How to read a cash flow statement
CFS helps to compare the operating performance of peers in the same industry
Cash is king for any business. Before making decisions, investors who scan financial statements should also evaluate a company’s liquidity position as well its ability to generate cash. This is important since a company’s accounts are prepared on an accrual basis — revenues/expenses are recorded even before the cash is collected/paid.
For this reason, the Companies Act, 2013, made it mandatory for most of the companies to prepare cash flow statements (CFS).
A CFS represents the cash movements in and out of an entity and divides all cash transactions during a particular period into three categories — operating, investing and financial.
Operating activities include the principal revenue-producing transactions of the entity (sales and purchases); investing activities include acquisition and disposal of long-term assets and other investments; and financial activities include those transactions that change the capital structure of the company, such as borrowings and issuance of new capital. The amount of net cash flows arising from operating activities in a CFS is a key indicator of the ability of the company to generate sufficient cash flows for its activities.
Net operating income in a CFS is arrived by adjusting the net profit reported by the company. First, non-operating items are removed by subtracting non-operating incomes
(for example, interest earned on fixed deposits made by the company) and adding non-operating expenses (example: incidental charges on sale of a fixed asset). Next, noncash expenses such as depreciation are added to it.
The resulting figure is adjusted with the changes in working capital.
Companies with positive operating cash flows are healthy and self-sustaining. However, negative cash flows needn’t always paint a gloomy picture. For example, start-ups might have negative cash flows from its operations due to high preliminary-marketing and product-launch expenses.
CFS helps investors better compare the operating performance of two companies within the same industry.
This is because cash flows do not take into account the effects of using different accounting methods for similar transactions and events.
For example, for recognising revenues, realestate companies follow either of two accounting methods — project completion or percentage completion. While one company may recognise revenue only after completion of a whole project (un- der the former), another may recognise it at various stages of the project. This makes peer comparison difficult. In such cases, examining the cash flows is a simple yet effective method to measure operational performance.
Net cash flows from investing activities indicate if a company is on the growth path .
Negative cash flows from this category is not necessarily a bad sign. It implies that the company is investing its resources to prepare for the future.
But at the same time, one has to examine if the company is investing in assets that are strategically aligned to its business and vision, and that support its long-term growth.
Positive investing cash flows show that the company has sold its assets. If a company has low/negative operating cash flows and positive investing cash flows, it could imply the company is funding its operations by selling its assets.
If core assets sold, it could imply the company is facing liquidity issues and is are trying to meet working capital requirements.
Financing activities are those that result in changes in equity and borrowings of an entity. In other words, it includes cash proceeds from borrowings and issuance of new shares, and cash repayments on borrowings and buyback of shares. It shows how the company is funding its expansions and operations.
Investors should examine if the company maintains an optimum mix of debt and equity. Increase in borrowings alone raises the interest expenses and reduces the net profits of a company. Similarly, issuance of more capital is also not ideal as it dilutes the ownership and reduces earnings per share.
Note that cash flows arising from interest paid are classified as cash flows from financing activities, while interest and dividends received are classified as cash flows from investing activities.
However, in case of financial institutions, cash flows arising from interest paid, and interest and dividends (on operating investments) received are classified as cash flows arising from operating activities as financing is the key business of such companies.