The distinction between Profit and Cash. A business can be profitable but short of cash.

Cash is completely different from profit, a fact that is not always properly appreciated.

It is possible, and indeed quite common, for a business to be profitable but short of cash.

Among the differences are the following:

1. Money may be collected from customers more slowly (or more quickly) than money is paid to suppliers.
2. Capital expenditure (unless financed by hire purchase or similar means) has an immediate impact on cash.  The effect on profit, by means of depreciation, is spread over a number of years.
3. Taxation, dividends and other payments to owners are an appropriation of profit.  Cash is taken out of the business which may be more or less than the profit.
4. An expanding business will have to spend money on materials, items for sale, wages, etc. before it completes the extra sales and gets paid.  Purchases and expenses come first.  Sales and profit come later.

Four Key Questions when using Financial Information and Interpreting Accounting Ratios

There are many traps in using financial information and interpreting accounting ratios.

You are advised to approach the job with caution and always keep in mind four key questions:

1. Am I comparing like with like?
2. Is there an explanation?
3. What am I comparing it with?
4. Do I believe the figures?

1.  Am I comparing like with like?

Financial analysts pay great attention to the notes in accounts and to the stated accounting policies.

One of the reasons for this is that changes in accounting policies can affect the figures and hence the comparisons.

For example:

• Consider a company that writes off research and development costs as overheads as soon as they are incurred.
• Then suppose that it changes policy and decides to capitalize the research and development, holding it in the Balance Sheet as having a long-term value.
• A case can be made for either treatment but the change makes it difficult to compare ratios for different years.

2.  Is there an explanation?

Do not forget that there may be a special reason for an odd-looking ratio.

For example:

• Greetings card manufacturers commonly deliver Christmas cards  in August with an arrangement that payment is due on 1 January.
• The 30 June Balance Sheet may show that customers are taking an average of 55 days' credit.
• The 31 December Balance Sheet may show that customers are taking an average of 120 days' credit.
• This does not mean that the position has deteriorated dreadfully and the company is in trouble
• The change in the period of credit is an accepted feature of the trade and happens every year.
• It is of course important, particularly as extra working capital has to be found at the end of each year.

3.  What am I comparing it with?

A ratio by itself has only limited value.

It needs to be compared with something.

Useful comparisons may be with the company budget, last year's ratio, or competitors' ratios.

4.  Do I believe the figures?

You may be working with audited and published figures.

On the other hand, you may only have unchecked data rushed from the accountant's desk.

This sort of information may be more valuable because it is up to date.

But beware of errors.

Even if you are not a financial expert, if it feels wrong, perhaps it is wrong.

Cash Flow Statement

There are sometimes disputes about the figures in the Profit and Loss Account and Balance Sheet.

This is one reason why cash is so important.  

Cash is much more a matter of fact rather than of opinion.

It is either there or it is not there.

Whether the cash came from (banks, shareholders, customers) is also a matter of fact.

So too is where the cash went to (dividends, wages, suppliers, etc.).

The Cash Flow Statement gives all this information.

How do you identify an exceptional company with a durable competitive advantage from the CASH FLOW STATEMENTS?

How do you identify an exceptional company with a durable competitive advantage?

Financial statements are where you can search for companies with a durable competitive advantage that is going to make one super rich.

CASH FLOW STATEMENTS

The cash flow statement keeps track of the actual cash that flows in and out of the business.

A company can have a lot of cash coming in, through the sale of shares or bonds and still not be profitable.

A company can be profitable with a lot of sales on credit and not a lot of cash coming in.

The cash flow statement will tell us if the company is bringing in more cash than it is spending (“positive cash flow”) or if it is spending more cash than it is bringing in (“negative cash flow”).

Cash flow statements like income statements cover a set period of time.

The cash flow statement has three sections:

·               Cash flow from operating activities

·              Cash flow from investing activities

·              Cash flow from financing activities

Cash flow from operating activities

Net income + depreciation & amortization = Total Cash from Operating Activities

Depreciation and amortization are real expenses from an accounting point of view.

They don't use up any cash because they represent cash that was spent years ago.

