Companies publish accounts annually, with UK listed companies also providing interim statements covering a six-month period. In our example we were following the fortunes of a company monthly, like most companies would in their management accounts – those pre- pared for internal consumption. In the published accounts we would see:
● a profit and loss account for the period;
● a cash flow statement for the period;
● a balance sheet as at a certain day.
This means that profits and cash flows are totalled for the period, and we get very little indication of the monthly fluctuations. To illustrate this we will prepare a profit and loss account and a cash flow statement for the four-month period. The profit and loss account is simply prepared by totalling the four months’ profit and loss accounts (Table 1.11).
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The profit and loss account
1 The published accounts
APRIL
The profit and loss account
Companies have to make provisions for likely costs that they will probably incur in the future, but which relate to the period’s sales. These provisions are charged to the profit and loss account.
The balance sheet
The current assets shown on the balance sheet are those that we expect to realise. We would reduce the value of stocks and debtors by any provisions that we made during the period. Not all provisions represent a writedown of the value of assets. Some, like ratio- nalisation provisions, reflect probable future cash outflows for the business. These would be shown as a liability, under the heading of ‘provisions for liabilities and charges’.
SUMMARY
Profit and loss account for the four months ending 30 April 199–
Table 1.11
£...
Turnover 19 200
Decorating materials (3 800)
Salaries (9 600)
Petrol (250)
Electricity (160)
Rent (3 200)
Depreciation (1 360)
Provision for bad debts ...(500)
OPERATING PROFIT 330
Interest ...(280)
PROFIT AFTER INTEREST ...(250)
We can see that the company has made a very small profit, 2.6 per cent of sales, barely enough to cover our interest payments. But what we cannot see is how this has been steadily falling over the last month, even though turnover was rising (Figure 1.1).
This is why it is important not to look at financial information in isolation. We should always have a number of periods’ results before we can really comment on the businesses performance – we need to know if it is getting better or worse. A set of published accounts will always have last year’s results alongside for comparison, and listed companies publish five-year summaries of their results.
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The cash flow statement
The cash flow statement uses the total cash flows in the business and groups the company’s cash flows into eight categories:
(1) Cash flows arising from trading. These are called cash flows fromoperating activities.
(2) Cash flows arising from the payment and receipt of interest and the receipt of dividends are called cash flows from returns on investment and servicing of finance.
(3) Cash flows from taxation.
(4) Cash flows from buying and selling fixed assets and long-term investments. These are called capital expenditure and financial investment.
(5) Cash flows from buying and selling companies. These are called acquisitions and disposals.
(6) Dividend payments to ordinary shareholders. These are called equity dividends paid.
(7) Cash flows from buying and selling short-term investments. These are called manage- ment of liquid resources.
(8) Cash flows from borrowings and shareholders. These are called financing.
Totalling these cash flows will give the increase or decrease in cash.
Our example was too simple to have entries for all of these headings, but we can construct a cash flow statement once we have totalled our cash flows for the four months.
TURNOVER AND OPERATING PROFIT Figure 1.1
Thousands
-2 0 6
Jan Feb Mar Apr
2 4 8
Operating profit Turnover
Cash flows January – April
£..
Cash coming in
Share capital 14 000
Loans 6 000
Sales – cash 7 500
Sales – credit ..7.300
Total cash available 34.800
Cash going out
Van (15 000)
Painting and decorating tools (1 000)
Decorating materials (3 300)
Salaries (9 600)
Petrol (250)
Electricity (110)
Rent (4 000)
Interest on loan (280)
Total cash spent 33.540
Closing cash ..1.260
Operating activities
First we need to identify the operating cash flows.
Sales – cash 7 500
Sales – credit ...7300)
Total sales 14 800
Less:
Decorating materials (3 300)
Salaries (9 600)
Petrol (250)
Electricity (110)
Rent ,(4.000)
Total 17.260)
Operating cash flow ..2.460)
We have a cash outflow from operating activities of 2460.
Returns on investment and servicing of finance This is simply the £280 interest paid.
Capital expenditure and financial investment
This is the purchase of the van and the decorating tools:
Van (15 000)
Painting and decorating tools ..(1.000)
Capital expenditure 16 000
1 The published accounts
Financing
This would be the proceeds of the share and the loan:
Share capital 14000
Loans ..6000
Financing cash flow 20000
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Constructing the cash flow statement
We can now construct our reported cash flow statement for the four months (Table 1.12).
