Statement of cash flow is the third financial statement given in the annual reports. You would have noticed that all five elements of financial statements have already been covered by Statement of Profit or Loss (Income & Expense) and Statement of Financial Position (Assets, Liabilities and Capital). Therefore, a question arises on the purpose for this statement.
This may surprise you but Statement of Cash Flow explains only one figure from Statement of Financial Position, usually given in Current Assets, “Cash & Cash Equivalents.” If the business is out of cash and running on overdraft, then this figure will be given in Current Liabilities as “Bank Overdraft.” However, in some cases, it is also possible to have both of these figures as a business may have more than one bank account with some positive and some negative balances.
Statement of Cash Flow gives detail on the cash and cash equivalent of the business. “Cash & Cash Equivalents.” are assets which are cash or can be converted to cash on a short notice. This figure shows the company’s ability to meet its financial obligations in short term. For example, paying a supplier of goods or a bank overdraft.
It is important to have more information on cash & cash equivalents to understand the performance of a business. To understand the significance of this statement, let’s take an example of two businesses business A and business B. The opening and closing balances for cash and cash equivalents for these two businesses are given below in the table:
Which business has performed better during 2020?
Considering information given above only, our assessment would be that A has performed better than B as business A has increased his cash and cash equivalent by 10 times whereas the cash and cash equivalent for business B has halved. However, this evaluation will change if we consider the following information.
During 2020, business A took a loan worth £10 million, sold a building for £3.5 million and bought an asset for £2 million. Business B took a loan for £2 million, paid back a loan of £2million and bought plant and machinery £3 million. This was all the cash capital expenditures which both businesses incurred during 2020.
After considering the above information what do you think which business has performed better?
Ignoring the missing figure from the table, the balance for Business A should be £12.5 million and for business B it should be £-2 million. However, the closing balance for A is less and for B it is better than it should be. The missing figure is the “Cash Generated (or lost) from Operation.” Business A lost £2.5 million while Business B generated £1.5 million (missing figures) during 2020 which means B has performed better than A.
Statement of Cash Flow also helps to understand an important concept which is distinctions between profit and cash. Profit is the difference between selling price and cost. However, it is not necessary that the business would actually receive the profit which it made. As many businesses now-a-days offer credit, sometimes the customers take longer to pay. This (among many other reasons) creates difference between the figure of profit and cash which can be seen in the first part of this statement.
The presentation related issue regarding columns, dates given above the columns and the title of this statement are similar to the one which we have discussed in Chapter 6: Statement of Financial Position.
This statement looks at three separate areas which are
•Cash flow from Operating Activities
•Cash flow from Financing Activities
•Cash flow from Investing Activities.
Cash flow from operating activities is calculated by taking the figure of Operating Profit from Statement of Profit or Loss and making various adjustments for working capital movements which cause profit to differ from cash generated from operations figure. This process converts operating profit into the cash generated from operations. This is an important figure which is used in some ratios and we will discuss in detail while calculating and discussing those ratios.
In financing activities, if the company has raised more capital by issuing more shares, this could be a sign off better performance as this reflects that the shareholders has confidence on the company and are willing to invest more money in the business. Therefore, it is important to look at this figure to see if the company has issued any share capital during the year and what was the market response as a result.
If the company has paid back some are all of its loan, this could also be a positive sign as this shows the business has the capacity to meet its commitment. However, if the company has taken more loans this needs to be looked at more carefully. Although taking a new loan could be a sign of poor liquidity which is a negative point but it could also indicate that the lenders are confident about the company’s long-time survival and performance. The rate at which the loan has been taken should also be checked as a higher interest rate would mean that the company is struggling and there is higher risk attached to this company. These issues will be discussed in details while carrying out “Gearing Ratios.”
Under investment activities, purchasing of new plant and machinery would be taken as a good signal while sale of non-current assets would be a negative sign. These aspects should be inspected while carrying out ratios involving non-current assets.
The bottom line figures for cash and cash equivalent are the same as given in Statement of Financial Position in Current Assets section. However, sometimes an adjustment is required if there are any overdrafts which sit in the current liabilities section.
This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.