WHILE conducting financial analyses of companies, analysts many a times focus more on balance sheets and income statements, while not giving cash flow statements the attention they deserve.

This article highlights the significance of the cash flow statement through a simple example.

Firstly, we identify the main groups of people who should be interested in a company’s cash flow statement.

Besides the company’s management, those interested in the firm’s cash flows include its creditors and suppliers, potential corporate or individual investors and tax and regulatory authorities

Besides the company’s management, the main parties with direct or indirect interest in the firm’s cash flows include its creditors and suppliers; financial analysts working as advisors to potential corporate or individual investors; prospective buyers (in case the company is being sold or merged with an existing company); tax authorities; relevant regulatory authorities; employees; trade and industry associations; and research scholars.

Here is an example highlighting the significance of the cash flow statement. Suppose two jobless friends A and B decide to try their luck in business. Both of them set up similar cold drink stalls on footpaths located opposite to each other, with each stall being close to a school. The size of investment is modest, with both friends investing Rs1,000 each.

Further suppose that both A and B are able to sell all their first-day inventories at a margin of 30pc. However, a major contrast is that A sells his entire inventory against cash, while B sells his on a one-week credit to a larger vendor. Ignoring all other possible costs, except the cost of inventories, let us build up the financial statements of A and B at the end of their first day in business.

The table shows that A and B have exactly the same profit margin and net income. However, A has relatively higher liquidity, whereas B is completely drained of cash. Now, what does the next day (June 1) have in store for A and B?

For A, perhaps a more profitable day with higher sales is likely as compared to the previous day. In contrast, B may not even turn up at his business place. In fact, he may need to borrow funds without which he might not be able to continue his business.

Companies also sometimes find themselves in similar dire straits as Mr B, i.e. in reasonable profitability but an extremely tight liquidity position. For instance, a company supplying furnace oil to a power generating company may continue its sales despite extraordinary delays in payments by the buyer.

In such an event, the oil company would continue to record revenues and profits but would simultaneously be facing a liquidity crunch due to piling up of accounts receivable from the power company. In general, any company facing the problem of piling accounts receivable would have to increase its borrowings to continue its operations, thus increasing its financial costs and reducing net profit margins.

Obviously, this is not a sustainable position as there is a limit to the borrowing capacity of a company. While some companies facing a temporary phase of delay in collecting receivables may come out of such a crisis, for others, this could be the sign of financial distress, eventually leading to bankruptcy.

For a company, the possible implications of good profitability but tight liquidity position include:

• Greater need for short-term borrowings, likely leading to a decline in profitability

• Higher interest rates and stricter security or repayment terms may be demanded by lenders

• Its ability to buy on credit would be hampered

• Employees may not get salaries regularly on time, affecting their morale. Some of them (particularity the better ones) may leave the company

• The company may default on payments to suppliers and lenders with a consequential downgrading of rating by credit rating agencies

Thus, whichever interest group one may belong to, it must be appreciated that a complete financial picture of an organisation cannot emerge if the analysis is restricted to the balance sheet and income statement and if a cash flow analysis is ignored.

The writer is the Head of the Accounting and Finance Faculty at IoBM, Karachi.

jamal.zubairi@iobm.edu.pk

Published in Dawn, Economic & Business, November 3rd, 2014