What is a cash flow statement and why is it needed?
We need to take a couple of steps backwards and then take a deep breath.
The first retraction concerns what you will find on this website under “How to read a balance sheet” and other pieces such as the frequently asked question on a balance sheet. Fundamentally, a balance sheet records the financial strength or weakness of a business overall and at a point in time. In particular, does the business have financial reserves (some fat to feed off in times of strife) or is it highly indebted to outsiders (highly geared). Cash is shown on a typical balance sheet but is only one component of current assets if cash balances exist or current liabilities if the business runs on an overdraft or similar short-term debt. It may also have long-term cash or near-cash investments tucked away (shown in “reserves”) or long-term indebtedness that has to be repaid or rolled-over at a fixed future date (long-term liabilities reducing reserves). But essentially a balance sheet is showing the overall picture and is not a cash indicator.
The second step backwards concerns the profit & loss account. It is vital to understand that when a financial director presents a profit statement, he/she is giving a best shot at what the business has made or lost in a specific period, usually one year or half year or quarter. To do this properly, many payments and receipts in cash are manipulated. That is to say, that part of an amount relating to a prior or future time block will be excluded from the charge to P&L account. Typical examples would be rent and rates paid in advance (prepayments) or trade purchases made but not paid for (accruals and creditors) at the period end. Similarly with income which may be due but not received or received but not yet due (say proforma invoiced.)
A cash-flow statement straightens out prepayments, accruals, cash received in advance and so on by dealing with cash receipts and payments solely. So important are cash flow statements that entities within the scope of FRS 1 (Financial Reporting Standard No 1) are required to prepare a cash flow statement in a prescribed manner. In this way, proper comparisons can be made from period to period and across companies and industries.
The format of the statement starts with the reported profit or loss (taken directly from the published P&L account) adds back depreciation (being non cash), deducts an increase in stock value (or the reverse if lower) and an increase in debtors and adds an increase in creditors. This will produce what is known as “net cash inflow from operating activities”. This figure is then adjusted for:-
* Returns on investments and the servicing of finance
* Capital expenditure
* Acquisitions & disposals
* Dividends on shares
* Management of liquid resources (such as Treasury bills)
to produce the net movement of cash in the period. There is then a reconciliation of this net cash flow to the movement in net debt.
Whilst many businesses need not conform to FRS1, preparing a statement in this format is a very good discipline.
Why is a cash flow statement needed? The best answer to this question lies with another question. Why did XYZ Ltd go bust when it has just reported a whopping great profit? Because it failed to understand that cash is a finite resource and in many people’s eyes the only true test of success in business. If you overreach or fail to collect your debts or carry too much stock etc, etc, you will run out of money whatever the bean-counter says is the “profit” you have made this year.
jgs – April 2010