Importance of Cash Flow over Accounting Profits
Discuss About The Management Accounting Control Tools Concepts.
In general, the evaluation of a company involves two aspects, first deals with presentation of financial statements and second deal with analysis of the same. Normally, while measuring the performance of an enterprise, two factors on which the analysis is based are net profit and cash flow. These are the two aspects which clearly reflects financial position of the company and presents a true and fair view of it (Charifzadeh, & Taschner, 2017).
Accounting profits is the excess amount of total income over total expenses. It is the value which is derived by deducting all the expenditures from the total revenue earned. (Knight, 2012). On the other hand, cash flow is the inside and outside movement of cash within the business. The inflow and outflow of cash is represented by cash flow statement and is recorded on cash basis (Periasamy, 2009). The main difference between the two is the way in which they are recorded in the books of accounts. Profit is recorded on accrual basis and cash flow is reported on cash basis.
- Since the profits are recorded and reported on accrual basis, they do not provide a true representation of actual profits and may prove to be wrong in near future. The transactions in income statement are reported as per accrual accounting and there is a possibility of them getting deferred or change in future (Boex, 2015).
- The calculation of profit include non-cash items such as depreciation and amortization while the same are not included in cash flow statement. It is true that the asset of the company reduces its value over the time and that’s why it is necessary to record the amount of depreciation. But in actual, such amount is not been paid by the company and thus it does not affect the profits (Fernandez, 2006).
- Another reason is that the management of an organization can easily manipulate the accounting profits as compare to cash flow. The figure of the profit can be easily exaggerated by the mangers by reporting a transaction on accrual basis ( 2018).
- The cash flow is a performance measure from the shareholders’ perspective while the profit only evaluates the outcome of the company’s operations (Fernandez, 2006).
From the above reasons, it can be said that user should rely more on cash flow rather than accounting profits at time of evaluating or measuring a company’s performance. Also the cash flows are generally easy to forecast as compare to profits and they reflect the true liquidity position. Critical evaluation of cash flow helps in knowing about the future trends that will prevail in the business and also reflects the cash position of the company. Accounting profits are not reliable and can be modified, thus not reflecting a true position of the entity. Therefore, it is important to take into account, the cash flow of the company while evaluating or determining its position and situation within the industry (Berk & DeMarzo, 2010).
The financial statements mentioned in the annual report of a company are used by many people for their own purposes. As these statements clearly represent the financial view of an organizations, users evaluate them as per their needs and requirements. However, there are many users of financial statements classified as internal and external. Both the type of users are as follows:
- Management: The Company’s managers uses the information for understanding the profitability, liquidity and efficiency of the business and analyse them to take important decisions related to its operations and management (Dick & Missonier-Piera, 2011).
- Employees: They are those people who form an organization and work for it in return of a compensation. They look up to the statements to know about the profits of the company so that they can demand for bonus and salary increment.
- Owners: They are the people who owned the organization or entity. For analysing and measuring the viability and profitability of their investment they look up to the financial statements and the key ratios of the firm (Alexander, Britton & Jorissen, 2007).
- Creditors and suppliers: They evaluate the final accounts of a company to know about its creditworthiness and its ability to pay them back on time.
- Investors: For knowing about the feasibility of their investment in a firm, they analyse the final accounts of that firm. By critically reviewing the statements, they came to know about the percentage of return offered by the organization and can decide to continue with the investment or not.
- Government: To ensure that the entity complies with all the regulatory requirements and pay the tax liability on time, the government official require to check its financial records.
- Competitors: Entities generally functions in a competitive environment where a cut throat competition prevails. In order to evaluate the financial conditions, competing companies access each other financial data and gain knowledge regarding the same (Palepu & Healy, 2007).
However, the financial statements prepared are according to the Generally Accepted Accounting Principles and only provides limited information. Thus there are some limitation of them to its users. Following are the limitations of financial statements:
- They are been prepared on historical cost concept. Initially, transactions are recorded on their historical cost (Sinha, 2012). This can create a problem for the government officials while calculating the tax liability and any other legal charges for the firm.
- In GAAP format, treatment of derivatives and securitization is done according to some specified rules. This implies that they not modified as per the changes taking place in the market. This give a faulty view of financial position of the business.
