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Thursday, March 11, 2010

Cash Flow Statements

It has been argued that “profit” does not always give a useful or meaningful picture of a company’s operations. Readers of a company’s financial statements might even be misled by a reported profit figure.
  • Shareholders might believe if a company makes a profit after tax, of say, 100000$ then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders’ expectations would be wrong.
  • Employees might believe that if a company makes profits, it can afford to pay higher wages next year. This option may not be correct: the ability to pay wages depends on the availability of cash.
  • Cash is the life board of the business. Survival of a business entity depends not so much on profits as on its ability to pay its debts when they fall due. Such payments might include “profit and loss” items such as material purchases, wages, interest and taxation etc, but also capital payments for new fixed assets and repayment of loan capital when this falls due.

From these examples, it may be apparent that a company’s performance and prospects depend not so much on the “profits” earned in a period, but more realistically on liquidity or cash flows.

The great advantage of a cash flow statement is that it is unambiguous and provides information which is additional to that provided in the rest of the accounts. It also describes the cash flows of an organization by activity and not by balance sheet classification.

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