The cash flow statement

• Sources and uses of funds – method
• Opening and closing cash reconciliation
• Long and short analysis
• Financial reporting standards

But when times are bad and the breath of fear has already chilled the markets, the banker must be cautious, conservative, and severe. His business has been aptly compared to that of a man who stands ready to lend umbrellas when it is fine and demand them back when it starts to rain.

SIR GEOFFREY CROWTHER (1907–1972)

The cash flow statement

There are those who would contend that the cash flow statement is more reliable and less subject to manipulation than the profit and loss account.

Many operating cash movements do not appear in the profit and loss account. One reason is that the profit and loss account uses the accruals concept to adjust a company’s cash flows to bring them into line with revenue earned and costs incurred for a specific period. While it is most important that true revenue and costs are identified, these adjustments sometimes hide important aspects of a company’s affairs.

The cash flow statement has in the past been presented in many formats, but it has now been standardized into the layout shown (in slightly simplified form) in figure 11.6 (later).

However, despite its clarity, it cannot, as is occasionally suggested, replace the profit and loss account. The latter correctly distinguishes between cash paid for electricity consumed last month and cash paid for a building that will be occupied by the company for the next 20 years.

This chapter looks at the logic of the cash flow statement and how it can be of use to management.

Sources and uses of funds – method

To get at the data needed in order to build a cash flow statement, we go through a sources and uses exercise. The mechanics of this exercise are easy to grasp and are shown in figure 11.1.

In figure 11.1 a simplified balance sheet is shown for the two years 2000 and 2001. It has been laid out in vertical columns to facilitate comparison between the two years. The assets are in the upper section of the statement and the liabilities in the lower. To the right of the balance sheet, two extra columns have been added – respectively ‘Source’ and ‘Use’.

An entry will be made in one of these columns for every change that has taken place in a balance sheet item.

• If the change has caused a cash out-flow, the entry will be entered in the ‘Use’column.
• For a cash in-flow, the entry will be made in the ‘Source’ column.

Two entries have been illustrated:

1	Fixed assets	$10,000	Use of funds
2	Tax	$500	Source of funds

The logic of the first entry is fairly obvious. The fixed assets have increased from $22,500 to $32,500. The company has had to write a cheque for $10,000. (For the purposes of this exercise we ignore revaluation and depreciation.)

The second entry is less obvious. The amount shown under ‘Tax’ has increased from $2,500 to $3,000. How can an increase in tax be a source of funds? The answer is that the tax amount of $3,000 shown as a liability in the closing balance sheet is unpaid. The company now has the use of $500 more government money than it had one year ago, so for the present it is a source of funds. This liability will have to be paid off in due course. It will then disappear from the balance sheet and be picked up as a use of funds.

Figure 11.1 Sources and uses of funds – example

Rules of construction

The completed statement is shown in figure 11.2. All changes in balance sheet values have been identified and classified as sources or uses. The total sources agree with the total uses. This will always be the case.

It can be difficult at first to distinguish sources from uses and to put items into the wrong columns. Fortunately there is a rule that makes the classification very simple:

	Increase	Decrease
Asset	Use	Source
Liability	Source	Use

Therefore to complete the statement one simply needs to identify a change in any balance sheet value and answer the following questions:

• ‘Is the item an asset or liability?’
• ‘Has its value increased or decreased?’

then the item automatically slots into its correct column.

The exercise illustrates a technique for translating all balance sheet changes into corresponding movements of funds. The reader will appreciate that this method does not in fact identify all cash payments and all cash receipts. What it does is track net movements in assets and liabilities that will impinge on a company’s cash position. The method demonstrated is called the ‘indirect method’.*

Hidden movements

A word of caution is needed here. The indirect method picks up only the net movements in balance sheet values. Of course a net change can be the result of two opposing movements that partly cancel out. A full cash flow statement should pick such items. Even more importantly some movements in balance sheet values do not give rise to cash flow – revaluation of fixed assets is an example (see appendix 1). It may be necessary to get behind some of the numbers to find out if there are any hidden or non-cash movements. Notwithstanding these qualifications, the method illustrated here is a powerful tool of analysis.

Figure 11.2 Completed allocation of sources and uses of funds

Opening and closing cash reconciliation

Once the sources and uses have been identified and reconciled, we can use various layouts of the cash flow statement to draw management’s attention to specific issues.

For instance, the company’s cash position could deteriorate even though high profits have been achieved. To explain why, we could use a layout that would reconcile opening and closing cash with the net cash flow for the period. It would show:

• the opening cash balance,
• the itemized cash out-flows,
• the itemized cash in-flows,
• the closing cash balance.

The layout shown in figure 11.3 illustrates such a reconciliation.

(Note: A cash balance can be positive or negative. A positive position is where there is cash asset whereas a negative position shows up as short-term bank loan.)

The various entries are taken straight from the ‘sources/uses’ statement (see figure 11.2). ‘Cash-out’ items are taken from the ‘use’ column and ‘cash-in’ from the ‘source’ column. There is one exception to this rule: movements in ‘cash’ and ‘short loan’ are not listed because they are absorbed in the ‘opening/closing’ cash positions.

