Why the cash flow statement matters

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Cash flow for me is the most important financial statement as it can corroborate or invalidate what I see on the income statement. In the last three weeks I’ve looked at the income statements, balance sheet statements, and the link between the two for various companies. Today I will use Shuaa’s Q3 2017 financials to show how the cash flow statement can provide insight into the more famous income statement.

Cash flow basics

A little refresher course in accounting first. Cash flow accounting as a measure of the performance of a company is flawed because it does not reflect the timing of transactions. For example, if a company is paid an annual subscription to provide a weekly magazine, then cash flow accounting would recognise a large income upfront and then the expense of publishing the weekly magazine is recognised about evenly across the year. This can make things look far better than they are. There are other situations where the opposite could happen, or where the effect is on the balance sheet, eg depreciation.Unfortunately this has resulted in the cash flow statement being relegated to the black sheep of financial statements. Indeed, it is presented as the third statement in financial accounts, after the balance sheet and income statements. But although the cash flow statement is insufficient in itself to provide a complete picture of the financial performance of a company, the same can be true for the balance sheet and income statements. It is only when one looks at all three, the links and inter-dynamics between them, as well as the notes to the financials that one can get a full picture.

In this article I will be using the year to date numbers, as that is how Shuaa presents their cash flow statement. I will also round numbers to the closest million as this does not affect the picture but makes for easier reading.

Cash flow validation of profit quality

I normally start by comparing the profit/loss for the period with the net cash generated from operating activities, ie the core business of Shuaa excluding financing (borrowing from banks) and capital and financial investments, ie making them and realising them, not a mark to market (adjustment in value) of the value of the investment.

For 2017 Shuaa’s profit was Dh60 million compared to cash flow from operating activities of Dh63m. This looks reasonable as we know that income and cash flow do not exactly match. However in 2016 Shuaa had a loss of Dh114m and positive cash flow of Dh147m. This is a shockingly large gap.

The first question that I would ask is does the 2016 gap signal a better picture or a worse picture relative to the loss of Dh114m? The answer seems clear, if the loss for Shuaa in 2016 was accompanied by a positive cash flow of Dh147m then this signals a better picture for 2016, as Shuaa has generated cash, the lifeblood of a company.

Now the question is how does this affect the picture for 2017? To do that we need to dig deeper and understand what operating assets and liabilities are. Basically this is cash movement into and out of the rest of the assets and liabilities of Shuaa, ie it is not cash generated from business. For example, when Shuaa invests cash from its bank account into one of its own funds, then the cash does not leave the company. There is no performance information here, although it can be useful in some cases. Therefore to look at the performance information we need to look at operating cash flows before changes in operating assets and liabilities, which I will call core operating cash flow.

For 2017 core operating cash flow for Shuaa was Dh18m versus a profit of Dh60m, whilst for 2016 it was Dh29m versus a loss of Dh113m. We see now that when looking at the core operating cash flow, Shuaa only generated cash equivalent to 30 per cent of profit in the first 9 months of 2017. This leads us to look deeper and the core cash flow trail leads us to two large swings: an increase of Dh40m in gains from other investments and and a decrease of Dh137m in provisions.

The second number is more significant, in 2016 Shuaa provisioned Dh134m on loans, advances and leases of Dh691m (19 per cent) . In 2017 Shuaa reversed Dh3m of provisions on loans, advances and leases of Dh489m (0 per cent). Is the long term percentage for provisioning 19 per cent or 0 per cent? I don’t think it is 0 per cent. I doubt that it is 19 per cent either. If you took the average of 10 per cent, that would give, on average loans, advances and leases, an implied average provision of Dh59m for 2017. This would wipe out the YTD 2017 profit, but it is still better than the large loss of 2016, even when adjusted for the average provision rate of 10 per cent. Then again, we haven’t delved into the gains from investments.

You might ask why I look into the financials when there are management reports. The problem, across the market, is that these reports read more like public relations (PR) than they do investor relations (IR). PR is meant to make a company look good, and there is a role for that. But IR is meant to give investors a better understanding of the company and build trust in the company from its investors, current and potential. Stay tuned as I explain this in a future article.


This article was originally published in The National.