Cash tells the truth in accounting

When it comes to assessing business performance the fixation on “profit” is often all-consuming. This reaches its zenith with the obsession on the quarterly results of large, public companies where any deviation from anticipated bottom-line figures is usually disproportionately rewarded or punished.

Of course, as any student of accounting knows, the profit figure is usually something in the eye of the beholder with an array of accounting policies illuminating or obfuscating the true reality of affairs as the case may be. Accounting profit as reported in the income statement is derived after the application of numerous accounting techniques related to areas such as inventory valuation and depreciation policy.

In short, the options available to the creative accountant in preparing the profit and loss account or balance sheet mean that, depending on circumstances and the type of business, there is always a degree of subjectivity.

Cash, as opposed to profits, however, is an entirely objective measure and leaves no room for interpretation. For this reason the cash flow statement has assumed increasing significance over the years and while small business is not required to produce these statements for public disclosure purposes, an understanding of the methodology behind its preparation is useful.

A cash flow statement essentially provides the answer to the following questions: “Where did the money come from?” and “Where did it go?”

The principle difference between the cash flow statement and the income statement/profit and loss statement in that the latter is prepared under the accruals principle. This means that that revenue is recognised during the period when it is earned and expenses are recognised when they are incurred, whether or not cash is received or expended.

Cash flows that appear on the cash flow statement are typically divided into three types.

Operating cash relates to all cash generated and expended from normal business activities – the core product or service.

Investing cash flows relates to non-operating activities, for example the buying and selling of long-term assets, maintenance and servicing of assets.

Financing cash flows is the cash used to finance activities, receipts and payments to shareholders, investors and lenders.

The example below is typical, showing how the net inflows and outflows of cash explains the increase in the cash balance in the balance sheet.

Cash Flow Statement year ended 31 December 19xx (EURm)
Cash flows from operating activities
Operating income
Adjusted for:

Increase in debtors(57)
Decrease in creditors(23)
Decrease in inventory1299
Operating Cash Flow

Investment cash flows

Interest paid(23)
Interest received(11)

Tax paid

Capital expenditure/Financial investment

Fixed assets expenditure
Dividends paid


Repayment of long-term loans(321)
Issue of common stock221(100)

Increase in cash over year

The uses of the cash flow statement are numerous.

First, it allows an assessment of the overall health of the business. It answers questions such as “Can the business meet its funding needs from internally generated cash if external sources of funding dry up?”

It allows for a reconciliation with profit – major discrepancies should be analysed, such as sharply rising levels of debtors or inventory.

The cash flow statement also is a good starting point for projecting future cash flows. It is important to distinguish between one-off changes from those likely to be sustainable. For example, a sharp fall in debtors with no corresponding drop in turnover may represent improved collections but this may well be a one-off event unlikely to be repeated.

The cash flow statement also helps to address any questions over the company’s liquidity. In this respect there are three key areas.

First, there is the question of repayment of existing loans due in the next couple of years.

Second is working capital requirements. Working capital will normally rise in line with inflation or business expansion rates (turnover). A useful ratio to keep an eye on over time is the working capital/sales ratio:

Inventory + Debtors – Creditors / Sales

Finally there is capital expenditure: attention needs to be paid to future requirements although this may not be fully predictable.

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