If you regularly do a monthly income statement (also known as an P&L Statement), you will be aware that there are certain items which may not affect your income statement for some time, such as:

• Substantial increase in inventory purchases
• Increase in accounts receivable (money owed to you by customers)
• Reduction of credit by suppliers
• Purchase of equipment
• Unrecognized obsolescence of inventory (stale items)
• Bank’s refusal to renew or extend loan
• Lump sum payment of debt

A cash flow statement will highlight these activities in a way that an income statement will not.  And certainly your banker will want to see a cash flow statement showing how you have used the funds from a previous loan before they approve an extension or a new one.  Without the cash flow statement, you will have an incomplete picture of your business.

Both the balance sheet and the income statement are based on the accrual principle, which in essence means that you acknowledge a profit the moment you sell a product, and not when you receive the cash.  This means that the profit figure in the income statement and the cash in the bank are seldom if ever that same figure.  It is for this purpose that the cash flow statement was developed.  Basically the cash flow statement is constructed by taking the latest two balance sheets and the income statement covering that period.  Three of the four issues concerning financial management form the structure of the cash flow statement.  They are as follows:

• Operating Cash Flow, often referred to as working capital, is the cash flow generated from internal operations.  It is the cash generated from sales of the product or service of your business. It is the real lifeblood of your business, and because it is generated internally, it is under your control.  This cash flow is the only cash flow that is sustainable.  If the company does not make surplus cash in this section, it is in a precarious position.  Research has shown that companies that have a negative cash flow from operating activities for three years in succession stand a very good chance of being delisted or facing financial ruin.
• Investing Cash Flow is generated internally from non-operating activities. This component would include investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.  It also includes the sale of fixed assets or investments.  Cash generated from this activity is not sustainable as you will rob the company of its ability to function if you sell off all the assets.  In addition, one should also expect a company to spend cash on investing activities as the company should at the very least maintain its assets.  If it has a strategy of growth, one would also expect the company to acquire new assets, which would be reflected here.
• Financing Cash Flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, and the issuance of shares are some of the activities that would be included in this section of the cash flow statement.

The net cash flow position after taking these three sections into consideration will explain the movement in the cash balance from the first balance sheet to the second balance sheet.  A typical example of a cash flow statement according to the indirect method is as follows:

CASH FLOW STATEMENT FOR THE PERIOD ENDING 31 DEC 2010

CASH FLOW FROM OPERATING ITEMS EBIT (Earnings before Interest and Tax – also known as operating profit) Plus/minus Non-cash items: Plus Depreciation Minus Profit on Sale of Fixed Asset Plus Loss on Sale of Fixed Asset Sub-Total 1 +/- changes in non-cash component of working capital: Plus decrease in debtors (means debtors are paying you what they owe you) Minus increase in debtors (more cash is now in the hands of your customers – bad for cash flow) Plus decrease in inventory (inventory is being sold and the cash tied up in it are released to you) Minus increase in inventory (more cash flow is now tied up in inventory) Plus increase in creditors (you are extending the period you take to pay them – good for cash flow as it stays in your pocket for a longer period) Minus decrease in creditors (means you are paying your suppliers – bad for cash flow) Cash Flow Generated by Operating Activities Minus Tax Paid Minus Interest Paid Cash Flow Available from Operating Activities Minus Dividends Paid A: Cash Flow Retained after Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES Acquisition of Fixed Assets (minus) Sale of Fixed Assets (plus) Acquisition of Investments (minus) Sale of Investments (plus) B. Net Position after Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES Repayment of loans (minus) New loans issued (plus) Repurchase of shares (minus) Issue of new shares (plus) C. Net Position after Financing Activities
Change in cash position from Year  1 to Year 2: D = A+B+C

FIGURE: FORMAT OF THE CASH FLOW STATEMENT

The difference in the cash balance from the starting balance sheet to the ending balance sheet should be equal to A+B+C.  This statement provides a very good explanation for the change in the balance in the cash figures.

Please note that this is the indirect method of stating a cash flow statement.  I have opted for this method as it is easier to understand than the direct method.  In addition, the newer trend is for dividends to be shown as an item under financing activities, while depreciation is also stated as an item under investing activities.  I have opted for the above method as there is a lot of research available that is based on the above format.  Once you understand the essence of the cash flow statement, you can change the format as you wish.  The latest Cash Flow Statement published by Shoprite/Checkers was in the indirect format, as was the case for Pick ‘n Pay.

Understanding the cash flow statement will enable you to pick up what companies are growing too fast given their working capital requirements, and what companies are hiding their shortfalls in cash flow from operations by issuing shares or taking on new debt.  One can also pick up what companies are issuing shares to hide their debt as well.

When you see a company that has a negative cash flow from operating activities, you need to take good care to understand the reasons for this.  As already stated, this is the only place where you can generate cash flow for the business without having to pay it back or pay a return on it, and without undermining the company’s ability to generate turnover by selling off its assets.  So if you are not generating surplus cash flow from your operating activities your company is in trouble.  The following could be reasons for this:

• Insufficient volumes of products and services are sold.
• The prices charged for the products and services are too low, or they are too high and there is a resultant drop in the number of products sold.
• The costs at which the products are obtained are too high, with the result that the Gross Profit (Sales minus the Costs of the Sales) is too low.
• The costs associated with your operating model is too high, meaning that items such as salaries, rent, transport, etc are too high for the Gross Profit generated.
• Too much cash is tied up in the debtors book of the company.  This could be due to bad debt (debtors are not paying what they owe you), or due to too lenient credit terms for your customers given the profit margins you charge.
• Too much cash is tied up in the inventory. This could be due to too high stock levels or stock being outdated.
• Too much pressure from creditors to pay them.

The bottom line is that cash is the lifeblood of the company.  Without it you cannot continue operations. As one previous CEO of Pick ‘n Pay said, no company went belly up because it had too much cash! Manage it carefully!