Cash is King

The truest picture of how well a company is doing comes from understanding not just the profit and loss statement and the balance sheet, but how these describe what is happening to cash in the company.

by John Royden

Head of Research

Understanding Finance

But to get a firm picture of what is happening to cash you need to reverse out non cash entries.

Here’s an example of a company’s profit and loss statement:

cash is king

It looks as if Fudge Company Ltd is doing well; profit in 2013 of £21.7m was up on profit of £19.7m in 2012. However, a closer inspection of the statement shows that this might well be just because the directors changed the depreciation policy.

Depreciation is the accountants’ way of moving the purchase cost of a machine into the profit and loss statement over time. Usually it is something like 10% of the cost of the machine every year for ten years.

If the directors of Fudge Company Ltd saw cash costs go up from £50m to £60m they could change the depreciation policy to write their machines off over twenty years, rather than just ten. This would halve the depreciation charge from £25m to £12.5m and result in a higher profit in the Report and Accounts. In fact, Fudge Company Ltd is doing less well as it only made £40m of pre-tax cash profit, or EBITDA, rather than £50m in the year 2012.

EBITDA stands for Earnings Before Interest Tax Depreciation and Amortisation and means cash profit before tax.

Understanding Finance

Helping clients understand what we do is key to building relationships. To explain some of the industry jargon that creeps into our world, we’ve pulled together a section of our site to help.

Related articles
Understanding Finance

Conceptually we have a reasonable understanding of inflation. As an economic term, inflation represents the general price rise of goods and services over a predetermined time.

Understanding Finance

Usually, your bank would pay interest on your savings accounts. Negative interest rates turn this around and mean customers have to pay banks to hold their savings.

Understanding Finance

You probably sort of know how index linked gilts, or “linkers,” work. The redemption value is linked to the change in the retail price index, or RPI, that takes place over the life of the gilt.