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~ Statement of Cash Flows ~ One Rationale

 1) A company can have a positive net profit and yet not have the money to buy some asset.

2) On the other hand a company can have a lot of money, on hand, in cash but not have profit.

~ Both situations are concerning.

Hence, the reason for a statement of cash flow to understand this. 

The statement of cash flow is a crucial financial statement that provides a clear picture of a company's cash inflows and outflows over a specific period. It helps to explain the discrepancies between net profit and cash availability.

Here's a breakdown of the two scenarios you mentioned:

  1. Positive Net Profit but Insufficient Cash:

    • A company can have a positive net profit on its income statement due to revenues exceeding expenses. However, this profit doesn't necessarily translate into cash.
    • Reasons for this include:
      • Non-cash expenses: Depreciation, amortization, and provisions are expenses that reduce net profit but don't involve actual cash outflows.
      • Timing differences: Revenues might be recognized before cash is received, while expenses might be paid before they're recorded as expenses.
      • Capital expenditures: Investments in new assets can significantly reduce cash flow, even if the company is profitable.

  2. High Cash Balance but Low Profit:

    • A company might have a substantial amount of cash on hand but a low or negative net profit.
    • Reasons for this include:
      • High upfront costs: Startups or companies undergoing significant expansion might have high initial costs that reduce profits in the short term.
      • Strategic decisions: A company might choose to defer revenue recognition or increase expenses strategically to achieve long-term goals.
      • Non-operating income: Gains from investments or asset sales can increase cash flow without affecting operating profit.

The statement of cash flow helps to bridge this gap by:

  • Categorizing cash flows: It divides cash flows into operating, investing, and financing activities, providing a comprehensive view of cash movements.
  • Explaining changes in cash: It shows how changes in cash are related to the company's operations, investment activities, and financing decisions.
  • Assessing liquidity: It helps to assess a company's ability to meet short-term obligations and fund future growth.

By analyzing the statement of cash flow in conjunction with the income statement and balance sheet, investors and analysts can gain a more complete understanding of a company's financial health and its ability to generate and manage cash.

ME> I want to run a very simple and perhaps crude example by you see if I get this. Suppose 10 year old Gopal sets up a lemonade stand business on a street corner. The way he does this is that he allows people to give him IOU's in exchange for the lemonade. His costs for equipment purchase (e.g. cups, water) and production amount to $10 for a week. Now if over the course of the week, Gopal receives about $10 in cash and $90 dollars in IOUs (I owe you), for a total of $100, then his net profit is $90, right however the money cannot be used just yet.


Yes, you’ve got the basic idea right! Let's walk through this simple example with Gopal’s lemonade stand to confirm your understanding:

Breakdown of Gopal’s Week:

  • Total revenue: Gopal sells $100 worth of lemonade over the week. This includes:
    • $10 received in cash.
    • $90 in IOUs (customers promising to pay later).
  • Expenses: Gopal spent $10 on supplies and production.

Calculating Net Profit:

  • Net profit = Total revenue - Total expenses.
  • Net profit = $100 (total sales) - $10 (costs) = $90.

So yes, Gopal’s net profit on paper is $90.

Cash Flow Reality:

  • Although Gopal’s net profit is $90, he only has $10 in cash on hand.
  • The remaining $90 is tied up in Accounts Receivable (the IOUs).
  • Until the customers fulfill their IOUs and pay him the $90, Gopal cannot use that money to buy more supplies or invest in new equipment.

Conclusion:

Even though his Income Statement shows a $90 profit, Gopal's actual cash position is only $10. This means that while he’s profitable on paper, he doesn’t have the liquidity (available cash) to spend $90 on anything just yet. This illustrates why a business can be profitable but still face cash flow challenges.



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