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Where cash appears in financial statements

Cash is recorded as an asset in the balance sheet, specifically as a current asset. It has to be shown as a current asset as it is the most liquid of assets and can immediately be exchanged for other assets or to settle a liability. If an entity has an overdraft facility then, while the use of the facility means that a current liability has to be recorded, it does allow purchase of other assets or the settling of other liabilities; therefore the facility acts like cash because it brings liquidity to operations. One way of thinking of cash is that it is the oil that lubricates trade - it is an asset that by itself might earn a very modest return but is invaluable in that it allows trading to take place.

The operational generation of, or investment of, cash which results in holding cash in the balance sheet permits investment, capital expenditure on tangible, intangible or fixed assets and reduction of debt.

Cash flows for trading - working capital

The main difference between profit and cash flow is the accruals concept, on which most financial reporting is based. This means that the P&L account's purpose is to show the amounts of income and expenses which relate to the period of the account and not simply the amounts of money received or paid in the period.

An organization that cannot meet its financial obligations has to stop trading; the position of'insufficient funds' must therefore be avoided. If the organization is making losses, its owners or managers should expect that there will be a shortage of cash, and this expectation will probably be realized. If it is making profits, however, it is possible that they will expect the cash flow to Took after itself, and this expectation may not be realized. Cash flow may differ substantially from profits. Knowledge of the reasons for, and effects of, this difference is necessary for the successful management of an organization's finances. An essential task in administering finance is to ensure that the organization can meet its obligations as they fall due, meaning that there are liquid funds, or facilities to borrow funds, sufficient to cover peak cash requirements.

The issues surrounding working capital cash flows are:

- determining the 'correct' level of working capital required;

- monitoring working capital components and thus the level of cash surplus or overdraft at any time;

- reporting cash and working capital components in such a way that managers know what is going on and that they may need to take action.

From a purely numbers perspective, the single rule for working capital management amounts is one immutable truth: assets should be minimized in amount and liabilities maximized in amount. This truth of working capital management is very obvious, as the arithmetic of the simple example shown in Table 8.1 clearly demonstrates. This base position is a replica of the small company balance sheet in Chapter 3. As explained there, it has been in business for years, making profits, paying dividends and maintaining the balance sheet profile that is the 'norm' for its industry sector; it is successful and in a sustainable mode.

Table 8.2 shows the same company with the 'rule' of arithmetic applied. Note that net worth and working capital do not change in amount but there

TABLE 8.1 Balance sheet with 25 cash and 205 total working capital

Balance sheet with 25 cash and 205 total working capital

TABLE 8.2 Balance sheet still with 205 working capital but now 490 of available cash

Balance sheet still with 205 working capital but now 490 of available cash

is now 490 of cash available to spend, for example to invest or pay out as dividends. This cash has come from cutting inventory levels, pursuing debtors or changing terms of trade and delaying paying creditors. All very easy to do on a spreadsheet, but this obvious strategy may be more difficult to achieve in reality.

Here is a typical example of comment you will read in the financial press:

Credit to the new chief executive. Some of the gains in free cash come from improved earnings and lower capital spending. But the biggest contribution came from better inventory management.

(Vestas, from Lex, FT, 6 November 2013)

However, simply cutting inventory levels, chasing debtors and delaying paying creditors to achieve the lowest current asset amounts and highest current liability amounts is subject to the following, probably obvious, caveat: there must be sufficient levels of working capital amounts and amounts of inventories and receivables to permit the business to function. Delaying paying suppliers will not endear them to you and their ultimate sanction is to withhold supplies.

I once made a presentation on accounting matters to a large aero sector company whose CFO, as an aside, asked me as an outsider to remind his staff of the need to control inventory and specifically to delay payments. I retorted that I did not think this a good idea, especially as his suppliers were specialist engineering companies whose bank facilities were being cut back, and thus their very existence completely depended on his company.

And the caveat to the above praise of the new chief executive:

Declining working capital will not, however, be a sustainable source of cash flow unless payment terms improve and growth is sustained.

(Vestas, from Lex, FT, 6 November 2013)

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