People often believe that a cash flow statement shows a company’s profitability. But that’s not the case…they are two different things.
A cash flow statement lists only the cash inflows and outflows. It helps us understand where the cash is coming in and where the company is spending it. While the income statement lists cash as well as credit income and expenses.
A cash flow statement helps an investor analyze a company’s liquidity. While the income statement helps analyze the profitability.
So, what if we can skip the cash flow statement and instead focus on the income statement only?
The answer is simple. No, we can’t skip the cash flow statement. The reason behind the same is simpler!
Let’s understand this with an example –
In this example, the company’s income statement shows a net profit of Rs. 400. But when we look at cash transactions in isolation, the company is incurring a loss of Rs. 100.
How to interpret this information? Does this mean that the company is not safe to invest in? We will learn that in this article.
The above example explains why we must analyze the cash flow statement. Cash flow tells us if the company has enough cash to pay its expenses to avoid insolvency.
Cash Flow Statement Format:
There are three sources of cash flow –
- Cash Flow from Operating Activity
- Cash Flow from Investing Activity
- Cash Flow from Financing Activity
Let’s break this down and understand how to analyze this statement.
- Cash Flow from Operating Activities
Here is Dabur India Limited’s cash flow from operating activity –
Operating activities include the company’s day-to-day activities that create revenues. It begins with the profit before tax amount from the income statement. Here, we add back all the non-cash items to arrive at a cash-based figure.
In simple words, cash flow from operating activities works backward to achieve a cash figure.
For example, depreciation is a non-cash expense. It was deducted as an expense in the income statement. In the cash flow statement, depreciation is added back to the profit before the tax’s figure. Similarly, interest income is added in the income statement but subtracted in the cash flow statement.
- Effects of exchange rates on translations of operating cash flows:
When a company has foreign operations, they need to convert the foreign currency into the reporting currency. Exchange rates in effect at the time are used for the same.
We can see that Dabur India’s effects of exchange rates on translations increased from Rs. 5.21 crores to Rs. 95.29 crores. That is a huge addition to operating activities’ cash flow. What we must check next is if this was a one-time event. Find the past five years data and observe the foreign operations volumes.
- Adjustment for changes in working capital:
Working Capital is the amount required to run the daily business operations. It gives you a quick idea about the liquidity of the business.
Working Capital = Current Assets – Current Liabilities
If the working capital is in line with the industry average, it is considered favorable. Whereas low working capital compared to the industry average is considered risky. It indicates that the company cannot generate enough revenues for short-term requirements.
- Net cash flow from operating activities
Compared to the previous year, cash flow from operating activities (before working capital adjustments) has grown by 7.64%. While the company’s profit before tax increased by 0.16% only. This is a good sign for the company!
2. Cash flow from Investing Activities
Investing activities include purchasing and selling assets and other investments. This includes tangible & intangible assets, equity and debt issued by other companies, etc.
When we buy an asset, cash goes out, and hence the amount is deducted from the cash flow. Likewise, when we sell an asset, cash comes in, and hence the amount is added to the cash flow.
Cash inflows include the sale of non-trading securities and assets. Cash outflows include cash payments for the purchase of these assets.
Here is Dabur India Limited’s cash flow from investing activities –
- Purchase of investments
Purchase of investments shows a negative cash flow of Rs. 8,478.78 crores. The amount has increased by 57.22% when compared to previous year. Parking funds in bank deposits suggest that the company might have liquidity needs in near future. The returns with bank deposits are minimal but it assures safety. Had the company invested in purchase of assets instead, there would have been a growth opportunity.
- Sale of investments
Sale of investments has resulted in a positive cash flow of Rs. 8,114.22 crores. When an asset is sold, cash comes in. Thus, this generates cash for the business operations.
- Net cash flow from investing activities
This is the final output from investing activities. Here we can see that the company has a negative cash flow which is largely due to the purchase of investments.
Though it generated a negative cash flow for the current year, this kind of expenditure has future economic inflows. The future implications of current investment look brighter.
- Cash Flow from Financing Activities
Cash flow from financing activities includes obtaining or repaying capital. A company can finance its resources by both – debt and equity.
Cash inflows include cash receipts from issues of debt, stock, or bonds. It also includes cash receipts from borrowing. Cash outflows include cash payments for redemption of debt and equity buy-back. Dividends paid to the shareholders are recorded under this head.
Here is Dabur India Limited’s cash flow from financing activities –
- Repayment of Borrowing
If a company borrows funds from a bank to invest in the business, then they have to repay it at some point. Here, the company repaid the borrowings of Rs. 182.88 crores which resulted in an outflow of cash.
- Dividend Paid
Dividend is the share of a company’s profit that is distributed among the shareholders. Dabur India Limited paid Rs. 1,324.71 crores as dividends in 2019. This amount came down to Rs. 512.45 crores in 2020.
Dabur India has a strong dividend-paying record. So, this is not something to worry about. Not all stocks pay dividends. Especially in a pandemic-hit economic environment, dividend paid comes as a green signal for the company.
- Net cash flow from financing activities
In 2019, net cash flow from financing activities was negative Rs. 1,888.20 crores. In 2020, there is a sharp drop. . Though the net cash flow from financing activities is negative, it is less than the previous year. This is a sign that the company spent less on financing activities.
We can trace this back to that in 2019, Dabur India Limited paid out Rs. 1,324.71 crores as dividend. In 2020, the dividend payments went down to Rs. 512.45 crores. This ultimately reflected in the net cash flow amount.
4. Net cash flow all activities combined
When combining cash flows from all three activities, the balance is Rs. 91.74 crores. This is the net balance cash the company has at the end of the financial year. We can see a huge increase from Rs. 37.72 crores in 2019 to Rs. 91.74 crores in 2020. An increase of almost 143.21%. This is a massive improvement and a good sign for a company.
Cash flow statement analysis helps us understand the cash operations of a business. You need enough cash in hand to ensure smooth functioning to run and grow a business.
One disadvantage is that one cannot have a complete picture if we study the cash flow alone. You need an income statement as well as a balance sheet to understand the transactions better. Only cash flow analysis would not be able to give you the right picture of a company. Look for net cash inflow, but also make sure that you have checked how profitable the company is over the years.
To understand a company’s performance, analyze all their financial statements. Compare past trends with the help of ratio analysis for a deeper insight. Start by reading their balance sheet and observe what a company owns and how much it owes to others.