds, savings and loan associations.
- Government (central, state, and local).
- Savings and Investment.
- Rest of the world or foreign sector.
Each of these sectors consists of two divisions highlighting the sources and uses of funds side by side in the form of a matrix.
Flow of Funds Example
The following table illustrates the Flow of Funds data in the Indian economy in the Financial Year 1995 – 96.
Note: Here, a negative value is represented within brackets ().
|Particulars||Households||Banking||Other financial institutions||Private corporate business||Government||Rest of the world||Total|
|Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)||Sources (in Rs. Crore)||Uses (in Rs. Crore)|
|Other financial institutions||2,207||42,197||11,274||(1337)||Nil||Nil||45,673||(457)||8,384||2,344||(9)||5,128||67,529||47,875|
|Private corporate business||342||5,976||2,156||22,082||(754)||62,736||Nil||Nil||Re. 1||2,319||Nil||11,978||1,745||105,091|
|Rest of the world||Nil||Nil||4,850||(5,933)||11,990||4,226||4,549||389||12||97||Nil||Nil||21,401||(1,221)|
|Sources – Uses||(99,520)||(33,367)||(48,272)||105,393||75,854||18,319||(18,231)|
Ideally, the Sources – Uses row should show 0 against the column of Total, it is usually not the case.
How to Understand Flow of Funds?
As per Flow of Funds in financial system, the heading of Sources of Funds denotes all income and borrowing in a sector, and another heading, i.e. Uses of Funds represents all expenses and advances/lending.
Moreover, in the flow of funds accounts, sources relate to change in the value of assets, whereas uses relate to change in the value of liabilities.
In the case of sector-wise analysis, it might reveal a disparity between total assets and total liabilities within a sector. However, as far as the economy as a whole is concerned, total sources of funds or liabilities should equal total uses of funds or assets ideally.
- What does change in uses of funds tell?
If there is a positive change in uses of funds, it is telling of the fact that there has been an increase in the value of assets. In case the change in uses of funds is negative, then it represents a decrease in the value of assets.
- What does change in sources of funds tell?
In case sources of funds show positive change, then it represents an increase in the value of liabilities, savings, or net worth. If it shows a negative change, then it denotes a decrease in savings, net worth, or debt repayment.
- Determination of economic growth
One can also reckon the development of an economy as a whole as well as sectoral growth over time by comparing the Flow of Funds accounts. Concerned entities can look at the sources of funds of a sector across periods to understand its income and borrowing patterns. Conversely, they can also view the uses of funds of a sector across periods to reckon its expense and lending patterns.
- Basis for monetary and fiscal policies
Governments can use the Flow of Funds accounts to devise monetary and fiscal policies. Since it offers a detailed matrix concerning how funds are flowing across sectors, it provides a basis for which sector requires what kind of measure to tide over financially adverse conditions.
What are the Limitations of Flow of Funds Accounts?
- Due to its meticulous recording of sectoral financial transactions, it is difficult to analyse and resultantly more complicated.
- It does not account for human capital flow.
- It is challenging to record assets, obligations, and claims sans a fixed value.
Nevertheless, despite its few limitations, the Flow of Funds approach is an exceptional financial account to determine how a nation’s economy is performing and also helps understand its financial standing vis-á-vis different sectors.