The Cash Flow Statement is perhaps best explained by way of an example. Supermarkets buy goods from a large number of suppliers on credit. This means that the suppliers allow the supermarkets to take possession of the goods for a certain period of time (e.g. 30 days) before they must actually pay. Supermarkets then generally sell the goods on to customers in the interim period. Those customers typically pay immediately. Under such circumstances, accounts payable (the amount still owed to suppliers for goods already supplied under the credit agreement) is greater than accounts receivable (the amount owed to the supermarket by its customers). The fact that the supermarket effectively hoards cash received from customers for a certain period of time before paying back the suppliers means it is operationally cash positive (assuming the items received are sold).
One way of measuring the extent to which this applies to a business is through calculating its ‘working capital’.
Working Capital = Current Assets (including accounts receivable) - Current Liabilities (including accounts payable)
Having a low (or negative) working capital figure can mean that the company lacks sufficient current assets to pay its current liabilities, suggesting it may to some extent be financially unstable. Note that if the company is genuinely unable to pay its debts, then it may well have to cease trading. If the working capital figure is too high however, this may suggest that the company is failing to invest its excess cash, which is financially inefficient. The optimal working capital figure often depends on the particular company and industry.
The Cash Flow Statement shows the actual movement of cash in and out of a company over a period of time (typically 1 year). It is important to understand the fundamental difference between profit and cash. The profit figure contained within the Income Statement (which is determined by revenue and costs) is based upon the number of legally concluded transactions, regardless of whether any cash has yet been transferred (for instance if goods have been supplied on credit). However, the Cash Flow Statement shows the actual transfer of cash in and out of a company during a given time period and will detail the previous year-end cash balance and end with the new cash balance.
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By Jake Schogger - City Career Series