The cash flows summary tells a very important part of the story of a business. But, cash flows do not tell the whole story. Business managers, investors in business, business lenders, and many others need to know two other essential things about a business that are not reported in its cash flows summary. The two most important types of information that a summary of cash flows does not tell you are:
- The profit earned (or loss suffered) by the business for the period
- The financial condition of the business at the end of the period
Profit is an accounting-determined number that requires much more than simply keeping track of cash flows. The differences between using a checkbook to measure profit and using accounting methods to measure profit are explained in the following section. Hardly ever are cash flows during a period the correct amounts for measuring a company’s sales revenue and expenses for that period. Summing up, profit cannot be determined from cash flows.
Also, a summary of cash flows reveals virtually nothing about the financial condition of a business. Financial condition refers to the assets of the business matched against its liabilities at the end of the period. For example: How much cash does the company have in its checking account(s) at the end of the year? We can clearly read on a cash flow statement. But we can’t tell from a cash flow report the company’s ending cash balance. A cash flows summary does not report the amounts of assets and liabilities of the business at the end of the period.
Profit Cannot Be Measured by Cash Flows
A company may sell its products on credit. In other words, the business offers its customers a short period of time to pay for their purchases. Most of the company’s sales are to other businesses, which demand credit. (In contrast, most retailers selling to individuals accept credit cards instead of extending credit to their customers.) For example: a company collected $10,225,000 from its customers during the year. However, some of this money was received from sales made in the previous year. And, some sales made on credit in the year just ended were not collected by the end of the year.
At year-end the company had receivables from sales made to its customers during the latter part of the year. These receivables will be collected early next year. Because some cash was collected from last year’s sales and some cash was not collected from sales made in the year just ended, the total cash collected during the year does not equal the amount of sales revenue for the year.
Cash disbursements (payments) during the year are not the correct amounts for measuring expenses. Like sales revenue, the cash flow during the year is not the whole story. Let say a company paid out $7,130,000 for manufacturing costs during the year. At year-end, however, many products were still on hand in inventory. These products had not yet been sold by year-end. Only the cost of products sold and delivered to customers during the year should be deducted as expense from sales revenue to measure profit. Shouldn’t it?
Furthermore, some of its manufacturing costs had not yet been paid by the end of the year. The company buys on credit the raw materials used in manufacturing its products and takes several weeks to pay its bills. The company has liabilities at year-end for recent raw material purchases and for other manufacturing costs as well.
There’s more. Its cash payments during the year for operating expenses, as well as for interest and income tax expenses, are not the correct amounts to measure profit for the year. The company has liabilities at the end of the year for unpaid expenses. The cash outflow amounts shown in a cash flow statement do not include these additional amounts of unpaid expenses at the end of the year.
In short, cash flows from sales revenue and for expenses are not the correct amounts for measuring profit for a period of time. Cash flows take place too late or too early for correctly measuring profit for a period. Correct timing is needed to record sales revenue and expenses in the right period.
The correct timing of recording sales revenue and expenses is called accrual-basis accounting. Accrual-basis accounting recognizes receivables from making sales on credit and recognizes liabilities for unpaid expenses in order to determine the correct profit measure for the period. Accrual-basis accounting also is necessary to determine the financial condition of a business—to record the assets and liabilities of the business.
Cash Flows Do Not Reveal Financial Condition
The cash flows summary for the year does not reveal the financial condition of a company. Managers certainly need to know which assets the business owns and the amounts of each asset, including cash, receivables, inventory, and all other assets. Also, they need to know which liabilities the company owes and the amounts of each. Business managers have the responsibility for keeping the company in a position to pay its liabilities when they come due to keep the business solvent (able to pay its liabilities on time). Furthermore, managers have to know whether assets are too large (or too small) relative to the sales volume of the business. Its lenders and investors want to know the same things about a business.
In brief, both the managers inside the business and lenders and investors outside the business need a summary of a company’s financial condition (its assets and liabilities). Of course, they need a profit performance report as well, which summarizes the company’s sales revenue and expenses and its profit for the year.
A cash flow summary is very useful. In fact, in no sense does the cash flows report take the place of the profit performance report and the financial condition report.
A Final Note: Over the past century an entire profession has developed based on the preparation and reporting of business financial statements—the accounting profession. In measuring their profit and in reporting their financial affairs, all businesses have to follow established rules and standards, which are called generally accepted accounting principles or GAAP for short.
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