Analysing financial statements is an analyst’s bread and butter. The three main statements (cash flow, income and balance) link to each other and should always reconcile; however, the accounting methodology used differs. This is most apparent when comparing the income (profit and loss) statement and the cash flow statement. The income statement follows what is called accrual accounting where the aim is to record revenue as it is earned, and expenses associated with this revenue are recognised in tandem. This can, and often does, differ from the actual flow of cash in and out of a business. Reflecting this reality is the job of the cash flow statement which follows cash accounting.
Imagine a business enters into an agreement to sell a good to a customer and duly delivers that good immediately but does not invoice for the good for three months. Revenue will be recognised on the income statement when the good is shipped to the customer. The cost associated with making the good will also be recognised as an expense on the income statement; the net of these two numbers leaving profit. Turning to the cash flow statement, no cash has been received yet so we cannot reflect a cash inflow yet. Only once the customer settles the invoice will the cash flow statement recognise this cash inflow. We therefore often get a mismatch between profit and cash but over the long term, these two statements must match.
Since the value of a business is ultimately determined by its ability to generate cash in the future, we must remember that profit can differ markedly from cash in the short term. This simple distinction is often misunderstood and should remain front of mind.