• The total for cash-out comes to: $12,850 (negative)
• The total for cash-in comes to: $ 6,000 (positive)
• The net cash flow is the difference: $ 6,850 (negative)

This net cash flow, added to the opening cash figure of $1,750 (positive) gives the closing cash position of $5,100 (negative).

The statement clearly identifies major movements in the cash position. Even a cursory examination of the figures shows the reason for the negative cash flow. The company has expended $10,000 on fixed assets. This relatively large sum has not been matched by any corresponding large cash in-flows. The assets have been purchased from day-to-day operating cash.

The heavily negative net cash flow also explains why the ‘current ratio’ has dropped from 1.8 to 1.2 times, and the ‘debt to total assets’ ratio of the company has increased from 47 per cent to 54 per cent.

This issue is pursued further in the next section.

Figure 11.3 Opening and closing cash reconciliation

Long and short analysis

The information provided in figure 11.3 adds considerably to knowledge of the company’s affairs that we could have derived from the balance sheet and profit and loss account. Alternative layouts of the cash flow data provide more insights.

In figure 11.4, the same original data have been plotted into a grid that distinguishes between ‘long’ and ‘short’ sources on the one hand, and ‘long’ and ‘short’ uses on the other (refer back to page 111 where the ‘long’ and ‘short’ sections of the balance sheet were identified).

Each item in the ‘Source’ column has been slotted into its appropriate ‘long’ or ‘short’ box. Ditto for all items in the ‘Use’ column. The boxes are totaled to give four major values for comparison.

The main expenditure has taken place in the ‘Long-Use’ box. We identify here the large fixed asset purchase of $10,000.

The corresponding ‘Long-Source’ box shows $2,250. The total amount of long-term cash received into the business by way of ‘Reserves’ and the ‘Long-term loans’ falls considerably short of the fixed asset expenditure.

Because ‘sources’ and ‘uses’ must balance, the above deficit must be made good from the ‘Short-Source’ box. We see that this is indeed the case. The bulk of the cash in-flow falls into the short-term box.

Most of the money that has come into the business has come from ‘accounts payable’ and ‘bank loan’. These are due to be repaid within 12 months. The company has used short-term sources to fund long-term assets.

This layout of the cash flow highlights the fact that ‘current liabilities’ have increased by much more than ‘current assets’ and has brought about the deterioration we have already seen in the ‘current ratio’.

The ‘debt to total assets ratio’ has also deteriorated over the 2000–01 period. This is analyzed in further detail in the next section.

Figure 11.4 Long and short analysis of sources and uses of funds

Long and short strategy

In figure 11.5, the long and short grid of figure 11.4 is repeated, but the detail has been removed to show only the total values in each section. Arrows show the movements of funds. The largest single movement of funds in the company for the 2000–01 period has been the $7,750 raised short and invested long.

The problem with this strategy is that short-term funds have to be repaid quickly, but they cannot be withdrawn from the investment to meet this repayment. Therefore a new source of funds must be found to meet the repayments. Conditions could deteriorate to the extent that the company would be unable to raise new money and it would then be in a financial crisis. The grid has identified a movement of funds that is loaded with risk.

For example, if the company had an existing ratio of 60 per cent debt to 40 per cent equity, then we would expect the new funds to reflect this mix approximately. In the example used, however, the funds have been raised as approximately 90 per cent debt ($11,600 including LTL) and 10 per cent equity ($1,250). It is this high level of debt in the new funds that has damaged the ‘debt to equity ratio’ of the company by moving it from 47 per cent to 54 per cent.

This must be so if we wish to maintain the existing ‘current ratio’. In the example used the short-source box should have a total that is just a little in excess of 50 per cent of the short-use box. In fact the figure that emerges is almost 400 per cent.

The analysis has shown that the company has breached all three principles of cash flow management.

Figure 11.5 Strategy for long and short movements of funds

Financial reporting standards

In recent years there have been a number of highly publicized situations where it emerged after the event that fully audited published financial statements had not provided satisfactory information to the investors or bankers involved. Criticism has been voiced of existing standards of reporting.

As a result the Financial Accounting Standards Boards (FASB) of the various developed countries have stepped up their efforts to impose more rigorous reporting standards. The cash flow statement has been one to receive particular attention.

Phrases such as: ‘to give users information on the liquidity, viability and financial adaptability of the entity concerned,’; ‘improved understanding of a reporting entity’s cash generating or cash absorption mechanisms,’; ‘basis for the assessment of future cash flow,’ give a flavour of the desired objectives.

The standards arrived at lay great stress on identifying the following separate components of the flow of cash and its equivalents:

• operating activities
• servicing of finance and taxation
• investing activities
• financing activities.

They further require a reconciliation of the figure shown for operating profit and operating cash flow, as well as a total showing the net cash in-flow or out-flow before financing.

Figure 11.6 identifies the main headings but omits much of the detail in the interest of clarity.

The terminology in the Reporting Standards will be widely used in boardrooms and management meetings over the coming years. It is important that managers be familiar with this terminology and appreciate the significance of the various components of cash flow. The sources and uses statement has been dropped as a reporting requirement, but it still remains a powerful tool of analysis for managers to use for their own benefit.

Figure 11.6 Main headings of a corporate cash flow report

* One sometimes sees a ‘payments and receipts’ form of cash statement that gives summaries of all cheques paid and received. Such a statement has little analytical value but is crucial for control purposes.