It can be argued that 'profit' does not always give a useful or meaningful picture of a company's operations. Readers of a company's financial statements might even be misled by a reported profit figure.

Shareholders might believe that if a company makes a profit after tax of say Rs.100,000, then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong. Survival of a business depends not only on profits but perhaps more on its ability to pay its debts when they fall due. Such payments might include 'profit and loss' items such as material purchases, wages, interest and taxation etc, but also capital payments for new fixed assets and the repayment of loan capital when this falls due (e.g. on the redemption of debentures).

Chapter objectives

This chapter is intended to provide an explanation of:

· The aim, use and construction of cash flow statements

· The meaning and calculation of the source and application of funds statement and their importance to business

· A discussion on credit and types of loans available to businesses

· An explanation of the cost of funds and capital

· The importance and calculation of ownership costs, including depreciation, interest, repair, taxes and insurance.

Structure of the chapter

"Cash flow" is one of the most vital elements in the survival of a business. It can be positive, or negative, which is obviously a most undesirable situation. The chapter develops the concept of cash flow and then shows how the funds can be used in the business. Funds are not only generated internally; they may be externally generated, and so the chapter finishes with a discussion of externally generated funds.

Aim of a cash flow statement

The aim of a cash flow statement should be to assist users:

· to assess the company's ability to generate positive cash flows in the future
· to assess its ability to meet its obligations to service loans, pay dividends etc
· to assess the reasons for differences between reported and related cash flows
· to assess the effect on its finances of major transactions in the year.

The statement therefore shows changes in cash and cash equivalents rather than working capital.

Indirect method cash flow statement

Figure 3.1 shows a pro forma cash flow statement.

Figure 3.1 Pro forma cash flow statement

NOTES ON THE CASH FLOW STATEMENT

1. Reconciliation of operating profit to net cash inflow from operating activities

2. Analysis of changes in cash and cash equivalents during the year

3. Analysis of the balances of cash and cash equivalents as shown in the balance sheet

4. Analysis of changes in finance during the year

Note: Any transactions which do not result in a cash flow should not be reported in the statement. Movements within cash or cash equivalents should not be reported.

Explanations

It is often difficult to conceptualise just what is "cash" and what are "cash equivalents". Cash need not be physical money; it can take other forms:

a) Cash in hand and deposits repayable on demand with any bank or financial institution.

b) Cash equivalents: Short term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

c) Operating activities