How to read a cash flow state­ment

CFS helps to com­pare the op­er­at­ing per­for­mance of peers in the same in­dus­try

The Hindu Business Line - - YOUR MONEY - SATYA SONTANAM

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.

Growth path

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

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.


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