Profit and Cash Flow 1

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	Accounting: Profit & Cash flow

Profit and Cash Flow

The profit and loss account and balance sheet are based on cash flow measurement but this basic data are coded and classified, allocated to time periods and presented according to the accountant's traditional rules and conventions. In order to convert profit back to operating cash flow we have to strip out the accountant's time allocations so that we get back to the basic aggregated cash flows. We must therefore remove the effects of depreciation, provisions etc., accrual and prepayment timing differences, and revenue realisation timing differences. In addition we must consider all non-operational inflows or outflows of funds related to investing and financing activities. In fact, we are concerned with all cash transactions between the accounting entity and the outside world.

The Cash Flow Statement is the third financial statement you will find in a set of published accounts. As an example the Cash Flow Statement of Smiths Industries plc (1993) is presented (click here). Because this statement strips out the effects of the accounting adjustments and shows the main sources and uses of liquid funds within the company it can reveal information that the accountant may have attempted to 'creatively' disguise in the profit and loss account and balance sheet. The cash flow statement allows us to see more easily whether the company is funding long term investments properly with long term finance, rather than by running down the working capital of the company. It also shows whether sufficient funds are being generated from normal operations to cover operational expenditure. When a company is expanding rapidly this may not be the case and extra long-term finance may have to be introduced to allow for a larger investment in working capital.