Sarah Ardiles and Tom Clendon discuss the much-debated topic of what’s more useful, profit or cash flow. In this, the first of a two-part series, they investigate the benefits of cash flow.
Sarah sets the scene
I was teaching cashflow statements the other day and, as an introduction, I found myself singing the praises of this often-overlooked part of the financial statements. A student asked the very reasonable question, ‘if a statement of cash flows is so useful, what’s the point of publishing a profit and loss account too?’ It certainly got me thinking!
Tom speaks up for cash flow statements
Like you Sarah, I find it very easy to ‘sell’ cash flow statements to my students; I love their simplicity. Ultimately, it’s all about money in minus money out and I think everyone can relate to this (I mean we all have bank statements, don’t we?). The layout is a bit more elaborate than a bank statement – we classify the receipts and payments into various types of business activity: operating, investing, and financing. Also, what I like about the cash flow statement is it takes an annual view: it shows how much cash was received in the 12 months prior to a reporting date and how much was paid in that period to give a net cash inflow or outflow figure. So yes, the simplicity of this lovely statement certainly makes it very useful in that it is easy to understand.
Sarah investigates the word ‘useful’
I completely agree with you, Tom. Intuitively, a cash flow statement seems to me the easiest of all of the financial statements to make sense of. And actually, the Conceptual Framework states that financial statements are more useful if they can be easily understood. But, more fundamentally, the Framework points out that to be useful the financial statements must be relevant. Relevance, in the world of financial reporting, means being capable of making a difference in the decisions made by users of the financial statements.
Tom links the word ‘relevance’ to cash flow
The beauty of cash flow statements is that they are undeniably relevant, not least because they can help us make predictions about a company’s capacity to generate future cash and its ability to meet its obligations. Arguably, cash flows are a better indicator of a company’s financial health than profit is. It is perfectly possible for a company to report profits but still go out of business. Quite simply, sales don’t equate to cash received. If your customers are not paying you on time or if you are offering them unaffordably attractive credit terms, you may find you do not have the cash on hand to operate in the meantime. To be successful, it is paramount that a company pays special attention to its cash cycle: the number of days between the outlay of cash for its purchases and the subsequent cash received from its customers. In other words, a business must be able to cover the cash gap between receivables and payables. And of course a cash flow statement will best highlight any shortfall.
Sarah talks about being able to adapt
Sadly, as we have seen over the past 18 months, many businesses have been put under huge strain as a result of the COVID-19 pandemic. Having sufficient cash reserves has made all the difference to those businesses who were able to adapt to this unprecedented event. Many businesses had to find a new business model, for example selling online, while others had to invest in new technology, and a great many faced the urgent task of retraining their staff to use new equipment and processes. All of this involved cash. Cash that was readily available. And it is not as simple as just raising loan finance when you need it; lenders will look at a company’s current and projected cash flows to determine whether the company can afford the additional debt. And if you are able to secure finance, it will be accompanied by additional cash obligations, most pertinently compulsory interest payments.
Tom has the last word about cash flow
Sarah, we have clearly espoused the virtues of cash flow! The phrase ‘Cash is King’ has for good reason made its way into common parlance. And as an SBR tutor who teaches ethics, I can’t help but point out that (yet) another benefit of cash flow is that it is far harder to manipulate cash flow than it is profit so that has to be a good thing!
Sarah sums up
Reporting on cash flow is clearly extremely useful; it’s easy to understand, it helps investors make predictions about a business, and it can reveal a business’s potential to adapt to changing economic environments. Cash is ultimately the lifeblood of a business and is therefore an invaluable component of financial reporting. I can’t wait to catch up with you next month Tom to hear what you have to say about profit and dare I say ‘matching’ – a term I absolutely love and, like you, spend much of my time discussing and explaining.
Tom Clendon FCCA is an online ACCA SBR lecturer www.tomclendon.co.uk
Sarah Ardiles is an ACCA FR and SBR freelance lecturer – see courses here