In the final instalment of his series on financial reports, Mahmood Reza looks at cash-flow statements and the management use and interpretation of financial statements.
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A profitable organisation is not necessarily cash rich: it is not that unusual for an organisation to be profitable and also to be in debt. Cash is required to pay suppliers, employees and banks, and to invest in projects, and it is considered to be the life-blood of any business. Insufficient or inadequate control of cash is one of the primary reasons for organisational failure.
A cash-flow statement links the profit and loss statement and balance sheet together and shows the impact of an organisation’s activities in cash terms. It will show the sources of cash (for example, from operating activities, grants received, sale of assets) and it will also show where cash has gone (for example, in capital purchases, loan repayments, etc.) The overall effect of cash receipts and payments is reflected by the increase or decrease in the bank balance during the year. This statement also helps management assess the liquidity, solvency and financial adaptability of the organisation.
The published cash-flow statement is an historical statement, and, due to the criticality attached to cash management, it is recommended that all organisations prepare a forecast cash statement on at least a rolling twelve-month basis. This will prove to be an invaluable management tool. Financial statements can provide a valuable insight into the performance of an organisation and a number of other performance indicators can also be used to measure efficiency and effectiveness. Financial statements are those that tend to be published for groups outside the organisation, while management accounts are for internal use and contain more detailed information and are of more use as a management tool.
Efficiency is seen as the relationship between inputs and outputs – the fewer inputs required by an organisation to achieve its given outputs, the more efficient it is perceived to be. For example, we could relate income to the number of staff employed or profits to assets used. Effectiveness is considered to be the degree to which an objective or target is met.
Ratios (based on the relationship of one number to another) help to focus attention systematically on important areas and summarise information in an understandable form. Ratios on their own are of no use – they need to be compared with a comparable yardstick, for example, comparison to budget, to previous years or to organisations of a similar size and type. The main financial ratios look at the profitability, liquidity, and management of working capital (current assets and current liabilities). Profits can be related to income, assets and staff numbers. A decline in profitability can be caused by an increase in costs and no increase in revenue, an impact of discounting or a change in the mix of goods and services provided.
Liquidity indicates an organisation’s ability to pay its way; two key measures are the current and quick ratio. The current ratio relates current assets to liabilities; the quick ratio relates current assets (minus stock) to current liabilities. A decline in these ratios indicates a worsening cash position. These ratios are limited to an extent and an analysis of cash flows as a more comprehensive method of assessing liquidity.
Working capital provides the resources for organisations’ operational functions. Typical measures would be the average debtors’ collection period and creditors’ payment period. The debtors’ collection period is calculated as debtors/turnover x 365; this tells us how long it takes our customers to pay us from when the invoice is raised. An increase in the number of days could be indicative of weak credit control, or differing credit terms being offered. An increase in the number of days will result in extra financing costs and a higher risk of bad debts.
Meaningful measures of productivity or efficiency for an arts organisation depend upon clearly defined measures of activity and resource. The judicious use and selection of quantitative and qualitative measures is necessary to provide a comprehensive picture.
Mahmood Reza is Proprietor of the accountancy practice Pro Active Accounting.
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