Cash flow from investing activities

This area includes an entry for all capital expenditures made for that accounting period.

Capital expenditure is always a negative number because it is an expenditure which causes a depletion of cash.

Total Other Investing Cash Flow Items adds up all the cash that gets expended and brought in, from the buying and selling of income producing assets.

If more cash is expended than is brought in, it is a negative number.

If more cash is brought in than is expended, it is a positive number.

Capital Expenditure + Other Investing Cash Flow Items = Total Cash from Investing Activities

Cash flow from financing activities

This measures the cash that flows in and out of a company because of financing activities.

This includes all outflows of cash for the payment of dividends.

It also includes the selling and buying of the company’s stock.

When the company sells shares to finance a new plant, cash flows into the company.

When the company buys back its shares, cash flows out of the company.

The same thing happens with bonds.

Sell a bond and cash flows in; buy back a bond and cash flows out.

Cash Dividends Paid + Issuance (Retirement) of Stock, Net + Issuance (Retirement) of Debt, Net  = Total Cash from Financing Activities

Net Change in Cash

Total Cash from Operating Activities + Total Cash from Investing Activities + Total Cash from Financing Activities = Net Change in Cash

Some of the information found on a company’s cash flow statement can be very useful in helping us determine whether or not the company in question is benefiting from having a durable competitive advantage.

Capital Expenditures

Capital expenditures are outlays of cash or the equivalent in assets that are more permanent in nature – held longer than a year – such as property, plant and equipment.

They also include expenditures for such intangibles as patents.

They are assets that are expensed over a period of time greater than a year through depreciation and amortization.

Capital expenditures are recorded on the cash flow statement under investment operations.

When it comes to making capital expenditures, not all companies are created equal.

Many companies must make huge capital expenditures just to stay in business.

If the capital expenditures remain high over a number of years, they can start to have deep impact on earnings.

As a rule, a company with durable competitive advantage uses a smaller portion of its earnings for capital expenditures for continuing operations than do those without a competitive advantage.

Coca Cola spent 19% of its last ten years total earnings for capital expenditure.  Moody spent 5% of its total earnings for the last ten years for capital expenditure.

GM used 444% more for capital expenditure than it earned over the last ten years.  Goodyear (tire maker) used 950% more for capital expenditure than it earned over the last ten years.

For GM and Goodyear, where did all that extra money come from?

It came from bank loans and from selling tons of new debt to the public.

Such actions add more debt to these companies’ balance sheets, which increases the amount of money they spend on interest payments and this is never a good thing.

Both Coke and Moody’s, however, have enough excess income to have stock buyback programs that reduce the number of shares outstanding, while at the same time either reducing long-term debt or keeping it low. 

Both these activities helped to identify the businesses with a durable competitive advantage working in their favour.

When looking at capital expenditures in relation to net earnings, add up a company’s total capital expenditures for a ten year period and compare the figure with the company’s total net earnings for the same ten year period.

The reason we look at a ten year period is that it gives us a really good long term perspective as to what is going on with the business.

Historically, durable competitive advantage companies used a far smaller percentage of their net income for capital expenditures.

If a company is historically using 50% of less of its annual net earnings for capital expenditures, it is a good place to look for a durable competitive advantage.

If it is consistently using less than 25% of its net earnings for capital expenditures, that scenario occurs more than likely because the company has a durable competitive advantage working in its favour.

Stock Buybacks

Companies that have a durable competitive advantage working in their favour make a ton of money.

The companies can sit on this cash, or they can reinvest it in the existing business or find a new business to invest in. 

If they don’t require the cash for the above, they can also either pay it out as dividends to their shareholders or use it to buy back shares.

Shareholders have to pay income tax on the dividends.  This doesn’t make anyone happy.

A neater trick is to use some of the excess money that the company is throwing off to buy back the company’s shares.

This reduces the number of outstanding shares – which increases the remaining shareholders’ interest in the company – and increases the per share earnings of the company, which eventually makes the stock price go up.

If the company buys back its own shares it can increase its per share earnings figure even though actual net earnings don’t increase.

