Why the True Measure of a Company’s Performance Is the Cash Flow Statement

When it comes to financial statements, the balance sheet and profit and loss account receive the majority of attention. While the balance sheet displays the company’s financial situation, including liquidity, solvency, and the capacity to continue as a going concern, the profit and loss statement shows business performance over time.

As a result, while being an essential component of the financial statement, the cash flow statement is frequently disregarded. Many people are unaware that it offers vital information about how money enters and leaves the company, which can be very different from accounting earnings.

What is a cash flow statement, and what makes it crucial?

As everyone is aware, financial statements such as the balance sheet and profit and loss account are created using the accrual concept rather than the real movement of cash. As a result, the Profit & Loss Account does not show how much actual money entered or left the company. It doesn’t address important queries like:

Was there enough money coming in from core businesses to keep the company operating?

Did gaps need to be filled with debt or outside funding?

Were earnings supported by cash inflows or were they just on paper?

The Cash Flow Statement fills the gap between profitability and liquidity at this point, making it extremely useful.

How is the cash flow statement prepared?

It is a common accounting premise that there are two ways to arrange cash flow: the direct technique and the indirect method, as acknowledged by worldwide accounting frameworks.

Direct Approach

The direct method lists actual cash transactions, including money given to suppliers, money received from clients, money spent for expenses, etc. This approach does not begin with net profit and instead displays cash inflows and outflows directly.

Indirect Approach

The net profit according to the Profit & Loss account serves as the starting point for the indirect approach. Net cash flow from operational operations is then calculated by adjusting all non-cash expenses (such as depreciation and amortisation) and changes in working capital (current assets and current liabilities).

The cash flow statement’s structure

The three components of a cash flow statement are as follows:

Cash flows from business operations.
Cash generated via investing.
Cash flow from financing operations

The cash inflows and outflows from the company’s main operations are displayed in this section. A company needs to make real money from its operations in addition to profits in order to grow and survive. A robust and self-sustaining firm is one that consistently generates cash from operations.

Cash flow from business operations

Even if the company is reporting profits on paper, a persistent negative cash flow from operating activities indicates a significant liquidity issue. This disparity suggests that profits aren’t being converted into actual cash, which may have an impact on the business’s capacity to fulfil daily responsibilities.

Cash generated via investing

This section demonstrates how the business is using funds for long-term expansion, such as buying fixed assets, funding new initiatives, or pursuing mergers and acquisitions (M&A). These outflows show whether the company is making strategic investments for future growth and scalability.

In a similar vein, this component also communicates the cash inflow from loan repayment, investment sales, and fixed asset sales.

Cash flow from financing operations

Cash flow from financing activities includes cash inflows from raising equity capital or securing debt through bank loans, bonds, or debentures.

In a similar vein, this section also covers cash outflows such as dividend payments, share buybacks, and loan repayments.

Financing activity cash flow aids in determining whether the company is:

Dependency on outside funding for survival or expansion
Managing its debt responsibilities sensibly
Giving its shareholders a reward

What your company’s cash flow shows that profit and loss don’t

The profit made from business operations during a specific time period is displayed in the Profit & Loss statement. But a profit on its own does not always indicate good performance.

For example, even though the business shows accounting profits, it may struggle with liquidity if a significant amount of sales are made on credit and the cash conversion cycle is lengthy. Even worse, there may be severe financial strain if those credit sales result in bad debts.

Because of this, a company’s ability to generate positive cash flow from its operations is the true measure of its financial health. This shows how much money the company actually makes from its main activities.

Operating cash flow that is consistently negative is a red flag. It points to issues with the business model, such as ineffective collection cycles, excessive expenses, or unproductive activities.

Furthermore, the financing portion of the cash flow statement frequently shows greater activity when operating cash flow is negative, such as taking out extra loans or raising money. This demonstrates the company’s reliance on outside finance rather than internal cash generation.

In conclusion

A profitable firm is surely a good sign of future growth. But since cash is king, evaluating the company in terms of actual cash generation is just as critical, if not more so.

The market may not always continue to be favourable, and the future is unknown. Even seemingly robust businesses can be abruptly derailed by disruptive breakthroughs or external shocks. Only companies with steady, positive cash flows are resilient enough to endure and change under these kinds of situations.

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Disclaimer

This content is for general informational purposes only and does not constitute professional advice. For specific legal, tax, or financial needs, seek professional guidance. Agrim Advisors assumes no liability for reliance on this information. Note that the content is based on current laws, which may be subject to change.