In this age of creative accounting, accounting principles are changed, provisions are created or written back and generally accepted accounting principles are liberally interpreted or ignored by companies to show profits.Shareholders do not realise this when they look at the profits made as published in the financial statements. It comes therefore as a surprise when a regular profit making company suddenly downs its shutters and goes into liquidation. The reason usually lies in the fact that the company has no cash and is unable to get finance and is unable to pay its creditors. This is an area that is not often considered - the company's cash flow and yet it is, for a company, its very life blood.
A community of successful money handlers - the Marwari community of India - are an exception. They have always required its importance and their celebrated "partha" system deals entirely with cash flows and outflows. This is their strength and the reason for their growth. Unfortunately, most others do not payheed to cash flows, concentrating entirely on the "bottom line". History is strewn with corporations that have closed down because of their inability to pay.
In recent times in India, in the first flush of liberalisation and buoyancy in the capital markets, many companies embarked on very ambitious expansion plans. Their plans went awry in 1995-96 when, in order to contain inflation, money supply was restricted. A liquidity crunch followed. The primary market collapsed.
Many companies identified as the blue chips of the future were in a very difficult situation and some became bankrupt. Bankers, aware that loans advanced can go bad if the company does not have operating cash flows that are positive, will always check as they have to be satisfied that the company has adequate funds to meet interest and capital repayments. The three issues looked at are:
What is the company's cash earnings? How is the company being financed? How is the company using its finance?The answer to theabove can be determined by preparing a sources and uses of funds statement. Its importance has been recognised in the United States of America and in many European and Asian countries where it is mandatory for a company to publish with its Annual Report, a statement of changes in financial statements which is in effect a cash flow statement.
A sources and uses statement begins with the profit for the year to which are added increases in liability accounts (sources) and from which are reduced the increases in asset account (uses). The net result shows whether there has been an excess or deficit of funds and how this was financed.
A company published a profit before tax of Rs 10.81 crores a few years ago. This included however, other non-recurring income of Rs 24.77 crores, profit on the sale of fixed assets of Rs 11.29 crores and an amount of Rs 3.86 crores which was withdrawn from a revaluation reserve. If these are adjusted for the operating cash flows, profit changes to a loss of Rs 29.11 crores - avery material difference. The company had declared a dividend on its preference shares. This was, as the company had made a loss, in effect paid from reserves. Its inventories and other current assets had increased. As the company is in reality not doing well, the possibility of the company being unable to get rid of its surplus stock cannot be ignored.
Another company published a profit of Rs 14.17 crores. It was a fall from its previous year' profits of Rs 71.34 crores. It was constructed as a reasonable profit in hard times. However, a sources and application of funds statement reveals that the company raised Rs 75.15 crores from loans and that it effectively paid its dividends from borrowed funds. It poses the question that when the time comes to repay loans will the company have adequate monies to do so.
The charm or utility of the cash flow or sources and uses of funds statement strips the accounting creativeness from financial statements. While figures can be doctored to show high profits/losses,the cash flow shows how much cash has actually been generated from operations and how much has been sourced from external sources.
If a company has a negative cash flow from operations, a banker will ask serious questions on how the company will meet its interest obligations and its capital repayments - both of which should come from operations. If it is continuously raising monies from other sources to meet day to day obligations, a sources and applications statement will reveal that in no uncertain terms and the banker will need to be satisfied that there will be inflows from operations before he would actually consider lending monies. The importance and effectiveness of the cash flow cannot be over emphasised and the banker will always examine the cash flow to determine the viability of the project and the ability of a company to repay its loans and service its interest.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