The best part is that there is an increase in the shareholders’ wealth that they don’t have to pay taxes on until they sell their stock.

To find out if a company is buying back its shares, go to the cash flow statement and look under Cash from Investing Activities, under a heading titled “Issuance (Retirement) of Stock, Net”.

This entry nets out the selling and buying of the company’s shares.

If the company is buying back its shares year after year, it is a good bet that it is a durable competitive advantage that is generating all the extra cash that allows it to do so.

One of the indicators of the presence of a durable competitive advantage is a “history” of the company repurchasing or retiring its shares.

How to use a cash flow statement to identify strong versus risky companies

What is a Cash Flow Statement

This important document is used to help determine how money flows through a business. Prior to 1987, investors could only examine the health of a company from the income statement and balance sheet. Due to stricter regulations, publicly traded companies are now required to also disclose the cash flow statement.

The cash flow statement is broken down into three categories. 

1. Operating Activities: This is probably the most important section of the statement because it shows the money that's flowing into the business from the product or service that the company produces. Positive revenues listed on the cash flow statement from other activities are not sustainable in the long term, so that's why this section is so important. 

2. Investing Activities: A negative number listed in this section would mean that the company is investing money. A positive number in this section would mean that the company sold an asset in order to generate money. Obviously its better to see a negative number show-up under this section because it implies that the company is continuing to invest the revenues that it produces. 

3. Financing Activities: In this section, an investor can identify whether the business is try to raise money or pay off debts. A positive number in this section means the company is incurring debt or dilute the value of their shares. A negative number means the company is paying off debt or increasing the value of their shares (through a share buy back). Generally speaking its good to see a negative number under this section because it means the company is removing their leverage and creating a stronger position for their shareholders.

The Cash flow is a great document to help look at trends and how money flows through a business. Although the balance sheet and income statement are very useful documents for determining the intrinsic value of a stable company, the cash flow statement gives potential investors a glimpse into the current conditions of the company and how they manage their resources.

http://www.buffettsbooks.com/intelligent-investor/cash-flow-statement/what-is-cash-flow-statement.html



How to read the cash flow statement
http://www.buffettsbooks.com/intelligent-investor/cash-flow-statement/how-to-read-cash-flow-statement.html

Financial Statements: Introduction

Table of Contents

1. Financial Statements: Introduction
2. Financial Statements: Who's In Charge?
3. Financial Statements: The System
4. Financial Statements: Cash Flow
5. Financial Statements: Earnings
6. Financial Statements: Revenue
7. Financial Statements: Working Capital
8. Financial Statements: Long-Lived Assets
9. Financial Statements: Long-Term Liabilities
10. Financial Statements: Pension Plans
11. Financial Statements: Conclusion

Financial Statements:

Introduction
By David Harper

Whether you watch analysts on CNBC or read articles in The Wall Street Journal, you'll hear experts insisting on the importance of "doing your homework" before investing in a company. In other words, investors should dig deep into the company's financial statements and analyze everything from the auditor's report to the footnotes. But what does this advice really mean, and how does an investor follow it?

The aim of this tutorial is to answer these questions by providing a succinct yet advanced overview of financial statements analysis. If you already have a grasp of the definition of the balance sheet and the structure of an income statement, this tutorial will give you a deeper understanding of how to analyze these reports and how to identify the "red flags" and "gold nuggets" of a company. In other words, it will teach you the important factors that make or break an investment decision.

If you are new to financial statements, don't despair - you can get the background knowledge you need in the Intro To Fundamental Analysis tutorial. Read more: http://www.investopedia.com/university/financialstatements/#ixzz279MZnu00

The Essentials Of Corporate Cash Flow (3)

Digging Deeper into Cash Flow
All companies provide cash flow statements as part of their financial statements, but cash flow (net change in cash and equivalents) can also be calculated as net income plus depreciation and other non-cash items.

Generally, a company's principal industry of operation determine what is considered proper cash flow levels; comparing a company's cash flow against its industry peers is a good way to gauge the health of its cash flow situation. A company not generating the same amount of cash as competitors is bound to lose out when times get rough.

