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Chapter

Chapter 4

Profit v. Cash

4.1 Introduction 47 4.2 Cash Budgeting 49 4.3 Cash Flow Statements 53 4.4 Summary 56

Learning Objectives

After completing the study of this unit you should be able to:

• distinguish between profit and cash

• prepare a cash budget and appreciate the role that it plays in the running of the business

• scrutinise the figures presented in a cash flow statement.

4.1 Introduction

One of the basic errors made by new accounting students is believing that profit and cash are the same thing. Perhaps the example in the following scenario will help to convince you that this is not the case.

Example − scenario 1 Andy visited his local Sunday market and spotted a bargain. One of the stallholders was selling a computer for £120. With his in-depth knowledge of IT, Andy knew that this model of computer could sell for double the price and so he handed over £120 in cash and took the computer home.

On his way in to work on Monday morning, Andy stopped at the offices of the local newspaper and placed an advert in Monday evening’s edition of the paper, offering a computer for sale at a price of £250. The advert cost Andy £20 in cash.

On Monday evening, the phone rang in Andy’s flat and a sale was agreed. The customer came round to the flat one hour later, paid £250 in cash and went home with the computer.

If this was Andy’s only business transaction in the month what was his profit or loss for the one-month trading period?

Andy’s income statement

One-month trading period

£ £

Sales 250

Expenses

Computer 120

Advert 20 140

Profit 110

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Andy’s profit was £110 and, because all the transactions that took place were cash transactions, Andy’s cash balance had also increased by £110.

Scenario 1 summary

Increase in profit £110 Increase in cash £110

Imagine, however, if the scenario happened more like the one below.

Example − scenario 2

Andy visited his local Sunday market and spotted a bargain. One of the stallholders was selling a computer for £120. With his in-depth knowledge of IT, Andy knew that this model of computer could sell for double the price, so he handed over £120 in cash and took the computer home.

On Monday evening, the phone rang in Andy’s flat and a sale was agreed. The customer came round to the flat one hour later and explained to Andy that he was a bit short of cash at the moment. Andy agreed that the customer could pay him the following month and the customer went home with the computer.

If this was Andy’s only business transaction in the month what was his profit or loss for the one-month trading period?

Andy’s income statement

One-month trading period

£ £

Sales 250

Expenses

Computer 120

Advert 20 140

Profit 110

Andy’s profit was still £110 because a sale of £250 has been realised and matched against expenses of £140 that were incurred in generating the sale.

However, what has now happened to Andy’s cash balance?

Andy’s cash balance is −£140 because he spent £140 of cash on the computer and the advert but received no cash back on the sale of the computer.

Scenario 2 summary

Increase in profit £110 Decrease in cash £140

From the above scenario, it is evident that profit and cash are two entirely different things and, although profits ought to help with cash generation, they are no guarantee that cash surpluses will follow.

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Profit v. Cash

There are many examples of organisations that have reported healthy profits to the share- holders one month but are out of business by the following month.

Companies do not necessarily go out of business because they do not make profits. Companies go out of business because they run out of cash. It can, therefore, be argued that cash is the most important resource for businesses today because, to survive and prosper, a business must generate a healthy cash flow.

In this unit we will do as all sensible companies would do. We will review what has happened to our cash over the past financial year by looking at cash flow statements. But firstly, we’ll plan ahead to see what we think might happen to cash over the next trading period by considering how and why businesses prepare cash budgets.

4.2 Cash Budgeting

It is vitally important that organisations plan and control their cash flows by analysing the effect that the budgeted activities for the forthcoming period are going to have on their liquidity. The benefits of this are that it:

• ensures there are sufficient funds to meet the deadlines for future payments. The company needs to generate cash on an ongoing basis to pay the wages and the daily running costs

• ensures there is sufficient cash to carry out any planned investment. Purchasing a £1m state-of-the-art piece of plant and machinery for the shop floor will make a huge hole in your cash resources if you have not planned for such an expenditure

• allows for planning in advance for future shortfalls of cash. If cash projections suggest that additional funding will be required, then loans or overdraft facilities can be arranged

• enables investment decisions to be made about potential cash surpluses. Money sitting in a bank account is unlikely to generate sufficient return to please the shareholders. It is the directors’ responsibility to invest these surplus funds wisely in order to grow the business.

