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The importance of cash records and reports

The importance of information about an entity's cash flows is made clear in this GAAP extract:

Information about a reporting entity's cash flows during a period also helps users to assess the entity's ability to generate future net cash inflows. It indicates how the reporting entity obtains and spends cash, including information about its borrowing and repayment of debt, cash dividends or other cash distributions to investors, and other factors that may affect the entity's liquidity or solvency. Information about cash flows helps users understand a reporting entity's operations, evaluate its financing and investing activities, assess its liquidity or solvency and interpret other information about financial performance.

A cash flow analysis should reconcile profit or loss and net cash inflow or outflow of cash for a period.

Cash flow reports - illustration

The P&L account for a business for the year ended 31 December 20XX shows that the business has made a profit of 3,000. It might be expected that as this is a very simple and straightforward business there will be a cash or bank balance of 3,000. Note that the word cash is very often used in businesses small and large when in fact the money will be in one or more bank accounts.

The business has made sales of 30,000 and incurred costs of 25,000 plus a depreciation charge of 2,000. The P&L account for the year is shown in Table 3.1.

Cash movements relate to trading but also include capital transactions, that is, balance-sheet-related transactions. In this case there was a loan of 10,000 taken out, 1,000 repaid and a van purchased - all capital items (Table 3.2).

TABLE 3.1 P&L account

P&L account

TABLE 3.2 Cash book - a simple cash flow statement

Cash book - a simple cash flow statement

Further, the sales and expenses were not all received or paid as cash immediately, 7,000 of sales being due after the year-end - debtors or receivables and 2,500 expenses were due to be paid in the following period. Also, the van was used for one year and the cost of it wearing out while being 'consumed' is estimated at 2,000; this is not a cash cost, as the cash outflow took place when the van was purchased for 9,000 (depreciation is discussed in more detail in Chapter 5).

It is vital in a business of whatever size to track cash, as a deficit that cannot be funded short or long term inevitably leads to insolvency and bankruptcy. At the highest level, the CFO and executives need to have reliable summary cash reports.

TABLE 3.3 Reconciliation of profit amount with final cash amount

Reconciliation of profit amount with final cash amount

The net effect of the differences between occurrence of P&L transactions and the receipt or payment of cash plus the other balance sheet movements in cash is that in this simple illustration the business has a closing cash balance of 500 rather than 3,000, which is the profit figure. The principal reason is, of course, the 7,000 outstanding from customers less the 2,500 owing to suppliers, but there are also the other capital movements.

Another important exercise and statement that the CFO, if not executives, ought to review is a reconciliation between profit and cash (Table 3.3).

Cash flow reports do not require additional record keeping; they may be produced by appropriately summarizing and classifying cash book entries or by identifying the movements between the beginning and ending balance sheets (adjusting for non-cash movements).

This simple example does illustrate the important point that cash records (the mirror of the entity's bank statements) do not readily distinguish between 'capital' and 'revenue' transactions:

- capital - relating to the balance sheet;

- revenue - relating to the P&L account.

The word 'capital' crops up in many places in finance, for example share capital, capital expenditure, capitalized expenses, capital employed; the clear inference from all of these is that the item is a balance sheet item and not considered to be directly related with trading. The word 'considered' is used as there will be different views on what is capital or not and 'directly' is used as there are very often links between the balance sheet and trading - the P&L account, again leading to views on what is capital or not. This reveals, as if you were not aware, that accounting is subjective: there are conventions, even sometimes rules, but subjectivity remains, and being aware of the subjective areas is essential if financial strategy is to be properly understood.

Cash flow forecasts

Larger entities have to produce cash flow statements at year ends or interim period ends but will also focus on the cash position and projections by use of a cash flow forecast.

Internal cash flow statements or reports often take the form of a short-term, eg one year, cash flow forecast, with the starting point being the cash position today. A sensible format is to distinguish between capital inflows and outflows and revenue inflows and outflows, as is the case with published statements of cash flows considered in Chapter 8.

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