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.

Late filing of financial accounts

Unfortunately, a small minority of companies file their accounts late or even not at all.

This is an offence for which the directors can be punished and the company incur a penalty, but it does happen.

It is often companies with problems that file late.

Why profit is listed with the liabilities in the Balance Sheet?

Assets and Liabilities in the Balance Sheet

• Assets in the Balance Sheet are the debit balances in the bookkeeping system.
• Liabilities in the Balance Sheet are credit balances in the bookkeeping system.

Credit and Debit Balances in the Profit Statement

• In the Profit Statement, sales and income are the credit balances.
• In the Profit Statement, costs are the debit balances.
• The net total of all the balances is the profit or loss.
• This one figure (profit or loss) goes into the Balance Sheet as a single item.
• A profit is a credit which is listed with the liabilities.

Explanation on why profit (a credit balance in the Profit Statement) is listed with liabilities in the Balance Sheet

• The explanation is that the profit belongs to someone outside the business. 
• If the Balance Sheet is for a company, the profit belongs to the shareholders.
• It may one day be paid to them in the form of a dividend or by return of capital on the winding up of the company.

Debit and Credit Balances

The first rule of double-entry bookkeeping is that for every debit there must be a credit.

This means that an accounting entry always involves one account being debited and another account being credited.

Let us consider what happens when a $20,000 car is purchased.

• The Motor Vehicle account (which is an asset) is debited with $20,000.
• The Bank Account is credited with $20,000.

Two accounting rules to Understand Balance Sheets

In order to understand the Balance Sheets, you must be familiar with the following two fundamental accounting rules:

• For every debit there must be a credit.
• Balance Sheet assets are debit balances and Balance Sheet liabilities are credit balances.

Depreciation

Fixed assets are assets that will have a value to the business over a long period, usually understood to be any time longer than a year.

They do usually lose their value:

• either with the passage of time (e.g. a lease),
• with use (e.g. a piece of machinery that wears out) or
• due to obsolescence (e.g. computers).

Therefore, they are written off over a number of years.

Depreciation is a book entry and no cash is involved.

The entry is:

• debit depreciation (thus reducing profit)
• credit the asset (thus reducing the value of the asset).

Fixed assets are grouped together in the Balance Sheet and one total is given for the net value of all of them.

Examples of fixed assets are:

• freehold property
• plant and machinery
• computers
• motor vehicles

Prudent Reserves

When something happens that causes an asset to lose value, it is written off.

• For example, if some stock (asset) is stolen, the value of the stock in the Balance Sheet is reduced.

The same thing must happen if a prudent view is that an asset has lost some of its value.

• For example, if some of the stock is obsolete and unlikely to sell for full value.
• Normally, the Balance Sheet will just show the reduced value, which will be explained with notes.

Stock reserve

The creation of a stock reserve reduces the profit.

• If it is subsequently found that the reserve was not necessary, the asset is restored to its full value and the profit is correspondingly increased in a later period.

Bad debt reserve

It is often necessary to create a bad debt reserve to cover money that may not be collectable from customers.

• This bad debt reserve reduces the profit.
• For example, loan loss reserve or provision by the banks.

Working Capital

This is the difference between current assets and current liabilities.

It is extremely important.

• A business without sufficient working capital cannot pay its debts as they fall due. 
• In this situation it might have to stop trading even if it is profitable.

Possible alternatives might include:

• raising more capital,
• taking out a long-term loan, or
• selling some fixed assets.

Try to get a long-term loan

A bank overdraft is repayable on demand.

A long-term loan is repayable at a future date, or more likely in installments over a period.

If times are hard (or even if they are not), there are obvious advantages to having a long-term loan instead of an overdraft, or as well as an overdraft.

So long as you do not breach the terms of the agreement, you cannot be forced to pay it back quickly.

This gives you peace of mind.

Get your customers to pay on time

Take it seriously and give the task the time and resources necessary.

Tel yourself that you are entitled to be paid on time and that you are being cheated if you are not.

Agree the terms in advance and make it clear that they should be honoured.

A good motto is "ask early and ask often".

If all else fails take legal action.

A tough but fair line will probably not upset your customers, but it might.

Ask yourself if you really want those customers.

Never forget the importance of working capital

Working capital is the difference between assets realizable in the short term and liabilities payable in the short term.

It includes cash held and money owed.

Quickly realizable assets are the next best thing to cash.

If you can get the working capital right, you should be safe.

Try hard to achieve this.

Never forget the importance of cash

"Cash is King"

Losses may eventually force a business to close but in the short term, lack of cash is likely to be the critical factor.

You should hoard cash and you should plan your cash flow very carefully - daily if necessary.

Talk to your bank early and explain your plans.

Cash should be the number one priority.

Keep an eye on the accounting ratios

These are always useful, but are particularly so if a business is in trouble.

You should know what is acceptable and you should monitor trends over a period.

If things are going wrong, this may spotlight the dangers and indicate where remedial action is needed.

Gearing and the number of days' credit given and taken may be especially useful.

Do not overlook the value of marginal costing

When times are tough there is likely to be pressure on sales and margins.

In this situation, marginal costing could be very helpful.

It may be essential to cut fixed costs and it may be necessary to adjust prices.

Marginal costing should help you make the right decisions.

Prevention is better than cure

It is good to be able to get out of financial difficulties but it is better not to have financial difficulties in the first place.

The intelligent and timely use of financial information can help avoid them.

