Assessing Cash Flow Statements

While the balance sheet accounts for assets and liabilities, and the P&L for profits made during the period, the cash flow statement gives reasons for the changing figures in a company's accounts or overdrafts. It provides answers to the questions: "where did the money come from, and where did it go?"

No. It is often assumed (incorrectly) that cash generated during a particular accounting period is the same thing as profit. This is not the case—in fact, a company can make a loss even when its cash balance has increased, and vice-versa. The cash flow statement shows the links between profit and the movement of cash, using figures issued in the company's annual financial statements.

• Net cash inflow from operating activities—this is essentially the company's profit, before changes in debtor/creditor balances. It may incorporate other items too, but depreciation is not included because it is not a cash cost. Annual financial statements will also explain how the figure for net cash inflow figure resulted from the balance sheet and P&L. Changes to debtor/creditor balances are effectively cash inflow/outflows, so they are represented here. For example, if a customer owes the company less at the close of the period than at the start, cash would have been flowing in. Similarly, if a supplier's balance has decreased, cash would have been flowing out.
• Returns on investments and servicing of finance—basically interest received on cash balances, minus the interest paid on loans. Other types of investment income that might appear here include dividends on shares owned by the company.
• Net cash outflow from servicing of finance—the total of all the above items. The example here shows an outflow of cash—which means the company paid out more in interest on its debts than it received in interest on cash. In the case of a company with significant cash balances, this figure could well show an inflow of cash.
• Taxation—the cash flowing out of the company to meet corporation tax bills. Sometimes this shows as an inflow—for example, if the company has claimed a repayment.
• Capital expenditure—cash used to buy fixed assets for the company, minus cash generating from selling off assets no longer needed.
• Net cash outflow from capital expenditure—the total of all the above items. The example here is typical, in that it shows a large outflow of cash. However, occasionally a company will spend less on new fixed assets than it makes from selling off old ones.
• Dividends paid—the outflow of cash used to pay shareholders' dividends.
• Net cash inflow before financing—a subtotal of the items above. This figure shows the flow of cash into the company during the period concerned, as a result of its business activities. Tax and dividend payments are included, but financing for the period is not. There is no typical figure to be expected here; it could equally be an outflow or an inflow (as in this case).
• Financing—cash flow relating to borrowing—like paying off loans and leases or taking out new ones—and other ways of raising money, like issuing shares.
• Increase in cash—the total change in cash flowing in or out of the company (the "bottom line"). This could as easily be a decrease as an increase. The figure is arrived at by adding together net cash inflow (or outflow) before and after financing. The result for this example shows that there was $950 more in the company's bank account at the close of the period than at the start.

The cash flow statement is derived from two other financial statements—the balance sheet and the P&L account—and creates a kind of bridge between the two. Its function is to analyze the company's cash position, and reveal the reasons behind the figures. A company with a big increase in borrowing, for instance, may have experienced a downturn in trading, or a major customer defaulting. Or it may have spent significant amounts of capital during the period in question. Such situations are not always apparent from other financial reports. The cash flow statement helps to identify what's really happening, enabling management to take action if necessary.

On the whole, it's better if a business has an inflow of cash financing, rather than an outflow. However, successful companies may well report an outflow occasionally. If this is explained by circumstances (such as high capital expenditure), there may be nothing to worry about. But an outflow over successive financial periods could be a sign of difficulties. Moreover, if the company is forced to find new sources of income (whether through sale of assets or new financing arrangements), things are likely to get worse.

No company can function without cash, so it's essential that reasons for inflow and outflow are well understood. The cash flow statement answers this need, albeit in a condensed form. After all, the aim of just about every business is to have more cash at the end of the year than at the beginning—by whatever means chosen—and to repeat this success time after time.

This has already been said, but as it's such a common error, it's worth repeating. Cash and profit are not the same thing!

Anyone interpreting a cash flow statement will need to understand basic terminology, such as the meaning of stockholders or creditors. Familiarity with related concepts is also important. For example, it's easy to misunderstand the tendency for cash to flow in as creditors increase (bills not settled yet means cash not parted with); or for cash to flow out as debtors increase (late payment by customers erodes profit).

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