$3,105,000 cash flow from operating activities, that is, from profit-making activities. In short, profit is $2,642,000 in one financial statement and $3,105,000 in another statement. This can be confusing, to say the least.
How can cash flow from profit be higher than profit? Is one of the two numbers fake profit? Where did the extra cash come from? In other situations, could cash flow be less than profit? (Yes, it can be.) A short explanation for this discrepancy is that actual cash inflow from revenue is typically somewhat higher or lower than the amount of revenue recorded for the period. And, actual cash outflows for expenses typically differ from the amounts of expenses recorded for the period.
Cash Versus Accrual Accounting
The first section of the statement of cash flows attempts to explain the differences between cash flows and revenue and expenses, line by line. But in our experience business managers, lenders, and investors generally cannot make heads or tails of this section of the cash flows statement. The main reason is that they don’t have a clear picture of how revenue and expenses are recorded. Do you?
Exhibit 3.2 compares the company’s revenue and expenses cash flows for the year with its revenue and expenses amounts for the year. The amounts for revenue and expenses are recorded on the accrual basis. This means that the transactions and other developments that affect the business are recorded when the economic event takes place, which is often before or after when cash actually changes hands. For example, this company, like many businesses, offers its customers credit. The sale is made today, but the business does not collect cash until a month or two later. The sale is recorded today but the corresponding cash is not recorded until later.
EXHIBIT 3.2 REVENUE AND EXPENSES: CASH FLOWS VERSUS ACCRUAL AMOUNTS
| Dollar Amounts in Thousands for Year Just Ended | ||
| Cash Flow Amounts | Accrual Amounts | |
| Sales of Products | $151,680) | $152,000) |
| Cost of Products) | $(34,760) | $(33,800) |
| Operating Costs) | $(11,630) | $(12,480) |
| Depreciation Costs) | $.(000.0) | $.(0.(785) |
| Interest on Debt) | $.(0(520) | $.(0.(545) |
| Income Tax) | $).(1,665) | $(.(1,748) |
| Net Amount) | $.(.3,105) | $.(.2,642) |
Notice in Exhibit 3.2 that the differences between cash flows and accrual amounts do not differ too much—except for those related to depreciation. The cost of a long-term operating asset, such as a building or piece of heavy equipment, for example, is allocated over the operating life of the asset. The allocation of its cost over the useful life of an asset is a prime example of the accrual basis of accounting. Deprecation for the year is not a cash outlay; cash was paid when the asset was acquired. Notice in the “Investing” section of the cash flows statement that the business made major cash outlays for long-term operating assets.
A document comparing cash flows with accrual amounts, like the one shown in Exhibit 3.2, is a tool of explanation. It is not a financial statement. It is not included in a financial report with the three required financial statements (i.e., income statement, balance sheet, and cash flows statement). Exhibit 3.2 should help you understand why cash flow from operating activities differs from bottom-line net income for the year. In reading an income statement, keep in mind that you are reading accrual-based amounts for revenue and expenses. Bottom-line net income is an accrual-based number. The net cash flow result of revenue and expenses is found in the statement of cash flows. Chapter 14 offers further analysis of cash flow, in particular cash flow from profit (or loss if that’s the case).
Financial Tasks of Business Managers
So far, we have introduced the three primary financial statements for a representative business example. These statements include: its income statement for the year just ended, its balance sheet at the end of the year, and its statement of cash flows for the year. Suppose you’re one of the outside stockholders of the business, meaning you’re not involved in managing the business but you have a fair amount of money invested in the business. You just received the financial report from the business. What should you look for? Here are some things that you might study to get started.
We call your attention to stockholders’ equity in the balance sheet. Its owners (one of whom is you) have invested $8,125,000 capital in the business for which it issued capital stock shares to them. (See the capital stock account in Exhibit 2.2.) Furthermore, over the years the business has retained $15,000,000 profit, which is called retained earnings. Taken together these two sources of owners’ equity equal $23,125,000. One purpose of the balance sheet is to disclose such information about the ownership of the business entity and the sources of its equity capital.
The stockholders expect the managers of the business to earn a reasonable annual return on their $23,125,000 equity ownership in the business. In its most recent annual income statement the business reports $2,642,000 bottom-line profit, or net income. This profit equals 11 percent on the company’s year-end stockholders’ equity. The stockholders, as well as the company’s managers and its lenders, want to know more than just bottom-line profit. They want to see the whole picture of how profit is earned. Therefore, the income statement reports totals for revenue and expenses for the period as well as bottom-line net income.
The ability of managers to make sales and to control expenses, and thereby earn profit, is summarized in the income statement. Business investors and lenders pay particular attention to the profit yield from revenue. Earning profit is essential for survival and it is the business manager’s most important financial imperative. But the bottom line is not the end of the manager’s job—not by a long shot!
To earn profit and stay out of trouble, managers must control the financial condition of the business. This means, among other things, keeping assets and liabilities within appropriate limits and proportions relative to each other and relative to the sales revenue and expenses of the business. Managers must prevent cash shortages that would cause the business to default on its liabilities when they come due, or not be able to meet its payroll on time.
Business managers really have a threefold financial task: 1) earning enough profit, 2) controlling the company’s assets and liabilities, and 3) generating cash flows. For all businesses, regardless of size, a financial statement is prepared