It is tempting not to plan and budget in the good times, but it is probably a mistake.

Do not drown in financial detail

You may be given a vast amount of financial information, particularly if you work for a large company.

This could be because someone believes that it is useful or just because the system automatically provides it.

Remember the old saying about not being able to see the wood for trees.

Learn to concentrate on what is important and give little or no attention to the rest.

That way you will get the key financial information and still have time to do your job.

This is particularly important when things are tough and your time is at a premium.

Use the financial figures quickly

Financial data should help you survive tough times and it will be more valuable if you can get it quickly and use it quickly.

It is sometimes better to have slightly inaccurate or incomplete information quickly than perfect information some time later.

Talk this over with your financial colleagues.  Make time to look at it and act on it when it comes.

Be sceptical about expert advice

Experts will probably give you good advice, but do not overlook the possibility that they may be mistaken.

• For centuries, experts said that the world was flat, but Christopher Columbus proved them wrong.
• Experts (who were paid a lot of money) or some of them at least, failed to foresee and plan for the economic mess that has plaqued much of the world in 2008/2009.

You may not be a financial expert but you are probably an expert at your particular job.  If the advice feels wrong, perhaps it is wrong.

Investment Decisions

Some investment decisions are easy to make.

• Perhaps, a government safety regulation makes an item of capital expenditure compulsory.
• Or perhaps, an essential piece of machinery breaks down and just has to be replaced.

Many other investment decisions are not nearly so clear cut and hinge on whether the proposed expenditure will generate sufficient future cash savings to justify itself.

There are many very sophisticated techniques for aiding this decision.  Here are three techniques that are commonly used:

• Payback
• Return on investment
• Discounted cash flow.

Payback

This has the merit of being extremely simple to calculate and understand.  It is a simple measure of the period of time taken for the savings made to equal the capital expenditure.

Return on investment

This takes the average of the money saved over the life of the asset and expresses it as a percentage of the original sum invested.

Discounted cash flow.

This technique takes account of the fact that money paid or received in the future is not as valuable as money paid or received now.  For this reason, it is considered superior to payback and to return on investment.  However, it is not as simple to calculate and understand.  Discounted cash flow involves bringing the future values back to its Net Present Value.

Accounting for a Major Project Lasting 4 Years in the Construction Sector

In accounting, costs must be fairly matched to sales.

This is so that the costs of the goods actually sold, and only those costs, are brought into the Profit and Loss Statement.


A Major Project lasting 4 years

Contractor will be paid $60 m
Costs over the 4 years are expected to be $55 m
Anticipated profit is $5 m.

It is almost certain the contractor will receive various stage payments over the 4 years.

This poses a multitude of accounting problems and there is more than one accounting treatment.

The aim must be to bring in both revenue and costs strictly as they are earned and incurred.

Accounting standards provide firm rules for the published accounts.

1. The full $60 m revenue will not be credited until the work is completed.
2. In fact, there will probably be a retention and it will be necessary to make a reserve for retention work.
3. The final cost and profit may not be known for some years.
4. Conventions of prudent accounting should ensure that profits are only recognized when they have clearly been earned.
5. Losses on the other hand should be recognized as soon as they can be realistically foreseen.  

Failure to act on this convention has led to scandals and nasty surprises for investors.  The collapse of some big companies being examples.


Prudence and the matching of costs to income - the Principles:

• Accruals are costs incurred, but not yet in the books.
• Prepayments are costs in the books, but not yet incurred.
• Profit is reduced by expected bad debts.
• Depreciation is a book entry to reduce the value of fixed assets.
• Profit accounting may differ from cash accounting.
• Profit Statements should be prudent.
• Costs must be matched to income.

Additional Notes:

Accruals (costs not yet entered)
Invoices are submitted after the event and some will not have been entered into the books when they are closed off.  This problem is overcome by adding in an allowance for these costs.  The uninvoiced costs are called accruals.

An example is a company whose electricity bill is around $18,000 per quarter.  Let us further assume that assume that accounts are made up to 31 December and that the last electricity bill was up to 30 November.  The accountant will accrue $6,000 for electricity used but not billed.  If electricity invoices in the period total $60,000 the added $6,000 will result in $66,000 being shown in in the Profit Statement.

Prepayments (cost entered in advance)
Costs may have been entered into the books for items where the benefit has not yet been received.  

For example, consider an insurance premium of $12,000 paid on 1 December for 12 months's coer in advance.  If the Profit Statement is made up to 31 December the costs will have been overstated by 11/12 x $12,000 = $11,000.  The accountant will reduce the costs accordingly.  These reductions are called prepayments.

Bad debt reserves and sales ledger reserves
Many businesses sell on credit and at the end of the period of the Profit Statement money will be owed by customers  Unfortunately not all this money will necessarily be received.  Among the possible reasons are:

• bad debts
• an agreement that customers may deduct a settlement discount if payment is made by a certain date.
• the customers may claim that there were shortages, or that they received faulty goods; perhaps goods were supplied on a sale-or-return basis.

The prudent accountant will make reserves to cover these eventualities, either a bad debt reserve or sales ledger reserve.  Sales (and profit) will be reduced by an appropriate amount.

Time will tell whether the reserves have been fixed at a level that was too high, too low, or just right.  If the reserves were too cautious there will be an extra profit to bring into a later Profit Statement.  If the reserves were not cautious enough there will be a further cost (and loss) to bring into a later Profit Statement.