Profit is an Illusion Cash is King

We had earlier discussed the accounting cycle for a business organization, which starts from your source document to your journal then to your ledger, trial balance, adjustments, adjusted trial balance, and finally your financial statements. One of the components of a financial statement is the Statement of Cashflow. International Accounting Standard (IAS) 7 guides the preparation of the statement of cash flow, the statement of cash flow represents the cash position and its equivalent in an organization.

Remember, we raise funds for a business through two sources of finance which are: Debt and Equity finance, we use these funds to invest in the business by acquiring assets, and we use the assets to carry out our operations and then the outcome of the operations is what we get as revenue but by incurring revenue we would have incurred some expenses and the difference between the revenue and expenses is your profit or loss.

Sometimes when we generate revenue for our organization it is not always in cash hence, the statement Profit is an Illusion Cash is king. For instance, Mr. Peter is the manager of an organization and at the end of the month he says they have made a profit of N10,000,000.00 (Ten Million Naira) only now it is possible that his customers might have paid him only N2,000,000.00 (Two Million Naira) only and this is the only money available to him in the bank, but he said they have made a profit of N10,000,000.00 (Ten Million Naira) and the remaining balance is yet to be paid. Also, there are some expenses that he has not paid for, this is a situation where Mr. Peter went to get goods from his supplier and they give him inventory it is possible he has not yet paid.

Furthermore, remember our financial statements are prepared on an accrual basis. Accounting profit is full of estimates such as depreciation expense which is just an ordinary paper expense. Hence, we see that profit is an illusion and cannot be relied on. There are questions to be asked which are: How much of my profit is backed up by cash? From this profit how much is my cash? Hence, the statement of cash flow is used to explain profit that is cash and not. statement of cash flow is about cash inflow and cash outflow from the organization.

International Accounting Standard (IAS) 7 states that statement of cash flow consists of cash and cash equivalent which means short-term liquid investment, for example, treasury bills, the things you can easily convert to cash within 90 days, the bank is cash equivalent because I can go to the bank issue a cheque and collect my money.

Activities of a business are broken into three namely:

Operating Activities: This involves activities from your core operations, that is your core business gives you your revenue.

Investing Activities: Remember, our sources of finance for the business are debt and equity finance, we would use this finance to acquire assets or shares in another business. These are cash inflows and cash outflows which relate to the acquisition and disposal of the operating assets and investments of the organization. It includes the acquisition of property, plant, and equipment (PPE), investment in associates, sale of PPE, interest received, and dividend received just to mention a few.

Financing Activities: Cash inflows and cash outflows that result from raising capital to finance the business. It includes the issue of shares, issue of debentures, acquisition of loans and advances, loan repayment/redemption of debentures, and interest/dividend paid just to mention a few.

#MBA 21

Reference

Admin (2012) IAS Plus, IAS 7 – Statement of Cash Flows. Available at: https://www.iasplus.com/en/standards/ias/ias7 (Accessed: November 23, 2022).