The year 1996-97 will be remembered as the year in which corporate India was plagued with problems of an unprecedented inventory build-up and overdue receivables.

Money supply was scarce, and adding to these problems was the crippling slowdown in earnings witnessed in the corporate sector, all of which led to bloated inventories and creditors delaying payments. But despite these adverse circumstances, quite a few corporates have been able to show a healthy growth in their bottomlines for the financial year-ended March 1997.

While some corporates have been projecting a strong earnings growth, their cash flow statements sometimes indicate a totally contrasting picture. In fact some companies have negative operating cash flows. Take the case of TELCO. According to chairman's statement, TELCO had an outstanding year and the company was able to achieve new levels of turnover and profits. However, cash flow statement presents a different picture. For 1996-97, the cash generation from operations was negative to the tune of Rs 816.6 crore . The company managed to have positive cash flow mainly because of equity dilution and and heavy borrowings. The RONW (PAT/Average net worth), declined from 27.7 percent in 1995-96 to 25.15 percent in 1996-97. In the circumstances which exist at present, however, while the profit and loss account by itself may not be the best statement to give a comprehensive picture about a company's state of affairs, the half-yearly results simply cannot be used as any indicative signal of the financial health. There is no better indicator than the cash flow statements to judge the liquidity and solvency of a company.

Although the profit & loss account does give a picture of the company's state of affairs in a particular year, the cash flow statement is a superior indicator of the liquidity of the company.

Cash flow defined: Put very simply, cash-flow is the difference in the cash-balance of the company as on two distinct dates. However, this is a very simplistic view and provides no information as to the source of the cash ie., whether cash is generated from operations, investing activities (sale of assets, for example) or financing activities (increase in borrowings).

Regardless of the nature of activity of an enterprise and irrespective of whether cash can be considered as raw material for the concern, as is the case with banks and FIs, any user of financial statements is interested in the sources and applications of cash and cash equivalents.

Cash flow vs profit as per books: Probably the biggest advantage of a cash flow statement is that it eliminates the effects of different accounting treatments. The profit and loss account, as has been the case in the past, can always be massaged by a bit of creative accounting to show a healthy profit. And how does it matter whether a company shows a fat profit when in reality it is sitting on large amounts of unsaleable inventory, or it is surviving by taking on ever-increasing amounts of borrowings. Moreover, you could show increased profits in a number of ways. You could, for example, treat certain items of cost as deferred expenditure. You could fool around with depreciation. You could change your methods of valuation. You cannot, however, change the amount of cash you have on hand, and the year's cash flow statement merely shows you, how that cash came to be in your hands. Fudging a cash flow statement, therefore, is very difficult.

The method of accounting followed by two companies in the same industry for valuation of stock as well as charging depreciation may be different. This could make comparisons very difficult. However, this problem can be eliminated by opting for a cash flow. When used in conjunction with the P&L account and the balance sheet, it facilitates the evaluation of changes in net assets, liquidity and solvency of the concern.

Cash flow statements also take into account the time value of money which the conventional P&L ignores. In the P&L, a sale is treated as income as soon as it is done and not when the revenue from the sale is actually realised. This could be particularly misleading in case of capital goods manufacturers as orders are generally given together with an offer of extended credit periods. Likewise with expenditure. It is accounted for as soon as it is incurred and not when actual payments are made. In short, accounting profit is a better criterion for performance evaluation, however the cash flow approach is far superior at the time of decision making. It must, however, be borne in mind that a highly liquid position is not always a good indicator. Extra cash, much beyond the requirements of a concern will result in reduced return on capital employed and is an indicator of poor management. It is also a very useful indicator to judge the ability of the concern to finance the expansion/modernisation through internal generation of funds.

The figure to watch out for is whether cash is being generated from operations, especially after working capital changes. If cash is not generated even before working capital changes, it is a major cause for concern. If there is negative cash flow after working capital changes, it will mean that cash is being locked up in inventory and money is not being cycled back from debtors.

That need not be all that bad it depends on the kind of market in which a company is in. Businesses having large market shares in slow-growth industries throw up the largest amounts of cash, and are known as cash cows. Those companies having small market-shares in fast-growing markets need a lot of cash, however, they have very low cash flow. Attempting to build market share in a growing market can consume a lot of cash. Takeovers too, if funded by cash, can lead to negative cash flows. It must be remembered that companies can generate cash by reducing marketing expenditure, withholding introduction of new products etc - none of these strategies being good in the long-term for the business. Investing for the future typically devours large amounts of cash.

The preferred method of reporting as per International Accounting Standard 7 is the indirect method. In India, AS 3 provides the option of selecting the method. It must be noted that direct method is more informative than the indirect method. The direct method provides information which is useful in estimating future cash flows, a benefit, which is not available in case of indirect method (see box).

The inclusion of cash flow statement has been made mandatory by the listing agreement. But, it is a classic case of too little, too late. Inclusion of cash flow should be made mandatory even in the half yearly results. This will certainly give a better indicator of the liquidity of the company, and help in timely monitoring of a company's cash position.

Cash flow should, however, not be used as a sole indicator to evaluate the performance of the company. Cash flow in isolation could be misleading. It should always be used along with the information in the P&L account.

Here, it may be noted that the revised AS 3 which is not mandatory recommends that an enterprise should disclose together with a commentary by management, the amount of significant cash and cash equivalent balances held by the enterprise which are not available for use by it. The disclosure of amount of undrawn borrowing facilities that may be available for use in future with any restriction on the use of these facilities and the aggregate amount of cash flows representing increase in the operating capacity along with cash flows required to maintain operating capacity may be disclosed separately. The track record of companies in case of disclosures which are voluntary in nature, is not very encouraging. One will have to wait for 1998 annual report to see whether the situation has changed.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.