Reading a Cash-flow Statement

Reading a Cash-flow Statement

The purpose of the cash-flow statement is to explain the movement in cash balances or bank overdrafts held by the business from one accounting period to the next.

What is a cash-flow statement?

Over an accounting period, the money held by a business at the bank (or its overdrafts) will have changed. The purpose of the cash-flow statement is to show the reasons for this change. The cash flow statement is the link between profit and cash balance movements. It takes you down the path from profit to cash. The figures are derived from those published in the annual accounts, and notes will explain how this derivation is arrived at.

What does a cash-flow statement not show?

In the same way that a profit and loss account does not show the cash made by the business, a cash-flow staetement does not show the profit. It is entirely possible for a loss-making business to show an increase in cash, and the other way round too.

Learn to interpret the figures

The cash-flow statement is a 'derived schedule', meaning that the figures are pulled from the profit and loss account and balance sheet statements, linking the two.

Its purpose is to analyse the reasons why the company's cash position changed over an accounting period. For example, a sharp increase in borrowings could have several explanations - such as a high level of capital expenditure, poor trading, an increase in the time taken by debtors to pay, and so on. The cash-flow statement will alert management to the reasons for this, in a way that may not be obvious merely from the profit and loss account and balance sheet.

The generally desirable situation is for the net position before financing to be positive. Even the best-run businesses will sometimes have an outflow in a period (for example in a year of high capital expenditure), but positive is usually good. This become more apparent when comparing figures over a period of time. A repeated outflow of funds over several years is usally an indication of trouble. To cover this, the company must raise new finance and/or sell off assets, which will tend to compound the problem, in the worst cases leading to failure.

Cash is critical to every business, so the management must understand where its cash is coming from and going to. The cash-flow statement gives us this information in an abbreviated form. You could argue that the whole purpose of a business is to start with one sum of money and, by applying some sort of process to it, arrive at another and higher sum, continually repeating this cycle.

COMMON MISTAKES

Confusing 'cash' and 'profit'

As mentioned previously, the most common mistake with cash-flow statements is the potential confusion between profit and cash. They are not the same!

Not understanding the terminology

It is clearly fundamental to an understanding of cash flow statements that the reader is familiar with terms like 'debtors', 'creditors', 'dividends', and so on. But more than appreciating the meaning fo the word 'debtor', it is quite easy to misunderstand the concept that, for example, an increase in debtors is a cash outflow, and equally that an increase in creditors represents an inflow of cash to the business.

Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)