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Cash flows vs income statements - Views on News from Equitymaster
 
 
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  • May 12, 2001

    Cash flows vs income statements

    While profit statements can be distorted by anomalies in the accounting policies, the cash flow statement can be considered as a gospel for investors. A cash flow in simple terms is a statement, which summarizes movement of cash (the lifeline of any business) in an entity. There are several issues on which cash flow statement scores over the income statement. While the profit and loss statement gives a summarized view on the profitability of the entity, cash flow measures the health of the business as well.

    Income statement ignores time value of money:  Income statement does not look at the time value of money. A typical example of the same could be refinery companies. The growing deficit in the oil pool account has reflected in increased receivables in the books of oil companies. The deficit in totality is estimated in the range of Rs 100 bn. In other words, though oil companies must have booked sales (profits thereon), they have in fact only resulted in huge receivables in the books of these companies. The government has decided to issue oil bonds to oil companies in lieu of their respective oil pool account receivables. With lack of a definite period for redemption of oil bonds it would take much longer before they actually make profits.

    The cash flow statement on the other hand recognizes the time value of money. Probably, it's the most conservative way of looking at business. Look how BPCL's growing debt burden is in fact due to burgeoning receivables.

    (figures in Rs m) 1998 1999 2000
    Net Profit 5,327 7,012 7,039
    Current Ratio (x) 0.96 1.12 1.22
    Debt 14,645 16,673 25,927
    Debt/Equity (x) 0.58 0.55 0.74

    The above table would indicate that Oil Co-ordination Committee (OCC) receivables are putting a strain on the company's balance sheet, which can in no way be reflected through the income statement of the company. It is only when the investor looks at the cash flow position does he realize that the situation is strenuous (for no fault on the company's part). In this case, the income statement of BPCL thus ignores time value of money. Had the OCC receivables been on time, the interest cost of the company would have been considerably lower.

    • Difference in Accounting policies:  An income statement could be distorted depending on the nature of accounting policy, which the company follows. A typical example of the same could be the difference in accounting policies for right off of expenses on content creation (intangible assets). The treatment of the same ranges from company to company. A extremely conservative company may write off the entire expense on software creation in the same year while others may write it off over the useful shelf life of the content, may well be even ten years. Now, other things remaining constant the income statement of the company, which writes off expenses over a longer period, appear better.

    • Financial Management:  A cash flow statement not only provides a snapshot of the company's operational performance but also its financial management and utilization of scarce capital. While investment activities provide a bird's eye view of the treasury operations of the company, financing activities provide the financing tactics adopted. i.e the movement of cash from equity and debt.

    Let us take example of Himachal Futuristic Communication Ltd.

    (figures in Rs m) 1999-00 1998-99
    Cash flow from Operations 50.6 -87.4
    Cash flow from investing activities -333.3 -6.7
    Cash flow from financing activities 406.1 99.1
    Net cash inflow/( outflow) 123.4 5.0
    Net profit as per income statement 86.o 36.0

    The above table is self-explanatory. While net profit has grown by three digit rates year after year, cash from operations have not matched up with net profits. Secondly, inflows from financing activities (from issue of share capital) were utilized for investment activities (primarily as loans and advances).

    Thus a cash flow statement is a mirror of not only the company's profitability but also a reflection of the financial structure (including its liquidity and solvency) and the ability of the firm to adapt to the changing business scenario. Historical cash flow could also indicate the amount, timing and certainty of future cash flows. It therefore also offers comparability of operating performance of different enterprises because it eliminates the effects of using different accounting treatments for the same set of transactions and events.

     

     

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