4.2.1 Constructing a Cash Budget

The cash budget is prepared to show the anticipated cash receipts and cash payments of the firm during its budget period. However, not only is the amount of cash coming in and going out of the business important but, for good control, knowledge of the timing of the cash movement is vital. Typically, therefore, the cash budget is divided into smaller ‘control’ periods, usually one month, in order to highlight the cash position at regular intervals.

The main source of income generation for companies is likely to be cash received from the goods sold, or the services provided, to the customer. However, other cash receipts could come from a variety of different sources, such as:

• bank loans

• returns from investments, perhaps bank interest or dividend receipts

• issuing more shares to the public

• issuing debentures

• selling some fixed assets

• commission received

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• rent received from leasing out part of the business’s floor space

• royalties received.

Equally, there can be a variety of different reasons for cash leaving the organisation:

• purchasing raw materials

• paying the weekly wages and the monthly salaries

• rent and rates bills

• general overhead expenses

• buying non-current assets

• paying interest on bank overdrafts and loans

• interim and final dividend payments to the shareholders

• annual corporation tax bill to the Inland Revenue.

You should always remember that a cash budget is concerned only with the movements of cash during the period. Cash receipts and cash payments recorded in the cash budget will not necessarily be the same as revenues generated and expenses incurred in the profit and loss account because of the following:

• Sales are recorded in the income statement when the goods are despatched or the service has been provided to the customer. But if the sale was made on credit terms, the cash may not be due to be received until some future period.

• Similarly, purchases are recorded when the goods reach your organisation. If you have arranged credit terms with your suppliers, you may be able to delay the payment for a month or two.

• Some expense items are paid in advance (such as rent) and some in arrears (such as telephone bills) of the period when the expenses are actually incurred.

• Some expense items in the income statement have nothing at all to do with cash, the most obvious one being depreciation.

Companies will work through the following stages in preparing their cash budget for the period.

1. Sales forecast

An estimate will be made on the future level of sales to be generated by the business. The sales figure will be built up from the products/services to be sold, the markets/regions into which they will be sold and the selling prices that can be achieved in the various markets.

2. Trade receivables forecast

Having arrived at a sales target, the company will then need to estimate the split of business between cash sales and credit sales. If the average credit period being offered to customers is known, companies can then predict when those credit sales will turn into cash.

3. Inventory forecast

For a manufacturing business, which holds raw materials and finished goods, or an organ- isation buying in product and selling it on to the customer, consideration will have to

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be given to the monthly inventory levels that the company wishes to hold. Knowledge of both sales and inventory levels will be needed before companies can determine the purchases that will be required.

4. Trade payables forecast

Having arrived at a purchases target, the company will then need to consider the level of credit purchases and the credit periods offered by suppliers, as they do with trade receivables. Only then can the company estimate the timing of the cash outflows.

5. Capital investment forecast

Here the company will consider their capital investment activity in terms of buying and selling fixed assets. Buying, in particular, may involve cash up front or perhaps an initial deposit followed by a later lump sum. Knowledge of payment terms will be crucial in determining when the cash leaves the organisation.

6. Miscellaneous forecasts

The cash movements for all the other expenses of the business and the profit appropri- ations will need to be predicted here. When will the company pay their dividends to the shareholders and their tax dues to the Government? What payment arrangements exist for rent, rates, electricity and the other overheads involved in running the business?

Armed with the above information, a company should be in a position to consolidate all the financial information into a cash budget.

Worked example 4.1

Frank started his furniture business in January with a capital investment of £39,000 in cash. He estimates the following for the first six months of trading.

1. Sales are expected to be £20,000 in the first month, increasing each month thereafter by £1,000 each month. A total of 25% of the sales will be for cash, the balance being on credit to be paid in the month following the month of sale.

2. Raw material purchases are estimated to be 50% of sales value each month. In addition, a reserve stock of £10,000 of materials will be purchased in the first month. On average, raw materials will be paid for in the second month following purchase.

3. Plant and machinery costing £50,000 is to be acquired. A 20% deposit will be paid on delivery on 1 January with the balance being paid, along with 10% interest per annum on the outstanding balance, in the sixth month.

4. Annual rent of £10,000 will be paid in arrears on the final day of each calendar quarter.

5. Wages of £4,000 will be paid each month.

6. General expenses are estimated to be paid at £1,500 per month, except in month 1 and month 4 when they are expected to be £2,000 per month.

