Cash flow statement analysis and interpretation

Cash Flow Statement for the Year to 31.12.07.

Operating profit

Depreciation for 2007

Loss on disposal of fixed assets

Changes in stocks / inventories

Changes in debtors / receivables

Changes in creditors / payables

Net cash flow from operating activities

Taxation paid this year

Investing activities

Payments to acquire fixed assets

Receipts from sale of fixed assets

Financing activities

Issue of shares / stock

Repayment of loan

Dividends paid this year

Change in cash over the year between the Balance Sheets)

This cash flow statement tells us many things about the company's performance that are not found on the profit and loss report. It does this by isolating the three main types of activities - operating, investing and financing. In general, when evaluating the performance of the company year-over-year, the most important component is the operating activities. To accomplish this, the cash flow statement begins with net profits and then deconstructs this, to isolate the causes for the company's change in cash position.

With ABC company, the firm's bank account went from a £12 million overdraft to a £29 million positive balance. To the casual observer, this would indicate strong performance. However, we can see that the majority of cash flows at ABC in the past year were attributable to investing and financing activities. The company spent £115 million on new investments; in part this was paid for via a £50 million stock issue.

The operating activities for ABC show that the firm actually earned £155 million in cash in the past year. Some of this was leaked from the income statement in the form of depreciation. Much of the rest was spent on new buildings and equipment. All told, the firm's success last year was understated on the profit and loss report because of these investments and the effect of depreciation. Therefore, we can see that in 2007 the firm had very strong operating results, five times better than what was indicated on the profit and loss reports.

Each section of the cash flow statement tells a different part of the firm's story. For example, it may be understood by management that significant amounts of their profits went into new buildings and equipment. What the cash flow statement does is isolates that information. Management and shareholders alike can extrapolate that data from the balance sheet, noting changes in fixed assets, but the presentation of the cash flow statement provides a clean, easy-to-understand summary of those transactions.

The same situation occurs with regards to financing activities. These can have a dramatic impact on the firm's cash position. The firm's bank account may look much healthier after a year in which stock was issued, but the cash flow statement allows management and investors to understand the role that stock issue played in the improved bank balance.

This is critical to understanding whether the firm is improving its cash position through strong operations or through the issuance of debt or equity.

By isolating this information, we can see some of the ways in which cash flow statements can prove useful, alongside the profit and loss report. The P&L report is necessary, because it is constructed in accordance with accounting principles on the accrual accounting basis. The cumulative effect of the different items on the P&L report, however, can distort the firm's actual performance. The cash flow statement helps to deconstruct the P&L report to unwind these distortions.