Over the past three months, I have attended numerous meetings with clients to discuss audit results and the audited financial statements that needed to be finalized in time for the statutory filing deadline. During such meetings, the discussion would normally revolve around the client’s financial statements, particularly on the company’s financial performance, which is the first thing the client examines.
I have yet to encounter a client that inquired or even looked seriously at the cash flow statements. I, myself, would have to admit to giving less focus on the cash flow statements. When we perform our audit, we prioritize the examination of items in the statement of financial position: the assets, liabilities and equity of the company.
This pattern makes me think about whether the cash flow statement is still relevant to business owners. Aside from the financial reporting standards’ requirement to submit cash flow statements, does it provide other value?
Is the cash flow statement really inferior to other financial statements? Aside from making the financial statements a page thicker, how does the cash flow statement help business owners analyze and understand their organization better? Is it possible that business owners do not see the importance of cash flow statements, because they do not have a clear picture of what it conveys?
The cash flow statement is a critical and integral part of the financial statements, as it tells business owners how much cash the business generates. The profit or loss statement is also important, as it indicates whether a company generates a profit. I once encountered a client asking why their company had no cash despite the profits earned. This is where the role of the cash flow statement comes into play, as it supplements the information provided in the profit or loss statement.
The financial statements are based on accrual accounting, which takes into account non-cash income and expenses to best reflect the financial health of a company. The use of accrual accounting, however, creates accounting noise; it is influenced by the management’s choice of accounting policies, judgements and estimates.
The cash flow statement tunes out these management choices and clearly delineates how much actual cash a company generates. In terms of the reliability of the balances, the cash flow statement allows little room for manipulation, unlike reported earnings. Unless tainted by fraud, this statement tells the whole story of cash flow: either the entity has cash or it does not.
The cash flow statement is classified into three sections: cash flow from operations, cash flow from investing, and cash flow from financing. The net cash flow (the change in cash and cash equivalents during the period) shares little information in itself; it is the classification and individual components that provide the information.
Cash flow from operating activities measures the amount of cash generated or used by a company as a result of producing or selling goods and services. Although negative cash flow from operations is expected in some circumstances (e.g., rapid growth), positive cash flows from operations are essential for long-term survival.
Cash flow from investing activities normally reflects cash outflows used for capital expenditures, business acquisitions, and investments. For an owner, capital expenditure (capex) is the most important item as this is necessary to support a company’s efficient operations and competitiveness. Lastly, cash flow from financing is dominated by debt and equity transactions. This provides information about the type of financing used to support the company’s operations and investing activities, any returns provided to stockholders (dividends or repurchase of shares), and repayment of debt.
Owners can use the cash flow statement to know where the money went and where it came from. A company could have a reasonably good profit, but the unmonitored amount of money being used to pay off its debts could put it out of business. An entity’s use of cash to build up inventories, finance capital expenditures and extend credit to customers are not visible in the profit-or-loss statement. The profit-or-loss statement could reflect good profits camouflaging the underlying problem of cash deficiency and liquidity, especially if the owner’s focus is solely directed at the bottom line.
Cash flow is relatively (but not completely) free of the drawbacks of the accrual concept; it is less likely to be affected by variations in accounting principles and estimates, making it more useful than the reported income in assessing liquidity and solvency. The cash flow statement can also help business owners make financing and investing decisions. When owners decide on the best approach to grow the business, they can use the cash flow statement to decide how to fund their growth. Owners can opt to fund their growth through operations—if the company generates enough cash flow from operations—finance it through debt or equity, or both.
The cash flow statement helps predict an entity’s ability to sustain (and increase) cash flow from operations, making it a valuable measure of a company’s strength, profitability, and the long-term outlook.
It can also help determine whether a company is liquid enough to sustain its operations. Organizations can also
use a cash flow statement to predict future cash flows, making it an essential budgeting tool. Owners should not disregard the information in the cash flow statement and should seriously use it to their advantage.
I look forward to the day when in the course of a meeting with clients, someone would ask about the items in their cash flow statements.
Boyet Murcia III is a partner of Audit & Assurance of P&A Grant Thornton, one of the leading audit, tax, advisory and outsourcing firms in the Philippines, with 21 partners and over 900 staff members. We’d like to hear from you! Tweet us: @PAGrantThornton, like us on Facebook: P&A Grant Thornton, and email your comments to firstname.lastname@example.org or email@example.com. For more information, visit our website: www.grantthornton.com.ph.
As published in The Manila Times, dated 25 April 2018