by John Richard Edwards
01 Oct 2000
The merits of cash based financial reporting ? for example， it is based principally on facts rather than problematic accounting measurements ? have been known for many years. However， it was not until 1990 (revised 1996) that the Accounting Standards Board made the publication of Cash Flow Statements (FRS 1) a standard requirement for UK companies. FRS 1 tells us that the ?cash flow statement in conjunction with a profit and loss account and balance sheet provides information on financial position and performance as well as liquidity， solvency and financial adaptability?. Wise words， but what do they mean?
The usefulness of financial statements is enhanced by an examination of the relationship between them; also by comparisons with previous time periods， other entities and expected performance. Value can be further added through the calculation and interpretation of accounting ratios. An examination of accounting textbooks and the pages of accounting periodicals reveals an enthusiasm for rehearsing the potential of ?accounting ratios? demonstrated through calculations of the net profit margin， return on capital employed， current ratio and a host of other ?traditional? measures based on the contents of the profit and loss and balance sheet. But what about the cash flow statement? We have seen that its publication was required by the ASB in order to improve the informative value of published financial information. Indeed， some say it is the most important financial statement. One based on ?hard facts? which has helped prevent financial machinations such as those that are believed to have occurred at companies such as Polly Peck in the 1980s.
The lack of attention to cash flow-based ratios in accounting textbooks is particularly surprising given their acknowledged role in credit rating assessments and in the prediction of corporate failure.In these and other contexts， the traditional ratios suffer from the same defect as the financial statements (the profit and loss account and balance sheet) on which they are based. Such ratios are the result of comparing figures which have been computed using accounting conventions and ?guestimations?. Given the difficulty of deciding the length of the period over which a fixed asset should be written off， whether the tests which justify the capitalisation of development expenditure have been satisfied， the amount of the provision to be made for claims under a manufacturer?s twelve month guarantee (to give just a few examples)， ratios based on such figures are also bound to have limited economic significance. This is not to suggest that the traditional ratios are irrelevant. Clearly this is not so， as they reveal important relationships and trends that are not apparent from the examination of individual figures appearing in the accounts. However， given the fact that cash flow ratios contain at least one element that is factual (the numerator， the denominator or both)， their lack of prominence in the existing literature is puzzling.
Some recognition of cash flow ratios
The importance of cash flow ratios was dramatically demonstrated， early on， by W. H. Beaver whose 1966 study showed that the most effective predictor of corporate failure was the ratio of cash flow to total debt. Indeed， one of his most surprising findings was that the current ratio proved to be one of the least useful ratios in predicting impending collapse. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. Colourfully described as a company?s ?life-blood?， a strong cash flow will enable a business to recover from temporary financial problems whereas future negative cash flow will cause even an apparently sound enterprise to move towards liquidation. Expressing the importance of cash differently： a company which descends into a loss-making position often succeeds in making a comeback; one which runs out of cash is unlikely to have a second chance.
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