Even a company that is shown to be profitable according to accounting standards can go under if there isn't enough cash on hand to pay bills. Comparing amount of cash generated to outstanding debt, known as the operating cash flow ratio, illustrates the company's ability to service its loans and interest payments. If a slight drop in a company's quarterly cash flow would jeopardize its loan payments, that company carries more risk than a company with stronger cash flow levels.


Unlike reported earnings, cash flow allows little room for manipulation. Every company filing reports with the Securities and Exchange Commission (SEC) is required to include a cash flow statement with its quarterly and annual reports. Unless tainted by outright fraud, this statement tells the whole story of cash flow: either the company has cash or it doesn't.


What Cash Flow Doesn't Tell Us
Cash is one of the major lubricants of business activity, but there are certain things that cash flow doesn't shed light on. For example, as we explained above, it doesn't tell us the profit earned or lost during a particular period: profitability is composed also of things that are not cash based. This is true even for numbers on the cash flow statement like "cash increase from sales minus expenses", which may sound like they are indication of profit but are not.

As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of indicating the overall financial well-being of the company. Sure, the statement of cash flow indicates what the company is doing with its cash and where cash is being generated, but these do not reflect the company's entire financial condition. The cash flow statement does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts receivable and accounts payable, each of which can be very large for a company, are also not reflected in the cash flow statement.

In other words, the cash flow statement is a compressed version of the company's checkbook that includes a few other items that affect cash, like the financing section, which shows how much the company spent or collected from the repurchase or sale of stock, the amount of issuance or retirement of debt and the amount the company paid out in dividends.

The Bottom Line
Like so much in the world of finance, the cash flow statement is not straightforward. You must understand the extent to which a company relies on the capital markets and the extent to which it relies on the cash it has itself generated. No matter how profitable a company may be, if it doesn't have the cash to pay its bills, it will be in serious trouble.

At the same time, while investing in a company that shows positive cash flow is desirable, there are also opportunities in companies that aren't yet cash-flow positive. The cash flow statement is simply a piece of the puzzle. So, analyzing it together with the other statements can give you a more overall look at a company' financial health. Remain diligent in your analysis of a company's cash flow statement and you will be well on your way to removing the risk of one of your stocks falling victim to a cash flow crunch.

by Investopedia Staff
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.


Read more: http://www.investopedia.com/articles/01/110701.asp#ixzz1hW0PDzMV

The Essentials Of Corporate Cash Flow (2)

What Is the Cash Flow Statement?
There are three important parts of a company's financial statements: the balance sheet, the income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a company's assets and liabilities (see Reading the Balance Sheet). And the income statement indicates the business's profitability during a certain period (see Understanding The Income Statement).

The cash flow statement differs from these other financial statements because it acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the company's cash transactions (the inflows and outflows) during the given period. It shows whether all those lovely revenues booked on the income statement have actually been collected. At the same time, however, remember that the cash flow does not necessarily show all the company's expenses: not all expenses the company accrues have to be paid right away. So even though the company may have incurred liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are paid (see the section "What Cash Flow Doesn't Tell Us" below).

The following is a list of the various areas of the cash flow statement and what they mean:

Cash flow from operating activities - This section measures the cash used or provided by a company's normal operations. It shows the company's ability to generate consistently positive cash flow from operations. Think of "normal operations" as the core business of the company. For example, Microsoft's normal operating activity is selling software.
Cash flows from investing activities - This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement.
Cash flows from financing activities - This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the company is servicing debt but can also mean the company is making dividend payments and stock repurchases, which investors might be glad to see.

When you look at a cash flow statement, the first thing you should look at is the bottom line item that says something like "net increase/decrease in cash and cash equivalents", since this line reports the overall change in the company's cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the difference between the current CCE and last year's or last quarter's, you'll get this same number found at the bottom of the statement of cash flows.

