Cash Flow Statement

Companies need cash for essentially the same reasons, though they may engage in different activities – cash needed to conduct their operations, to pay their obligations, and to provide returns to their investors. In other words, cash is the lifeline of any business and it’s necessary to monitor its movement or flow. Fortunately, that task is made easy by the cash flow statements.

A cash flow statement demonstrates how much cash is flowing into and out of the business. It provides a detailed picture of what happened to a business’s cash during the period under consideration. It tells us how the enterprise generates and uses cash and cash equivalents.

For a company it’s mandatory to prepare a cash flow statement and present it for each period for which financial statements are presented.

But you should always remember that cash flow is different from profit or loss. While profit indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a business. While P&L account shows how much money the company has spent and earned, it fails to tell how much cash has actually been received and paid by the company during the period under consideration.

For example, a company sells Rs 1 lakh worth of goods from its ready stock to a customer on, say 15th February. It’s a normal practice of the company to offer one month credit to the customers. The cost of goods sold is Rs 75,000. If there are no other transactions during the month, monthly P&L account of the company for February will show a profit of Rs 25,000 (sales value minus cost of goods sold) while the cash balance will be nil as the credit period is not yet over and the money has not yet been received from the customer. It will be reflected only in next month’s cash flow when the customer pays the amount. In other words, the enterprise has to arrange for cash from elsewhere (to meet its regular financial obligations) despite making a profit of Rs 25,000.

The following example may make the point clearer to you.

Given above is the P&L Account and cash flow statements of an aluminium producer for the year ending 31st March 2020. While the company has earned Rs 138 crore net profit for the year, its cash flow from operations is negative Rs 348 crore. In other words, despite making some profits for the year, the company has not been able to generate enough cash to carry on its operations which may be due to poor working capital management. By studying P&L account only you would have been made to arrive at wrong conclusions. Cash flow statement helps you to know the quality of earnings also. 

Components of cash flow

A company’s cash flow statement is usually presented as cash flow from operating activities, investing activities and from financing activities. Classification by activity provides information that allows you to assess the impact of those activities on the financial position of the enterprise and the amount of its cash and cash equivalents.   

Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise like cash receipts from sale of goods, rendering of services, receipts from royalties, commissions and fees and payments for supply of goods, payment of rent, salaries, insurance, etc. 

Cash flows on account of investing activities include cash receipts from disposal of fixed assets, investments (in shares, bonds, etc.), repayments of advances to third parties and cash payments made to acquire fixed assets, shares in other companies, joint ventures, cash advances and loans made to third parties, etc. Disclosing cash flows arising out of investing activities separately becomes necessary because such cash flows indicate the extent to which expenditures have been made for resources intended to generate future income and cash flows.

Given above is an extract of the cash flow statement of a fast moving consumer goods manufacturer which shows some of the cash flow items from investing activities. You might have noticed that unlike cash flow from operating activities, companies cannot expect regular flow of cash from investing activities. So is the case on the outflow side too. 

Cash flows arising out of financing activities include cash receipts from issue of shares and other similar instruments, cash proceeds from issue of debentures, loans, etc and cash payments to repay debentures loans and payments for buyback of shares. Cash flows arising from financing activities help us to predict claims on future cash flows by providers of funds (both capital and borrowings) to the enterprise.

Ideally, cash from operating income should exceed net income. A positive cash flow reflects a company’s financial stability and ability to grow its operations. This may not always be the case, especially in the case of start-ups

Direct & Indirect method

Cash flows from operating activities can be reported by using either direct method or indirect method. Two methods of reporting cash flows from operating activities arise because transactions can be recorded either using cash system or accrual system of accounting. 

So, in case of direct method major classes of gross cash receipts and gross cash payments are disclosed. Such information is useful in estimating future cash flows and which is not available under the indirect method and is, therefore, considered more appropriate than the indirect method. Sources of information under direct method are accounting records of the company and financial statements, especially the profit and loss account. 

Indirect method is based on accrual accounting method. The net cash flow from operating activities is presented under the indirect method by presenting the operating revenues and expenses excluding non-cash items disclosed in the statement of profit and loss and the changes during the period in inventories and operating receivables and payables. The most common non-cash items are depreciation (in the value of assets) and amortisation (of expenses).

A cash flow statement helps us to identify whether a company is going through transition or in a state of decline. For the CEO of the company, a cash flow statement helps to identify which department is contributing and which department is bleeding. Cash flow statements can be used in the budgeting exercise and also to take some strategic decisions like expansion and disposal of a unit.

Example:

Cash flow statement for the year ending —– (using direct method) (Rs in lakhs)

Cash flow statement for the year ending — (using indirect method) (Rs in lakhs)

Uses of cash flow statement

A cash flow statement should not be used in isolation but should be read in conjunction with balance sheet and profit and loss account. Arriving at an investment decision based solely on the analysis of balance sheet and P&L account may prove to be suicidal and use of information provided by cash flow statement in the analysis would help to enhance its accuracy and consequently its utility. For example, it’s possible for a company to be profitable and have a negative cash flow hindering its ability to pay its expenses, expand, and grow. Similarly, a company with positive cash flow and increasing sales can fail to make a profit, as is the case with many startups. 

Often, historical cash flow information is used as an indicator of the amount, timing and certainty of future cash flows. 

Further, it also enhances the comparability of the reporting of operating performance by different companies because it eliminates the effects of using different accounting treatments for the same transactions and events.

Limitations

However, a cash flow statement suffers from certain limitations. It only deals with one aspect of the business, that is, cash – its inflow and outflow. It fails to reveal the net income of the company as it doesn’t take into account non-cash items. Profitability of a firm cannot be judged based on cash flow statement as non-cash items are not included in the calculation of cash flow from operating activities. Often negative cash flow statement may give misleading information as it ignores such important aspects like unused overdraft limits.

Recently a popular unicorn came out with an IPO and the following is summary of its cash flow statement for the last three completed years: (figures in crore Rs)  

From the above cash flow statement, it’s clear that the company has been witnessing continuous cash outflow from its operations for the last three years. But the company has been able to recoup its cash reserves through additional capital infusion by the shareholders and the investors. Despite the continuous negative cash flow and financial loss, the company has been able to raise huge money from the capital market. This is because the promoters have been able to convince the investors about the future potential of the company which the financial statements including cash flow statements fail to reveal. 

Nevertheless, a cash flow statement is an important tool in the hands of analysts, investors, bankers and also the management of the company. Though it cannot replace either balance sheet or the profit and loss account it very well complements them as part of the financial statement and increases their utility.

Frequently Asked Questions (FAQs)

Why a cash flow statement is prepared?

A cash flow statement is prepared to know how much cash is flowing into and out of the business.

What is the source of information for cash flow statement?

Accounting records, P&L account and balance sheet are source from where the data required to prepare cash flow statements are taken.

What are the different methods of calculating cash flow from operating activities?

Direct and indirect methods are used for calculating cash flow from operating activities. While the former is based on cash system, the latter is based on accrual system.

What is the difference between P&L account and cash flow statement?

While P&L account indicates the amount of money left over after all expenses have been paid, cash flow indicates the net flow of cash into and out of a business.