- The GAAP prepared financial statements record assets at their historical cost and not on their fair value. This created a problem for the investors to judge the value of company’s tangible assets.
- GAAP requires the company to report all their expenses on accrual basis that is it should be reported as and when they occur, irrespective of the fact that they are actually paid or not (Rajasekaran, 2011). Such increased expenses can be a limitation to the employees of the firm as it may impact their chances of getting bonus or increment.
- It is not always possible to compare the financial statements of different companies because of the different accounting concepts and policies used by them.
- The accounts prepared according to GAAP can be manipulated deliberately by the managers, as they are rule based which can easily be modified. It is a huge drawback to the investors and creditors as they can take wrong decisions regarding investment and lending credit on the basis of manipulated figures.
Users of Financial Statements
In order to decide between the purchase of Briscoe Group Limited and investment in term deposit worth $50000, following analysis is been done for Briscoe Limited:
- Ratio analysis
- Performance of share price
- Recent announcements
Ratio Analysis of the company
The key ratios calculated are as follows:
- Current ratio
It is one of the liquidity ratio that reflects the capability of a company to pay off its current liabilities with its current assets. It shows the financial health of the business.
Referring to the Appendix, the current ratio reflects the financial position of a company and is calculated by dividing the current assets with current liabilities. The CR of Briscoe group has been continuously increasing after facing a fall in 2016. In 2015, the CR of the company was 2.18 and the same reduces to 1.54 in 2016. After that, it falls further to 1.53 and currently, its CR is 1.74. This implies that company has improved its performance as a result of which, its liabilities has reduced in 2018. This boosted up the ratio make Briscoe capable enough to meet its short term obligations (Tracy, 2012).
- Quick ratio
It is another financial metric which reflects the same as current ratio does. The only difference is that it takes into account the value of quick assets which comprises of the most liquid assets that excludes inventory.
From the calculation done in Appendix, it can be said that Briscoe has the highest quick ratio in 2015 with 1.24. Post the year, the ratio falls to 0.40 in 2016. Reason was the sudden decrease in the current assets of the company. However, from 2016 a constant increase was there in Briscoe’s QR and in 2018 it is reported at 0.91. This implies that company has improved its current assets by managing them properly for meeting its quick and short term liabilities.
- Gross profit ratio
This ratio determoines the amount of profit earned by the firm after paying for its COGS, expressed as a percentage of total sales (Jenter & Lewellen, 2015). The GPR of Briscoe remains almost same during the past four years. Comparing between 2017 and 2018, the ratio has decreased by 1% that is in 2017, it was 41% and in 2018 it was 40%. However, such minor reduction does not impacted the company as a whole (Refer Appendix).
- Net Profit ratio
It is also one of the key financial ratio that is used for measuring the profitability of the company. It represents the amount of net profit in terms of percentage of sales. It shows the profits made by the company from its total revenue.
Limitations of Financial Statements
Referring to the Appendix, it is observed that the NPR of Briscoe Limited has increased over the years but with fewer changes. In 2015, its NPR was 8% which increase to 10% in 2018. The ratio remains same for the past two years because of the minor increase in the revenue and net profits of the company. This implies that company is able to maintain its profitability situation over the years and is performing better in financial aspects.
- Interest coverage ratio
From the calculation shown in Appendix, ICR shows how many times a company can pay its interest expense. Briscoe’s ICR in 2018 is 612.97 times which is way more than the ICR of 2017 and 2016. The highest was 8,853.67 times in 2015. This implies that company has enough earnings to meet its interest expense (Parrino, Kidwell & Bates, 2011).
- Return on Equity
ROE indicates the amount of return offered by a company to its shareholders (Saleem & Rehman, 2011). In case of Briscoe, the ROE reduces to 25% in 2018, however it was remain 29% for the two years that is 2017 and 2016. This is because the shareholder equity has increased over the year (Refer Appendix).
- Earnings per share
EPS shows the profits available for equity shareholders. Briscoe has positive and increasing EPS over the years. So, it can be interpreted that the same trend will follow in future also and the company will offer more profits to its shareholders (Refer Appendix).
- Price-earnings ratio
The P/E ratio of Briscoe is fluctuating due to the changes in market price. In 2018, it was 11.67 and the market price per share is $3.25. It is reduced as compare to 2017 because of reduction in the market price of the share (Refer Appendix).