In the sample Microsoft annual cash flow statement (from June 2004) shown below, we can see that the company ended up with about $9.5 billion more cash at the end of its 2003/04 fiscal year than it had at the beginning of that fiscal year (see "Net Change in Cash and Equivalents"). Digging a little deeper, we see that the company had a negative cash outflow of $2.7 billion from investment activities during the year (see "Net Cash from Investing Activities"); this is likely from the purchase of long-term investments, which have the potential to generate a profit in the future.Generally, a negative cash flow from investing activities are difficult to judge as either good or bad - these cash outflows are investments in future operations of the company (or another company); the outcome plays out over the long term.

The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6 billion in positive cash flow from its usual business operations - a good sign. Notice the company has had similar levels of positive operating cash flow for several years. If this number were to increase or decrease significantly in the upcoming year, it would be a signal of some underlying change in the company's ability to generate cash.


Read more: http://www.investopedia.com/articles/01/110701.asp#ixzz1hVxZy4dt

The difference between Earnings and Cash - Analyze Cash Flow The Easy Way

Summary

Once you understand the importance of how cash flow is generated and reported, you can use these simple indicators to conduct an analysis on your own portfolio. 

The point is to stay away from "looking only at a firm's income statement and not the cash flow statement." 

This approach will allow you to discover how a company is managing to pay its obligations and make money for its investors.

Difference Between Earnings and Cash

At least as important as a company's profitability is its liquidity - whether or not it's taking in enough money to meet its obligations. 

Companies, after all, go bankrupt because they cannot pay their bills, not because they are unprofitable. 

The Statement of Cash Flows


Cash flow statements have three distinct sections, each of which relates to a particular component - operations, investing and financing - of a company's business activities.

1.  Cash Flow from Operations: 

-  This is the key source of a company's cash generation. 

-  It is the cash that the company produces internally as opposed to funds coming from outside investing and financing activities. 

-  In this section of the cash flow statement, net income (income statement) is adjusted for non-cash charges and the increases and decreases to working capital items - operating assets and liabilities in the balance sheet's current position.

2.  Cash Flow from Investing: 

-  For the most part, investing transactions generate cash outflows, such as capital expenditures for plant, property and equipment, business acquisitions and the purchase of investment securities. 

-  Inflows come from the sale of assets, businesses and investment securities.

-  For investors, the most important item in this category is capital expenditures. 

-  It's generally assumed that this use of cash is a prime necessity for ensuring the proper maintenance of, and additions to, a company's physical assets to support its efficient operation and competitiveness.

3.  Cash Flow from Financing: 

-  Debt and equity transactions dominate this category. 

-  Companies continuously borrow and repay debt. 

-  The issuance of stock is much less frequent. 

-  Here again, for investors, particularly income investors, the most important item is cash dividends paid. It's cash, not profits, that is used to pay dividends to shareholders.

A Simplified Approach to Cash Flow Analysis


-  A company's cash flow can be defined as the number that appears in the cash flow statement as net cash provided by operating activities, or "net operating cash flow".

-  Many financial professionals consider a company's cash flow to be the sum of its net income and depreciation (a non-cash charge in the income statement). While often coming close to net operating cash flow, this professional's short-cut can be way off the mark and investors should stick with the net operating cash flow number.

Indicators to measure investment quality of company's cash flow 


The following indicators provide a starting point for an investor to measure the investment quality of a company's cash flow:

1.  Operating Cash Flow / Net Sales: 

-  This ratio, which is expressed as a percentage of a company's net operating cash flow to its net sales, or revenue (from the income statement), tells us how many dollars of cash we get for every dollar of sales.
-  There is no exact percentage to look for but obviously, the higher the percentage the better. 

-  It should also be noted that industry and company ratios will vary widely. Investors should track this indicator's performance historically to detect significant variances from the company's average cash flow/sales relationship along with how the company's ratio compares to its peers. 

-  Also, keep an eye on how cash flow increases as sales increase; it is important that they move at a similar rate over time.

2.  (a)  Free Cash Flow: 

-  Free cash flow is often defined as net operating cash flow minus capital expenditures, which, as mentioned previously, are considered obligatory. 

- A steady, consistent generation of free cash flow is a highly favorable investment quality – so make sure to look for a company that shows steady and growing free cash flow numbers.


