What Is Cash Flow Statement

The income statement tells us what a company has earned and spent during a year. Owing to the practice of accrual accounting, not all of these incomes and expenses are cash-based. Investors value information about cash-based inflows and outflows because these have already taken place. Accruals, on the other hand, have an element of uncertainty attached to them. The information about cash-based transactions is provided by the cash flow statement. Reading the cash flow statement and finding out trends is called cash flow analysis. This even helps you in cash flow forecasting.

Let’s find out a bit more about it.

Reading A Cash Flow Statement

First, let us look at what is cash flow. Imagine your bank account statement. You will see two different columns – credit and debit. Each line in the statement is when money has either been deposited or withdrawn. This is your cash flow. Now consider the company’s ledger. Every time the company actually receives or spends money in cash form, the ledger would be updated. These are called cash flows. The financial statement, which takes into account only the cash flows, and not the money promised or owed, is called the cash flow statement.

We’ll start understanding the cash flow statement by looking at its significance, structure and components.

This is why, it is important to maintain strict records of the inflows as well as the outflows. This process of keeping a detailed account of financial aspects of the company is called ‘accounting’.

Accounting Basics: Accruals, Adjustments And Assumptions

We start our study of accounting norms with an understanding of the accruals, adjustments and assumptions used in preparation of the financial statements.

Significance Of The Cash Flow Statement:

What if you sold something to someone and they requested for three months to pay for it? You would consider the sale completed and count the money as yours, but where is the guarantee that they will pay you duly, or even pay at all? Something similar happens with the companies. They record non-cash incomes and expenses on the income statement but are not always sure whether the cash exchange will ever happen. Such transactions result in no immediate change in their cash position. They are recorded as receivables or payables on the balance sheet.

Apart from these, there are some articles on the income statement, such as depreciation, which are only notional. They are reported as an expense (or income), but no flow of cash ever happens on their count. Such items are known as non-cash items. They only inflate the income and expense figures for the period. The cash flow statement eliminates the impact of all such figures and only talks about the transactions that took place in cash. Its scope extends beyond the income statement and also incorporates cash-based changes in balance sheet items, i.e. assets and liabilities.

Understanding the cash flow statement helps you understand how effectively the company is using its cash. If the company gets cash after great delays, while its expenses have to be met immediately, it is natural that the company would be under severe financial stress. It will then have to borrow money to meet its short-term needs. This is additional liability on the company. This is why the cash flow analysis is important.

During the times of economic stress, the cash flow statement can give you a better idea of how the company is performing in comparison with the income statement. If you see cash inflows are slowing down, you can predict the company’s near-term future too. This is called cash flow forecasting. This is very important, after all the stock markets react today in anticipation of the future.

Structure Of The Cash Flow Statement:

Companies can choose one of the two formats to present the cash flow statement—direct and indirect. The direct method begins with cash sales, i.e. the proportion of sales revenue that was received in cash. It then adds to it all the cash inflows that occurred on account of operating, investing and financing inflows and subtracts from it all the corresponding outflows. In the end, the cash balance at the end of last year is added. This is because the current year’s cash balance is the sum of cash balance at the end of the previous year and the net cash inflows this year. The resulting amount is the cash balance for the year, the same as found in the balance sheet.

The indirect method begins with the net income for the year, as mentioned in the income statement. Recall that for arriving at net income, we adjusted earnings before taxes and non-operating items (EBT) for some non-operating incomes and expenses (including tax). To show cash-based incomes and expenses, we must reverse this. So, we add back non-operating expenses and subtract non-operating incomes.

The resulting figure is EBT. Next, we adjust for non-cash items. We start by adding back non-cash expenses, such as depreciation and subtracting non-cash incomes. After this, we move to the balance sheet. We will adjust for changes in the current assets (other than cash) and liabilities. Increases in current assets and decrease in current liabilities represent an outflow of cash. They will therefore be subtracted. Similarly, increase in current liabilities and decreases in current assets are added back. The net value of these is called changes in working capital. After this, the statement progresses like the direct method, as can be seen in the illustration below.

In most annual reports, the cash flow statement is presented in the indirect format. However, it starts with EBT instead of net income. The adjustments to net income that we talked about are not shown. A pro forma cash flow statement using either approach is presented below.

Components Of The Cash Flow Statement:

As seen in the illustration, cash flows are divided into three categories—operating, investing and financing. This categorisation is common to both the formats. The only difference between the formats is the way of presenting operating cash flows. The presentation of the other two categories is the same for both approaches.

1. Operating cash flows:

This represents all categories of cash flows that are a part of the company’s core operations. The contents of operating cash flows differ according to the presentation format used. This can be seen in the illustration.

2. Investing cash flows :

This category represents all the cash flows that occur on account of investment in fixed physical assets (such as land, buildings and machinery) and financial assets (such as shares and bonds of other companies).