Required

Prepare a monthly cash budget for the first six months of Frank’s business.

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Workings

1. The first thing to determine is what the sales will be each month and then, more importantly, when these sales will turn into cash.

Sales Cash receipts

Cash sales Credit sales

January £20,000 £5,000 −

February £21,000 £5,250 £15,000

March £22,000 £5,500 £15,750

April £23,000 £5,750 £16,500

May £24,000 £6,000 £17,250

June £25,000 £6,250 £18,000

2. Secondly, determine what the purchases will be each month and when Frank will make the resultant cash payments.

Purchases Cash Payments

January £20,000 (£10,000 + £10,000) −

February £10,500 −

March £11,000 £20,000

April £11,500 £10,500

May £12,000 £11,000

June £12,500 £11,500

3. The only other complication relates to the purchase of the plant and machinery, particularly the calculation of the interest. The capital cost of the plant and machinery will lead to a £10,000 (20%) cash payment in January with the £40,000 balance being paid in June. However, also to be paid in June will be interest of £2,000. (£40,000 × 10% × 6 months).

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Cash budget for Frank − January to June

Cash inflows Jan Feb March April May June

Cash sales 5,000 5,250 5,500 5,750 6,000 6,250

Credit sales 15,000 15,750 16,500 17,250 18,000

Total cash inflows 5,000 20,250 21,250 22,250 23,250 24,250

Cash outflows

Raw materials 20,000 10,500 11,000 11,500

Plant and machinery 10,000 40,000

Interest 2,000

Rent 2,500 2,500

Wages 4,000 4,000 4,000 4,000 4,000 4,000

General 2,000 1,500 1,500 2,000 1,500 1,500

Total cash outflows 16,000 5,500 28,000 16,500 16,500 61,500

Opening cash 39,000 28,000 42,750 36,000 41,750 48,500

Net cash flow −11,000 14,750 − 6,750 5,750 6,750 −37,250

Closing cash 28,000 42,750 36,000 41,750 48,500 11,250

The monthly closing cash position shows that Frank has a positive cash balance in each of the first six months and therefore, no immediate need for additional sourcing of finance is evident. However, what would have happened if the balance of the plant and machinery had been payable in March rather than June?

The capital expenditure alone would have resulted in a negative cash balance at the end of March of £5,000 (£36,000 balance per the above cash budget less the £40,000 capital payment plus £1,000 interest). This would have informed Frank that action needed to be taken to compensate for this interim cash shortfall. Of course, the whole benefit of planning ahead is that Frank can now take corrective action to remedy the future short-term liquidity problem.

4.3 Cash Flow Statements

Where cash budgets plan ahead to determine the future cash inflows and outflows of the company, cash flow statements work backwards and tell the user how and why the cash position has moved from the previous trading period. The balance sheet and income statement of a business give a good indication of how healthy it is financially and how successfully it has been performing, but neither statement gives direct information about the most crucial aspect in the stability and success of any business, namely its ability to generate cash.

IAS 7 requires companies to publish a cash flow statement as part of their annual accounts and, perhaps in recognition of the fact that firms fail through lack of cash resources and not through lack of profits, the cash flow statement is to be seen as an integral part of the financial statements that companies produce.

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4.3.1 Objective of Cash Flow Statements

The objective of IAS 7 is to ensure that companies:

• report their cash generation and cash absorption for the period by highlighting the significant components of cash flow in a way that facilitates comparison of the cash flow performance of different businesses

• provide information that assists in the assessment of their liquidity, solvency and financial adaptability.

A number of user groups are specifically interested in information which will help them to assess the viability of businesses (see Chapter 1). Deriving this information enables a user to predict what the future cash flows of the entity might be and, in business today, these future cash flows are often regarded as the prime determinant in the worth of a company.

To help achieve the objective of cash flow reporting, companies are asked to comply with a prescribed format, which classifies the cash movement for the year across three standard headings.

4.3.2 Cash Flow Format

The following example illustrates a typical cash flow layout prescribed by IAS 7.