What does this tell us? On its own, not a lot! We have managed to grow cash by £1260 in four months. The operations of the business were not managing to generate sufficient cash in the period, so, if we are profitable, we have a problem in either our stock, debtors or credi- tors.These three are what companies refer to as their working capital.
At the end of April we have £3400 tied up in the working capital:
Stock 500
Trade debtors 3900
Trade creditors (1000)
Working capital 3400
The reason for the shortfall is the investment that a new business has to have in the work- ing capital. We are owed £3900 by our customers, have to carry some stock, and we only owe suppliers £1000.
Plus we had to give a month’s deposit on the rent, which is much greater than the £50 we owe the electricity company. The £20 000 capital that we raised from our shareholders and the bank was needed to fund the capital expenditure, working capital and interest.
The cash flow statement does not give us the monthly cash movement, as all it is doing is reconciling the opening position (we raised £20 000 in shares and loans) with the closing position (we spent £18 740) to show the movement in cash of £1260. We know that the monthly cash flows show a slightly different picture (Figure 1.2).
Cash flow statement Table 1.12
OPERATING ACTIVITIES
Net cash outflow from operating activities (2 460)
RETURNS ON INVESTMENT AND SERVICING OF FINANCE
Net cash outflow from returns on investment and servicing of finance (280) CAPITAL EXPENDITURE AND FINANCIAL INVESTMENT
Net cash flow from capital expenditure and financial investment (16 000) FINANCING
Net cash flow from financing 20.000
Changes in cash 1 260
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The balance sheet
The balance sheet that will be shown in the published accounts will be the one that we pre- pared for the end of the period, in our example the balance sheet as at 30 April.
1 The published accounts
CASH FLOW Figure 1.2
Thousands
-3 -2 0 1 2
Jan Feb Mar Apr
-1
The published accounts will show the profit and loss account and cash flow statement for the accounting period. The balance sheet will show the assets and liabilities of the com- pany at the end of that period.
The cash flow statement shows the movement of cash during the period, and looks at cash flows functionally. There are eight categories of cash flow shown on a UK cash flow statement:
● operating activities – these are the cash flows from trading;
● returns on investment and servicing of finance– these are the cash flows from interest. Any dividends received would also be included.
● taxation;
● capital expenditure and financial investment– these are the cash flows from buying and selling fixed assets;
● acquisitions and disposals– these are the cash flows from buying and selling companies;
● equity dividends paid– this is the dividend that has been paid to ordinary shareholders;
● management of liquid resources – these are the cash flows from the purchase and sale of short-term investments;
● financing– these are the cash flows from shares and loans.
SUMMARY
Accruals / accrued expenses Charges made to the profit and loss account to reflect any outstanding invoices relating to items that have been used in sales.
Asset Something of value that the business has. It is not necessarily owned by the company.
Balance sheet A snapshot of the business on a certain day showing where the company’s money has come from, and where the company has spent this money. It identifies the things that the company has (the assets) and the money that the company owes (the liabilities).
Cash flow statement A document showing the movement of cash in the financial period.
Creditors Money that the company owes, mainly to suppliers. These may also be called accounts payable.
Current assets Assets that can be realised in the short term. In the UK, they are assets that are not fixed assets, so may include assets that cannot be realised within a year.
Current liabilities Liabilities that have to be paid within 12 months. In the UK they are usually shown as creditors: amounts falling due within a year.
Debtors Money that is owed to the company, mainly by customers. These may also be called accounts receivable.
Depreciation A charge made to spread the cost of fixed assets over their useful life. The charge reduces both the profits and the asset value.
Equity The share capital plus any reserves. This may also be called the shareholders’ funds.
Equity dividends Dividends paid to ordinary shareholders.
Fixed asset Something that the business intends to keep, and, therefore, does not intend to resell.
Liability A financial obligation – something that the business owes.
Operating profit The sales in the period less the costs of materials, wages and overheads used in sales. This may also be called the trading profit.
Operating profit margin Operating profit expressed as a percentage of the turnover. It may also be called the trading profit margin.
Prepayment A payment that the company has made in advance, and does not relate to the sales that have been made in the period.
Profit and loss account A document that identifies whether the company is selling its goods or ser- vices for more or less than it costs to deliver them to the customer. It takes the sales that the company has made in the period and deducts the costs that relate to those sales.
Provision A charge made to reflect a likely future cost, that relates to the sales that have been made during the period. it could relate to the reduction of an asset (like a bad-debt provision) or a future cost (like a rationalisation provision).
Shareholders’ funds The share capital plus any reserves. This may also be called the equity.
Turnover The sales that the company has made in the period. It may also be called sales or rev- enue.
JARGON