These cash flows are in the form of:

• Cash flow from the sale/purchase of a fixed asset, such as land
• Cash flows from the sale/ purchase of entire business units
• Cash flows from the sale/purchase of strategic stakes in other companies
• Cash flows from sale and purchase of financial assets, such as shares, bonds and mutual funds
• Dividends/ interest received from the investment in financial assets

3. Financing Cash Flows:

This category includes all the cash inflows and outflows that are related to raising/repaying capital used in the business.

Financing cash flows include:

• Fresh debt capital raised
• Fresh equity (share) capital raised
• Repayment of debt
• Interest paid to creditors
• Share repurchases
• Dividends paid to shareholders

Out of these, fresh capital raised through debt and equity is treated as an inflow and added. All outflows on account of repayments of debt and equity capital as well as payment of interest and dividends are subtracted.

Why Operating Cash Flow Matters

1. Measures Profitability:

When looking at a cash flow statement, investors tend to look at the component of operating cash flows with the greatest interest. As with the income statement, investors like companies that raise cash predominantly from operating sources.

The other two activities should ideally be financed in totality by operating cash flows. Investors don’t mind negative investing and financing flows as long as the figure for operating cash flows is positive and greater than the combined outflows on account of the other two. (Although negative values must be investigated further.)

If this is the case, it means that the company has raised enough money from its operations to finance its investments, as well as repay money to creditors and shareholders. Such a company must be doing rather well!

2. Cash Flow Forecasting:

In case operating cash flows are negative and investing cash flows are positive, it means the company has sold its assets to raise money for its ailing operations.

In extreme cases, it may even be facing prospects of a shutdown, and is therefore selling parts of its business to support its operations and repay capital.

In case financing cash flows are positive and operating cash flows are negative, it may again mean that the company doesn’t have sound operations and therefore has to raise fresh capital to finance them. Shareholders are very sensitive about negative operating cash flows.

3. Investing V/S Operating Cash Flows:

Negative investing cash flows generally signify that the company is expanding its operations or replacing old, worn-out assets. In such cases, you must be concerned as to the purpose of these investments. Negative investing cash flows are frequently found together with large, positive financing cash flows. This is because funding for these investments comes from financing inflows. You may be interested in the source of this funding—debt or equity. Sometimes, there is no increase in either. This means the company is using its retained earnings to finance these investments. In the section on the income statement, we defined retained earnings as the pool of net income not distributed as dividend over the years. This is the best and the cheapest source of financing.

Why Operating Cash Flow Matters

An extension of the concept of cash flows is the concept of free cash flows. It is an important part of cash flow analysis. We just discussed how a company should ideally use its operating cash flows to finance investments in new opportunities (i.e. fixed assets). In very crude terms, the portion of cash flows that is left after making such investments and fulfilling all other cash obligations is called free cash flows. There are two types of free cash flows—free cash flows to firm (FCFF) and free cash flow to equity (FCFE).

The cash flows available to the company after all its investing needs are met are free to be used for the third avenue of outflows – financing outflows. The financing (or capital) for running the company is provided by two categories of investors – creditors and equity shareholders. Together, the funding provided by them therefore, forms the company, i.e., the firm. The cash flows available for distributing to capital providers are therefore called free cash flows to the firm.

The formula for the calculation of FCFF is presented below:

Since shareholders are owners of the company, creditors always have the first right over FCFF. As such, FCFF should be first directed towards making interest and principal payments. Post-tax interest expense has been added here because interest anyway goes to creditors. Thus, it should be a part of the funds available for them. However, interest is subtracted in the income statement while calculating net income. Since net income is the starting point of operating cash flows, interest is not able to flow into operating income. For this reason it has to be added back.

What remains of FCFF after providing for creditors can be directed to equity holders. This amount is therefore called free cash flow to equity or FCFE.

The formula for this is presented below.

We subtract post-tax interest and repaid debt from FCFF because this amount has been paid off to creditors out of FCFF. However, the company may also raise fresh debt during the year. This also provides cash for repayment to shareholders. It is therefore added in the calculation of FCFE.

It must be noted, that FCFF and FCFE are only estimates of what CAN go to debt and equity holders. They don’t represent what ACTUALLY goes to them. Free cash flows are therefore only a tool for assessing whether the company has generated enough cash to meet its obligations towards creditors and shareholders. FCFF is of particular interest to those who lend money to the company in the form of bonds or loans. It provides them an estimate of the company’s ability to cover its obligations towards them. FCFE on the other hand, is used by equity holders. It gives them an estimate of the safety of their dividend. Expected future values of FCFE are also used by equity investors to calculate the fair value of an equity share of the company. We will talk about this later, in the section on the relationship between stock price and dividends.