Business managers, lenders, and investors need to know the financial condition of a business. A summary of cash flows, though very useful in its own right. But, does cash flow provide information about either the financial condition or the profit performance of a business? We are just about to discuss this cash flow topic.
Mistaken-1st: Profit Can Be Measured by Cash Flows
Having a “negative change” (the cash out flow is bigger compare to the cash inflow) often overwhelms non-financial people (even managers). The cash flow summary seems like to tell them that company is in “loss position“. And when it shows a “positive change“, it seems like the company is making profit. That is more than understandable for non-financial people (or even managers) to think it that way. If that was you, it’s nothing to shy about, everyone need to learn for several things (So do I). I am going to show you; why a profit cannot be measured by cash flow. Read on…
Consider a company sells 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). Let’s assume the company collected $15,220,000 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.
Likewise, 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’s say the company paid out $8,130,000 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. Don’t you agree?
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.
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 Exhibit A do not include these additional amounts of unpaid expenses at the end of the year.
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.
Major Misatken-2nd: Cash Flows Reveal Financial Condition
In fact, the cash flows summary for the year does not reveal the financial condition of the company. Again, why? Stakeholders (and the manager him/herself) 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.
No doubt, a cash flow summary is very useful. In fact, a cash flow statement is one of the “three primary financial statements” reported by every business (Balance Sheet, Income Statement and Cash Flow Statement come in addition). But in no sense does the cash flows report take the place of the profit performance report and the financial condition report.
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. I’ve said a lot and will keep posting and updating about GAAP and the accounting profession here.
“So, what is the right way to report financial condition and profit performance?” you asked. Let’s move on the next section. Move on…
Reporting Financial Condition and Profit Performance
As mentioned already on the previous section; Business managers, lenders, and investors need a report that summarizes its assets and liabilities, as well as the ownership interests in the excess of assets over liabilities. And, they need to know the “profit performance” of the business. They need a report that summarizes sales revenue and expenses for the most recent period and the resulting profit or loss.
Financial condition is communicated in an accounting report called the “balance sheet”, and profit performance is presented in an accounting report called the “income statement“. Alternative titles for the balance sheet include “statement of financial condition” or “statement of financial position.” An income statement may be titled ”statement of operations” or ”earnings statement”.
The term “financial statements“, in the plural, generally refers to a complete set including a balance sheet, an income statement, and a cash flows statement. Financial statements are supplemented with “footnotes” and “supporting schedules“. The broader term “financial report” usually refers to all this, plus any additional narrative and graphics that accompany the financial statements and their supplementary footnotes and schedules.
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