Identify the differences between a cash flow statement and a profit and loss account. Which statement gives a better view of organisational performance? Fully explain your choice.
There is undoubtedly, a clear difference between what is termed “cash” and what “profit” is and by extension a cash flow statement and a profit and loss statements. Notwithstanding these differences, each statement gives a different yet important view of organisational performance.
Cash according to Holmes et al 2005:166 is “cash in hand and deposits repayable on demand less overdrafts repayable on demand; i.e. they can be withdrawn at any time without penalty. Cash includes cash and deposits denominated in foreign currency.”
Once, accounts were comprised of just the balance sheet and the profit and loss statements. However in the late 1960’s, a period characterised as a high inflationary period, it was felt that historical costing convention which is indicative of the profit and loss account, provided information that was outdated and as such provided little insight on the current market value of companies and by extensions their profits. Therefore, there became a need for an additional statement- the cash flow statement.
“A cash flow statement is a statement produced either for management or external reporting purposes showing, by broad categories cash receipts and payments in a period” (Leicester, 2001. 10.3), and is intended to supplement the profit and loss account and the balance sheet. The cash flow statement therefore, assists creditors, investors and generally all stakeholders in evaluating the liquidity and solvency of a business or rather, shows changes in cash be it negative or positive i.e. cash outflows and cash inflows.
The Cash flow statement is divided into three main sections:
1.Core operations (operating activities)
A typical cash flow statement can be seen in Appendix B.
Cash flows from operating activities generally include transactions that are associated with the calculation of income. It also includes items which are involved in the production or purchase of merchandise, the sale of good and/or services to the organisation’s customers and expenditure relating to the general administration of a business.
Under the broad heading of investing activities, are found important element relating to cash flow in an organisation. These transactions involve making and collecting repayments on loans, purchasing and selling of plant assets and other productive assets. All other investment activities are generally classified under this heading.
“Changes in debt, loans or dividends are accounted for in cash from financing. Changes in cash from financing are ‘cash in’ when capital is raised they’re ‘cash out’ when dividends are paid. Thus if a company issues a bond to the public, the company receives cash financing. However, when interest is paid to bondholders, the company is reducing its cash.” (Heakal, 2004)
It is now important that the issue of profit and the profit and loss account be examined. Profit by definition is the excess of revenue over expenditure. Revenues are increases in the company’s assets from its profit-driven activities, resulting in positive cash flows (inflows). Conversely, expenses are decreases in the company’s assets from its profit-driven activities, which results in negative cash flows (outflows). Net income/profit is therefore, the difference between the two. According to Williams et al 2002:54 if a company’s expenditure exceeds income then the difference is a net loss, suggesting that the enterprise has suffered a loss. Alternatively if the company’s income exceeds its expenditure the difference is a net profit.
“The profit and loss account is a financial statement which shows the profit (loss) made by a business during a defined period of time (normally one year). The account also shows the uses to which the...