XYZ Group plc

Cash flow statement for year end 31 December 20x6

Cash flows from operating activities £000 £000

Net profit before interest and taxation 17,213

Adjustments for:

Depreciation 2,928

Operating profit before working capital changes 20,141

Increase in trade and other receivables (3,774)

Increase in inventories (11,280)

Increase in trade payables 10,585

Cash generated from operations 15,672

Interest paid (1,889)

Tax paid (2,887)

Net cash from operating activities 10,896

Cash flows from investing activities

Purchase of property, plant and equipment (1,085)

Proceeds from sale of equipment 220

Purchase of other companies (17,824)

Net cash used in investing activities (18,689)

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Cash flows from financing activities

Proceeds from long-term borrowings 2,947

Dividends paid (2,606)

Net cash from financing activities 341

Net decrease in cash and cash equivalents (7,452)

Cash and cash equivalents at the beginning of the period 5,129

Cash and cash equivalents at the end of the period (2,323)

A disclosure note of the breakdown of cash and cash equivalents from the opening and closing balance sheets is also required.

Dec 06 Dec 05

Cash on hand and balances with banks (2,886) 2,450

Short-term investments 563 2,679

Cash and cash equivalents (2,323) 5,129

Let’s consider what all of the above is trying to tell us, starting with a definition of cash and cash equivalents, and the three standard headings that break down our cash movement for the year.

4.3.3 Cash and Cash Equivalents

Cash comprises cash in hand, while cash equivalents are short-term, highly liquid, investments that are readily convertible into known amounts of cash and whose maturity dates are within three months of their acquisition dates.

Note: In most countries bank overdrafts are deemed to be repayable on demand and are therefore part of an entity’s cash management programme.

The cash movement that the company is trying to explain is simply a comparison of the cash/cash equivalents/bank overdraft figures from the opening balance sheet compared with the same figures in the closing balance sheet.

4.3.4 Operating Activities

Cash flows from operating activities are the cash effects of transactions and events relating to the trading activities of the period. Typical inflows and outflows in this category are:

• the payment of wages and salaries

• the purchase of raw materials

• payment for general overhead expenses

• cash received from customers.

The method used to arrive at the total cash flow from operating activities is known as the indirect method. Companies start with their operating profit before interest and tax and adjust it for non-cash charges and credits, thus arriving at the cash generated from operations.

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Deducting the interest and tax payments from this figure leaves us with the net cash from operating activities.

4.3.5 Investing Activities

The cash flows included here show the extent of new investment in assets, which will generate future profit and cash flows for the business.

Cash inflows include:

• receipts from the sale of property, plant and equipment

• receipts from the repayment of loans made to other entities

• receipts from the sale of shares in other companies.

Cash outflows might include:

• payments to acquire property, plant and equipment

• cash payments to acquire shares in other companies

• loans made to other companies.

4.3.6 Financing Activities

Cash flows in this section mainly comprise receipts or payments of the capital amounts to or from the providers of finance.

Cash inflows include:

• receipts from issuing shares to investors

• receipts from taking out loans from providers of short- and long-term finance.

Cash outflows include:

• the capital element of finance leases

• repayments of borrowings

• dividend payments (Note: can also be shown as an operating cash flow)

• costs of issuing equity shares

• payments to buy back the company’s own equity shares.

4.4 Summary

Many potentially successful firms in the past have failed, not because of a lack of profits, but because of a shortage of cash. Profits do not automatically ensure cash surpluses (although they certainly help), while similarly losses, in the short-term, may not lead to cash deficits. It is vitally important, therefore, that organisations:

• plan and control their cash flows by analysing the effect that the budgeted activities for the forthcoming trading period are going to have on their liquidity

• review their cash flow statement at the end of the period to see where cash was generated and where cash was absorbed during the financial year.

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The benefits of preparing a cash budget are:

• to ensure there are sufficient funds to meet deadlines for future payments

• to ensure there is cash available to carry out any planned activities

• to enable plans to be made in advance for any future cash shortfalls

• to help with making investment decisions on future cash surpluses.

Unlike the cash budget, which plans ahead, the cash flow statement looks at what has happened to cash in the past. If the cash balance of a company at the start of the year is £1m and the cash balance at the end of the year is £5m, then the company has to explain why there has been a cash increase of £4m over the year. They are asked to explain the increase across three subheadings, namely:

• operating activities

• investing activities

• financing activities.

Basically, the cash flow statement can help assess each of the following:

• the company’s ability to generate positive net cash flows

• the company’s ability to meet its obligations whether it be servicing loan commitments or paying a dividend to the shareholders

• reasons for the difference between the reported profit and the related cash flow.