Performance of share price
The graph shown in the Appendix reflects the movements in share price of Briscoe Group Limited over the past four years. It can be interpreted from the graph that price was continuously increasing from 2015 and it was reported highest at $4.5 on March 2017. After that some fluctuations were there due to which the prices reduces by the end of 2017. However, in start of 2018 the prices again rises showing a positive trend for the investors. Currently the share price of Briscoe is $3.48.
In April 2018, the company announce about its 1st quarter sales of year 2018. The sales were worth $146.4 million showing a 3.57% hike as compare to the same quarter of 2017. The report also discloses that the group sales were 2.03% high and the departmental sales also increases (Briscoegroup.com. 2018).
Analysis of Briscoe Group Limited’s Financial Ratios and Performance
As per the article in NZ Herald, Briscoe’s total profit for the year 2017 rose by 25% to $59 million along with the upsurge in the sales. The increase in profit and revenue boosted up the share price of the company and bring it to the highest if $4.5 per share (NZ Herald. 2017).
As per the analysis, it will be recommended to invest $50,000 in Briscoe Group Limited by purchasing its shares at $3.55 (price as on April 22, 2018) because it is believed that the company is doing well and will give more return as compare to the term deposit. Also it has high profits, reasonable ROE and a good financial health. So, it will be recommended that the shares of Briscoe’s Limited should be purchased.
References
Alexander, D., Britton, A., & Jorissen, A. (2007). International financial reporting and analysis. (3rd ed.). London: Thomson.
Berk, J. B., & DeMarzo, P. M. (2010). Corporate finance. India: Pearson Education.
Boex, A. (2015). Why cash flow is more important than profit. Retrieved from https://www.unomaha.edu/nebraska-business-development-center/_files/publications/cash-flow.pdf
Briscoegroup.com. (2018). 1st Quarter Sales to 29 April 2018. Retrieved from https://briscoegroup.co.nz/wp-content/uploads/1st-Quarter-Sales-May-2018.pdf
Charifzadeh, M., & Taschner, A. (2017). Management accounting and control: tools and concepts in a Central European context. Germany: John Wiley & Sons.
CPA. (2018). The importance of linking profitability and cash flow when analysing financial statements. Retrieved from https://www.cpaireland.ie/docs/default-source/business-resource/profitability-and-cashflow-(2009).pdf?sfvrsn=2
Dick, W., & Missonier-Piera, F. (2011). Financial reporting under IFRS: a topic based approach (Vol. 1). UK: John Wiley & Sons.
Fernandez, P. (2006). Cash flow is cash and is a fact: Net income is an opinion. Retrieved from https://www.iese.edu/research/pdfs/di-0629-e.pdf
Jenter, D., & Lewellen, K. (2015). CEO preferences and acquisitions. The Journal of Finance, 70(6), 2813-2852.
Knight, F.H. (2012). Risk, uncertainty and profit. Courier Corporation.
NZ Herald. (2017). Briscoe Group’s full-year profit rose 25pc to about $59 million. Retrieved from https://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=11793458
Palepu, K. G., & Healy, P. M. (2007). Business analysis and valuation. USA: Cengage Learning EMEA.
Parrino, R., Kidwell, D. S., & Bates, T. (2011). Fundamentals of corporate finance. John Wiley & Sons.
Periasamy, P. (2009). Financial Management. 2nd ed. New Delhi: Tata McGraw-Hill Education Pvt. Ltd.
Rajasekaran, V. (2011). Financial accounting. India: Pearson Education India.
Saleem, Q., & Rehman, R. U. (2011). Impacts of liquidity ratios on profitability. Interdisciplinary Journal of Research in Business, 1(7), 95-98.
Sinha, G. (2012). Financial statement analysis. (2nd ed.). New Delhi: PHI Learning Pvt. Ltd..
Tracy, A. (2012). Ratio analysis fundamentals: how 17 financial ratios can allow you to analyse any business on the planet. RatioAnalysis. net.
Yahoo Finance. (2018). BGP.NZ Interactive Chart Briscoe Group Limited Ordinary Stock – Retrieved from https://finance.yahoo.com/quote/BGP.NZ/financials?p=BGP.NZ
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