Understanding Business Accounting For Dummies, 2nd Edition (56 page)

Scrutinising the Cash Flow Statement

Analysing a business's cash flow statement inevitably raises certain questions: What would I have done differently if I were running this business? Would I have borrowed more money? Would I have raised more money from the owners? Would I have distributed so much of the profit to the owners? Would I have let my cash balance drop by even such a small amount?

One purpose of the cash flow statement is to show readers what judgment calls and financial decisions the business's managers made during the period. Of course, management decisions are always subject to second-guessing and criticising, and passing judgment based on a financial statement isn't totally fair because it doesn't reveal the pressures the managers faced during the period. Maybe they made the best possible decisions given the circumstances. Maybe not.

The business in our example (refer to Figure 7-2) distributed £400,000 cash from profit to its owners - a 25 per cent
pay-out ratio
(which is the £400,000 distribution divided by £1.6 million net income). In analysing whether the pay-out ratio is too high, too low, or just about right, you need to look at the broader context of the business's sources of, and needs for, cash.

First look at cash flow from profit: £1.1 million, which is not enough to cover the business's £1,275,000 capital expenditures during the year. The business increased its total debt £500,000. Given these circumstances, maybe the business should have hoarded its cash and not paid so much in cash distributions to its owners.

So does this business have enough cash to operate with? You can't answer that question just by examining the cash flow statement - or any financial statement for that matter. Every business needs a buffer of cash to protect against unexpected developments and to take advantage of unexpected opportunities, as we explain in Chapter 10 on budgeting. This particular business has a £2 million cash balance compared with £25 million annual sales revenue for the period just ended, which probably is enough. If you were the boss of this business how much working cash balance would you want? Not an easy question to answer! Don't forget that you need to look at all three primary financial statements - the profit and loss account and the balance sheet as well as the cash flow statement - to get the big picture of a business's financial health.

You probably didn't count the number of lines of information in Figure 7-2, the cash flow statement for the business example. Anyway, the financial statement has 17 lines of information. Would you like to hazard a guess regarding the average number of lines in cash flow statements of publicly-owned companies? Typically, their cash flow statements have 30 to 40 lines of information by our reckoning. So it takes quite a while to read the cash flow statement - more time than the average investor probably has to read this financial statement. (Professional stock analysts and investment managers are paid to take the time to read this financial statement meticulously.) Quite frankly, we find that many cash flow statements are not only rather long but also difficult to understand - even for an accountant. We won't get on a soapbox here but we definitely think businesses could do a better job of reporting their cash flow statements by reducing the number of lines in their financial statements and making each line clearer.

You can download an Excel spreadsheet from the SCORE Web site (go to
www.score.org
and click on ‘Business Tools', ‘Template Gallery', and ‘Cash Flow Statement') that enables you to tailor a cash flow statement to your own needs. The spreadsheet has scope for three categories of cash in, thirty categories of cash out, and space at the bottom of the spreadsheet for non-cash flow operating data such as depreciation, sales volume, bad debts, and stock. A very useful tool!

Chapter 8
:
Getting a Financial Report Ready for Prime Time

In This Chapter

Making sure that all the pieces fit together

Looking at the various changes in owners' equity

Making sure that disclosure is adequate

Touching up the numbers

Financial reporting on the Internet

Dealing with financial reports' information overload

Chapters 5, 6, and 7 explain the primary financi
al statements of a business:

Profit and loss account:
Summarises sales revenue inflows and expense outflows for the period and ends with the bottom-line profit, which is the net inflow for the period (a loss is a net outflow).

Balance sheet:
Summarises financial condition at the end of the period, consisting of amounts for assets, liabilities, and owners' equity at that instant in time.

Cash flow statement:
Summarises the net cash inflow (or outflow) from profit for the period plus the other sources and uses of cash during the period.

An annual financial report of a business contains more than just these three financial statements. In the ‘more', the business manager plays an important role - which outside investors and lenders should understand. The manager should do certain critical things before the financial report is released to the outside world.

1. The manager should review with a critical eye the
vital connections
between the items reported in all three financial statements
- all amounts have to fit together like the pieces of a jigsaw. The net cash increase (or decrease) reported at the end of the cash flow statement, for instance, has to tie in with the change in cash reported in the balance sheet. Abnormally high or low ratios between connected accounts should be scrutinised carefully.

2. The manager should carefully review the
disclosures
in the financial report
(all information in addition to the financial statements) to make sure that disclosure is adequate according to financial reporting standards, and that all the disclosure elements are truthful but not damaging to the interests of the business.

This disclosure review can be compared with the notion of
due diligence
, which is done to make certain that all relevant information is collected, that the information is accurate and reliable, and that all relevant requirements and regulations are being complied with. This step is especially important for public corporations whose securities (shares and debt instruments) are traded on national securities exchanges.

3.
The manager should consider whether the financial statement numbers need
touching up
to smooth the jagged edges off the company's year-to-year profit gyrations or to improve the business's short-term solvency picture. Although this can be described as putting your thumb on the scale, you can also argue that sometimes the scale is a little out of balance to begin with and the manager is adjusting the financial statements to jibe better with the normal circumstances of the business.