Accountancy: Cash flow deserves more than a little respect: Roger Davis and Peter Holgate find a neglected area in company financial reports

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The Independent Online
WE know from our personal lives that cash flow is important. It is all very well to be asset-rich, but running out of cash in a country mansion has the same effect on the stomach as running out of cash in a bedsit.

Likewise in business. We all know of promising businesses that have run out of cash through overtrading or by being too reliant on short-term funding. We know of companies that have run out of cash simply by incurring big losses.

Fortunately, most businesses do not run out of cash. They survive - or thrive - not by chance but by keeping a close eye on cash flow and by preparing cash-flow forecasts and monitoring actual cash flows against that forecast.

That emphasis is not adequately carried forward into the outside world. Typically, the form of external reporting of cash flows is markedly different from what companies actually do. This disparity results in analysts and other users of financial statements not understanding companies' cash flow properly. Hence they tend to pay less attention to published information on cash flows than is merited.

What can be done to remedy this? Financial Reporting Standard 1 (FRS 1) introduced a requirement for companies to publish a cash-flow statement. FRS 1 was published in 1991 and has been in operation for about two years.

On 1 October 1991, the Independent welcomed the new cash-flow statements but warned that they would not be perfect. Their imperfections have become evident. An opportunity has now arisen, however, to address them. The Accounting Standards Board is considering submissions on how FRS 1 has worked in practice and how it might be improved.

In some respects, cash-flow statements under FRS 1 have been very useful and a big improvement on the statements of source and application of funds that they replaced - not least because they report the actual cash flows. They classify a company's cash flow - operating, interest and dividends, tax, investing, financing - in a way which is intuitively obvious. Thus a statement can show:

how much has been generated by operations;

how much of that is taken up by paying interest and dividends;

how much is taken up by tax payments;

the extent to which the operating cash flow - after interest, dividends and tax - has funded capital expenditure;

the implications for financing - in other words, whether there has been a net repayment of finance or whether extra funds have had to be raised through borrowing or share issues

Yet despite this, leading analysts acknowledge there is still too much emphasis on the profit and loss account, and that insufficient attention is being given to cash- flow information. This is due to inertia: analysts and others have been brought up on monitoring earnings and are reluctant to change. But it is also because the published cash-flow statements are still not good enough to be genuinely useful.

The main problem is that FRS 1's notion of 'cash and cash equivalents' (CCE) is defined in an arbitrary way (based around a cut-off of instruments with less than three months to maturity when acquired).

The three-month cut-off does not reflect how companies manage cash, debt and treasury operations. Financial management is more concerned with the liquidity and marketability of instruments than with their original period to maturity. The consequences of this are twofold.

First, the three-month criterion can cause treasurers to depart from what would be rational economic behaviour in order to show a particular result in the cash-flow statement. For example, assuming a December year-end, a treasurer might, when investing spare funds in October, prefer a three-month investment to a six-month investment, even though the funds are not needed until April. That an accounting standard has this effect is bad news indeed.

Second, investments and deposits that are liquid and marketable, yet which fall outside the narrowly defined CCE, are presented as investing cash flows, where they are aggregated with entirely different cash flows, such as purchases of new plant.

So the published cash-flow statement does not get the respect it deserves from the company management.

The cash-flow statement should not be seen as some kind of byproduct of the accounts. Rather its importance is equal to that of the profit and loss account.

The two are not mutually exclusive. The profit and loss account potentially gives a truer measure of performance because it estimates the outcome of transactions not yet concluded by a cash payment or receipt. But because it contains subjective estimates, it is vulnerable to shaky assumptions about the future. And in the wrong hands it can be subject to a favourable gloss. In contrast, cash is cash. It is the ultimate test of the quality of profits.

The publicised cash-flow statement needs greater respect from companies and analysts. For companies, it needs to reflect the way they manage their finances. For analysts, it needs to answer clearly the question: are the profits in the bank?

The ASB should take the opportunity to ensure that it meets those needs. For that is at least as important as any of the other measures the ASB has in hand to regulate company accounts - many of which would be less necessary if proper emphasis was given to cash flow.

Roger Davis is Head of Audit and Peter Holgate is Accounting Technical Partner at Coopers & Lybrand.

(Photograph omitted)