Accounting Business Reporting for Decision Making

CHAPTER 7 Statement of cash flows 269

The above example reinforces the importance of working capital. The following timeline highlights

the necessity of having enough cash to manage through the operating cash cycle of the entity.

Purchase Payment Sales Collection

$6000 $6000 $20 000

Operating cash cycle

Negative cash ow

$5000

The time between the payment of inventory, wages and so on and the collection of debts is called the

operating cash cycle. By minimising this time an entity can save on funding costs (i.e. interest). Prudent

companies tightly manage their working capital requirements and their operating cash cycle. Companies

such as Woolworths have a positive operating cash cycle. This means they collect funds from sales/

accounts receivable prior to paying their accounts payable. So rather than paying funding costs through

this period they are earning interest on funds collected prior to paying their accounts payable. This can

be a great competitive advantage over rival companies.

REALITY CHECK

Global liquidity crisis

Cash and access to funding is important for every individual and every business. It is also important

for countries. The credit expansion in 2007–2008 and the subsequent global financial crisis in 2009

have highlighted which governments have been managing their country’s liquidity and solvency needs.

During 2010–2011 the Bank of England, the US Federal Reserve, the Bank of Japan and the European

Central Bank borrowed heavily to inject funding into their economies. Bank bailouts were common-

place and in most of these countries people rioted in the streets against their government’s austerity

measures that would force sacrifices and a downgrade of living standards on the general population. In

2013, Cyprus’s financial crisis saw bank closures and the European Monetary Fund stepping in to help

stop contagion to other countries.

Despite the GFC occurring seven years ago, the world’s economy still hasn’t recovered.

The statement of cash flows is needed as it summarises the cash and types of cash flows

coming into and flowing out of the entity. The balance sheet does show the beginning and ending

cash balances, but the statement of cash flows shows the various categories of cash flows. For

instance, if the entity received cash from bank loans but no cash was coming into the entity through

normal operations, it would indicate to a user that it would not be a good business to invest in.

Likewise, if ample cash was coming in through the entity’s normal operations and it therefore

had no need for cash from borrowing, it would indicate to a user that it would be a good entity to

invest in.

The importance of cash to the ongoing survival of a business cannot be overstated. An entity needs to

have enough ready cash to ensure that it can meet its financial obligations in a timely manner, yet not

too much — there are costs associated with keeping a supply of ready cash (e.g. interest payments on

debt, or lost investment opportunities). The ability of an entity to manage the flow of cash in and out of

the business is critical for success. Paying for supplies, converting sales into cash and paying for assets

are central to managing a business. Entities can be quite profitable and yet still falter due to poor cash

management.