FCF = 
Net Operating Cash Flow - Capital Expenditures

2 (b).  Comprehensive Free Cash Flow:
-  For the sake of conservatism, you can go one step further by expanding what is included in the free cash flow number. 

-  For example, in addition to capital expenditures, you could also include dividends for the amount to be subtracted from net operating cash flow to get to get a more comprehensive sense of free cash flow. 

Comprehensive FCF 
= Net Operating Cash Flow - Capital expenditure - dividends.

-  This could then be compared to sales as was shown above.


FCF / Net Sales
Comprehensive FCF / Net Sales


-  As a practical matter, if a company has a history of dividend payments, it cannot easily suspend or eliminate them without causing shareholders some real pain. 

-  Even dividend payout reductions, while less injurious, are problematic for many shareholders. 

-  In general, the market considers dividend payments to be in the same category as capital expenditures - as necessary cash outlays.
-  But the important thing here is looking for stable levels. This shows not only the company's ability to generate cash flow but it also signals that the company should be able to continue funding its operations. 

3..  Comprehensive Free Cash Flow Coverage: 

-You can calculate a comprehensive free cash flow ratio by dividing the comprehensive free cash flow by net operating cash flow to get a percentage ratio - the higher the percentage the better.


Comprehensive FCF Coverage 
=  Comprehensive FCF / Net operating cash flow


Importance of free cash flow.


Free cash flow is an important evaluative indicator for investors. 

- It captures all the positive qualities of internally produced cash from a company's operations and subjects it to a critical use of cash - capital expenditures. 

-  If a company's cash generation passes this test in a positive way, it is in a strong position to avoid excessive borrowing, expand its business, pay dividends and to weather hard times.

-  The term "cash cow," which is applied to companies with ample free cash flow, is not a very elegant term, but it is certainly one of the more appealing investment qualities you can apply to a company with this characteristic. 



Read more:http://www.investopedia.com/articles/stocks/07/easycashflow.asp#ixzz1hPqfkDZZ

DIS Technology - Check List: What can we learn from this ugly saga?

As with Transmile, it is sad that the investors are again caught in such a fraud.  There must be heavy penalties for those involved, not least, to emphasize the seriousness of this matter and to deter future such happenings.

Could this fiasco, of false accounting, be predicted looking at the latest quarterly reported results?  Often the answer is NO, though it was obvious that the company's business was deteriorating and the balance sheet was not good quality. 

The revenues and earnings were manipulated in the accounting.  However, the cash flow statement would have indicated that not all is well with the company.  The CFO was strongly negative.

http://spreadsheets.google.com/pub?key=tZmdsnrXUbsFVCAmAaQRW4g&output=html

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Blogger Wisdom Wise has written a nice article on reading the annual report which I have copied and paste here:

Tuesday, March 09, 2010

Reading the Annual Report

When you look at a woman, which part of her anatomy do you look at first? Is it her face, her bosom or her bottom? It is all a matter of choice. It doesn't matter so long as you get to look at the whole picture. Now, when you look into an annual report, it is the same. Which statement do you prefer to see first. Is it the income statement, the cash flow statement or the balance sheet? Personally, I go straight for the balance sheet to find out what the company has and what it owes others. If I don't find things attractive there, I will just close the report, avoid the stock and move on.
The things that I pay attention in the balance sheet are: Paid-up capital, par value per share, retained earnings, current assets, and current liabilities. I pay special attention to its cash position and how much debt it has. If its debt is too high, when compared to its equity, I will normally lower the grading of the stock. Don't forget that all companies that folded are those with very high debt.
From the balance sheet, I go to the income statement , the cash flow statement, and then the CEO's statement, or Chairman's statement. If both are available, I'll read them both and also the notes in the annual report to ascertain that the company is not involved in any litigation. Lastly, I will go to the page that shows the names of the majority shareholders. A strong major shareholder is a advantage. Take the case of YTL Cement whose major shareholder is YTL Corp.
Things to consider when assessing a company are as follows: a) Calibre of management; b) Modal of business; c) Earnings per share; d) Dividend yield; e) Cash and debt position; f) Barrier of entry; and g) sustainability of profit.

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)