The cash flow statement is the financial statement that makes the most sense to entrepreneurs; it speaks their language where cash is what matters, not profit. Exactly as the name suggests, this is a statement of what cash has come into the business and what has left.
Accountants tend to get hung up on the P&L but for growing businesses cash is the most important thing; and so understanding where the cash came from and went to is fundamental.
It will not surprise you to hear that there is more than one way to prepare a cash flow, but unlike the Profit and Loss Account and the Balance Sheet, the difference in Cash Flow Statement format is harder to explain. But here goes:
“Inflow and Outflows” Cash Flow Statement (also known as Direct Method)
This is the simplest form of cash flow. It is generally split in to two sections with a top section dedicated to cash inflows and a bottom section for outflows. This is not a cash flow format suitable for inclusion in Financial Statements but is simple to understand and is often the format seen in management accounts (for that reason).
The Direct Method is simple to understand and is often the format used in management accounts.
There is no set format for how things are displayed in each section. Inflows will usually contain sales; receipts; loans; and tax repayments. Outflows will show the main business expense lines (wages, rent, travel etc.); as well as any capital asset purchases; and financing payments. Unlike a P&L, all the items are shown gross of any VAT.
|Profit & Loss Account|
|Year ended 31 March 2018|
|Year ended||Year ended|
|Cost of sales||(2,547,963)||(2,568,963)|
|Profit before tax||2,287,718||1,667,149|
|Result for the year||1,853,052||1,350,391|
“Financial Reporting Standards” (FRS) Cash Flow Statement (also known as Indirect Method)
The format of a Cash Flow Statement prepared to UK accounting standards is a bit more complicated and far less intuitive, but often more powerful than the simple inflow/outflow format above.
The aim of this format is to identify the main reasons why operating profit on the Profit and Loss Account does not equal the movement in cash. It is a reconciliation of ‘profit’ to ‘movement in cash’ over a given period.
This type of Cash Flow Statement keeps to the following format: operating profit at the top; movements in working capital; then the cash flow from various other activities (including capital expenditure, finance and investment, and taxation). Once all these adjustments are taken in to account, the total will equal the movement in the cash balance.
Let us break it down a bit to see why this format can be more informative.
Working Capital Adjustments
Trying to keep this as simple as possible, these adjustments take account of the timing differences between when an income or expense is booked in the P&L; and when the corresponding cash is received or paid.
This is displayed as a movement in a particular balance sheet account. Without going into the detail of double entry bookkeeping principles, if a sale is made but not paid for immediately, this creates a ‘receivable’ on the balance sheet. The movement in the receivable account will therefore be one of the items that reconciles the profit to cash flow. The same is also true of all other current assets and current liabilities on the balance sheet.
This method of displaying operating cash flow movements makes it easy for an accountant or business owner to see exactly which parts of the balance sheet are absorbing cash, something which cannot be easily identified from an inflows/outflows format (which is why we favour this format for larger, more established businesses).
Easy for an accountant or business owner to see exactly which parts of the balance sheet are absorbing cash
The purchase of large items of plant and machinery does not appear in the profit and loss account and so has not been deducted from revenue in arriving at operating profit. They therefore represent a key cash flow that is not included in operating profit; and are therefore shown separately.
Finance and investment
This section deals with loans and equity investment. If the business has taken out any debt (including bank or shareholder loans) this is clearly not income from trade but increases the cash in the business – so needs to be accounted for in this section of the cash flow statement.
Tax is shown as a separate cash flow as the timing of the payment of corporation tax is nine months and one day after the year end.
Understanding a cash flow can be both intuitive and complex at the same time, particularly in FRS format; however it remains the most critical statement in the accounts for understanding where cash came from or went to.
It is also an essential business planning tool. Check out our page on forecasting cash flow to understand how it can be used to unlock growth and value potential in your business.