Cashflow is the lifeblood of all businesses but disclosure remains very unsatisfactory, to put it politely. Businesses don’t fail because they run out of revenues or profit. They almost always fail because they run out of cash.
Cashflow should be the easiest metric to follow as it is inherently tangible – in theory, at least. In practice, the statutory cashflow statement is almost entirely useless as a way of monitoring the real health of a business.
I have never met a CFO who uses disclosures under IAS 7, Statement of Cash Flows, for internal purposes. Some companies do provide very helpful cashflow statements but only by producing additional voluntary information in a very different format.
Fundamental flaws
I think there are three main problems with the cashflow statement: where it starts, where it finishes and most of the stuff in the middle. It would be genuinely difficult to design a worse format.
IAS 7 states that its aim is to provide ‘information about the historical changes in cash and cash equivalents’, which probably partly explains why the standard is so ineffective.
The cashflow statement should be about how the entity’s operating activities generate cash and what that cash is subsequently used for. The movement in cash balances is by itself meaningless.
Think about EBIT
The logical place to start a cashflow statement is with operating activities, ideally with some measure of earnings before interest and tax (EBIT). This is a key performance metric and it’s always informative to see how much of the EBIT converts into genuine cash.
In my experience, the conversion ratio of EBIT into cash is a very good indicator of the quality of a business. In extreme cases, persistently low ratios can indicate major operating or accounting problems.
I have spent literally thousands of hours trying to unpick cashflow statements and very seldom found the process illuminating
Look at net debt
The logical place to finish a cashflow statement is with the movement in net debt. Net debt is another key performance metric that is ignored by IFRS. Cash balances are generally of no interest because it is the net indebtedness that matters, unless there is solvency risk.
The IAS 7 Disclosure Initiative tried to address this (after many years of lobbying by the Corporate Reporting Users’ Forum and others), but compliance is patchy and the information is often buried in the notes. It remains problematic to work out exactly why net debt has changed during the year.
Too much latitude
The last problem with IAS 7 is most of the stuff in the middle. Companies have far too much latitude to aggregate very different categories and can avoid disclosing really important stuff.
The movement in trade working capital is often missing. Capital expenditure is frequently lumped with ‘investments’, which could mean almost anything. There is often a large number called ‘movement in other liabilities’, which is perhaps the most opaque statement it is possible to make in a set of accounts.
Captive financing activities are almost never explained properly. Multi-segment companies often contain a segment called ‘Other’ or ‘Reconciliation’, which generates or absorbs lots of cash in an unexplained way. I have spent literally thousands of hours trying to unpick cashflow statements and very seldom found the process illuminating.
A win for all
There is currently a lot of debate about expanding company reporting and financial statements to include sustainability metrics. Leaving aside the difficulty of putting hard numbers on inherently slippery concepts, I think regulators would be better off putting their own house in order first.
Auditors and regulators are under fire for not spotting abuse in multiple cases. Suspect companies almost always have poor underlying cashflow, which is currently very easy to hide. Fixing the cashflow statement would be a win for everybody.
