Basics of Cash Flows Statement

Cash Flow Statement is considered the strongest pillar of the Financials. Cash Flow Statement helps an
individual to understand the rotation of money that takes place in the company

So in our final part 3 of series Cash Flow Statement we will learn the basics from an analyst point of view and that will help any layman to understand the companies easily.

So let’s delve deep into the topic ​“Understanding Cash Flow Statement from an Analyst Point of View”

Generating cash is critical for a firms’ long term survival. P/L statement and Balance Sheet do not focus on cash flows since accounting is on accrual basis and not cash basis. Accrual basis of accounting means that sales are booked at the time of delivery irrespective of whether payment from the customer is received or no. Similarly, purchase is booked at the time of receipt of goods irrespective of whether payment to the supplier is made or not

This creates a difference between the profits shown in the business and the actual cash with the business.

Let us take an example. If a business does all cash purchases of say Rs. 80,000 and cash sales of Rs. 100,000, there would be profit of Rs. 20,000 and business would be able to touch that cash as money has already come in. However, think of this business where purchase is done on cash and sales is done on credit the P/L statement would show a profit of Rs. 20,000 but the fact is that there is no money

Indeed, if the business is not able to collect the dues from its customers, there will be no profits and even the capital of the company, Rs.80,000 is likely to be lost. Therefore, along with the P/L statement and Balance Sheet, the cash flows generated by a business also needs to be assessed. In absence of cash, while there may be profits, they would be more paper profits and not the real profits.

If a business is continuously running negative operating cash flows for several years, there is an alarming signal of risk. A business, which is continuously running negative operating cash flows would need continuous doses of stimulus in terms of cash (borrowing or equity expansion) to keep going.

Needless to state that over a period of time, either it will turn into a positive operating cash flow business or die down in the absence of cash stimulus (when investors and/or lenders refuse to pump in further cash).

Whenever a business is expanding, it would need cash. Negative investing cash flows are financed through either positive operating cash flows or accumulated positive operating cash flows (bank balance) or positive financing cash flows (borrowing and issuance of equity).

Businesses that depend excessively on borrowed funds for expansion have to be seen with caution. The
assets that appear in the balance sheet may realize lower than their book value as shown in the B/S but the liabilities have to be met in total

To understand the concept further, there are cash inflows and cash outflows in every business as money comes in and money goes out. For simplicity and understanding purpose, cash flows are broadly divided into following three categories:

1. Cash Flow from Operating Activities

The first component is the cash flows relating to your operations – the core activities of your business. This includes cash receipts (cash received) from your customers, cash paid to suppliers and employees, interest received or paid and tax paid. Cash flows from business operations (P/L items). Incoming cash is positive and outgoing cash is negative. The net profit of a company can be converted into the operating cash flow number by adding back non-cash expenditures such as depreciation and amortization and changes in account receivables and payables

2. Cash Flow from Investing Activities

The second component is the cash flow from investing activities.

Cash flows on account of assets (B/S items). Buying assets is negative cash flow and selling assets is positive cash flow. Investing ​(in the context of the cash flow statement) means the spending of cash on non-current assets​. ​For an example: spending cash on computer equipment, on vehicles, or even on a building one purchased.Thus investing activities mainly involve cash outflows for a business.

We also include cash inflows in this section relating to the sale of a non-current asset that we have already invested in. Thus, the cash received this year from selling equipment that was originally bought (invested in) three years ago, would also be included in this section.As investing activities mainly deal with cash outflows (buying non-current assets), the total of this section is usually a negative.

Purchases of assets are put under two different categories: additions or replacements. Additions means
purchases of ​additional assets in order to ​expand the business.Replacements do not involve expansion but rather refer to an asset being purchased to ​replace​ an old or obsolete (no longer used) asset.

3. Cash Flow from Financing Activities

Cash flows on account of liabilities (B/S items). Borrowing money or issuing/expanding equity is positive cash flow and redeeming debt and/or equity is negative cash flow. Cash flow from financing activities is the third component. Financing ​is the source of the cash that we will be using to invest in non-current assets.It is where we get cash from. Thus financing activities mainly involve cash inflows​ ​for a business.

Financing can come from the owner (owners equity) or from liabilities (loans). We also include cash
outflows in this section that relate to financing that we originally obtained. Thus the repayment of a loan ​(in
part or in full) falls under financing activities (as a cash outflow), as the loan served as finance for the
business originally

Similarly, drawings (or ​dividends for a corporation) may also be placed under this section, although it can also be placed under the operating activities section if the business so chooses.

As financing activities mainly deal with cash inflows (receiving cash from shareholders or lenders), the total of this section is usually a positive for cash flow.

4. Net Increase / Decrease in Cash
The final section of the statement comprises the ​net cash increase or decrease for the period as well as the cash balance at the beginning and end of the period.

Some of the points to be kept in mind in case of cash flows are:

● Looking at net cash flows could be deceptive
● Each of the cash flow streams Operating, Investing and Financing have to be analyzed
● The objective of cash flow analysis has to be to focus on sustainable and recurring cash flows
● Non-recurring / extraordinary items that impact the cash flows should be recognized and adjusted

So here we conclude in brief all the Basics of Financial Statement and its importance while analysing the company. The 3 very important pillars of the company.

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