Page 43 - DIY Investor Magazine | Issue 37

SAVER > INVESTOR: UNDERSTANDING CASH FLOW The cash flow statement is arguably the most important of a company’s three main statements along with the income statement and the balance sheet – by Hannah Barnaby This article looks at the relationship between profit and cash, how cash management is vital to keep companies in business and what investors should look out for. WHAT IS CASH FLOW? Cash flow is the flow of money coming into and out of a company in a given period, usually a year. Companies manage cash in three main areas: • Operating • Investing • Financing Operating cash flows reflect a company’s operational activity – from paying cash to produce goods for sale to providing services and receiving cash in return. Investing involves buying or selling long-term assets; sales generate cash, acquisitions consume it. Financing refers to cash flows used to fund the company. Eg a company issuing shares receives cash when they are bought by an investor; repayment on borrowings is a financing cash outflow. HOW IS CASH FLOW REPORTED? The cash flow statement includes cash inflows and outflows from the company’s operating, investing and financing activities; the statement reports cash movements between one period end and the next. In contrast, the income statement records revenues, costs and profits within the period, and the balance sheet shows assets and liabilities at the period’s end. The differences between the income and cash flow statements explain the difference between profit and cash. WHAT IS THE DIFFERENCE BETWEEN PROFIT AND CASH? If a transaction is recorded when it occurs, rather than when cash is received or paid, it is reported as an ‘accrual’. Companies report revenues, costs and profits in their income statement as accruals, irrespective of cash transactions. However, transactions are only recorded in the cash flow statement when cash is received or paid. A company may recognise the profit made from a contract in the income statement, based on the stage of completion of the contract; however, the payment schedule could be timed later, when the company receives cash for work done. Thus, despite making significant profits, a company with low levels of cash may not be able to service its debts and may still be insolvent. Companies must control short-term cash inflows and outflows – also known as working capital – to remain in business. HOW CASH FLOW CAN INDICATE A COMPANY’S DEBT VOLATILITY? The period between recognition of profit on transactions and the receipt of cash indicates a company’s ability to pay its debt obligations; this is known as a working capital financing gap. This gap is determined by a company’s production cycle –how long it takes to sell its goods and services. A company that accrues profit long before cash is received has a long production cycle and must hold cash in reserve to pay upcoming debts. A company’s ability to pay its debts is also determined by how liquid the company’s assets are – its capacity to turn assets into cash. Managers and external observers use liquidity ratios to determine liquidity which compare current assets with current liabilities. Current assets are those that can be rapidly converted into cash, such as inventory and receivables; current liabilities represent items like short-term debt or accounts payable. The current ratio is calculated by dividing current assets by current liabilities; a ratio of less than one may suggest that the company is not able to pay its short-term debts, eventually leading to insolvency. 43 Apr 2023 DIY Investor Magazine ·