The profit and statement is accountants’ attempt at providing us with a picture of the underlying economic performance of the business. So, for example,[ibe_locked_content] in the profit and loss statement accountants recognise revenue when it is earned, not at the point the cash is actually received. Accountants recognise expenses when they are incurred (i.e. when the business commits itself to meeting the cost), not when the supplier is actually paid. In the profit and loss statement accountants spread the cost of an asset over its useful life (= depreciation), instead of expensing the whole cost of the asset in the profit and loss statement in the year the asset is purchased.
The cash flow statement
The cash flow statement gives us information about the actual cash flows of the business. If you imagine a shop with a cash till, the cash flow statement tells us about all the cash movements in and out of the till over the year.
So, if the business has made a sale but a customer has only paid part of their bill by the end of the year, only the part that they have paid in cash is recognised on the cash flow statement.
If the business has received goods from a supplier, but the business hasn’t paid the suppliers’ invoice in full, only the part that the business has paid in cash is recognised on the cash flow statement.
If the business has bought an asset, all of the asset’s cash cost is shown on the cash flow statement (under “capital expenditure”).
Profit and loss vs. cash flow vs. balance sheet
The following example may help explain how a transaction might affect the financial statements.
Profit and loss vs. the cash flow statement – cash is king!
Although the profit and loss statement is accountants’ attempt at providing an underlying view of the businesses’ performance (for example by recognising revenues and expenses when they are earned/ incurred, and by spreading an asset’s cost over its life), the profit and loss statement can be manipulated.
A company could, for example, need to spend a lot of money on long-term assets, all of which affect its cash flows. That same business could take an optimistic view of its ability to collect from customers who haven’t paid. Revenues might be increasing but, with high spending on assets, and without customers actually paying for the goods they have received, although the company’s profit and loss statement might show paper profits, the business could soon become bankrupt.
For this reason, many business analysts are quick to ‘grab’ key profit figures for businesses, but also take into account the cash flow impact of payment terms with customers and suppliers, and current and forecast spending on assets.[/ibe_locked_content]
Proceed with the finance for non-financial managers training course