Fundamental Analysis: The Cash Flow Statement

Cash flow statement is built by using two consecutive balance sheet and current year income statement. This Statement completes a company’s set of published accounts. Its purpose is to track the flow of funds through the company.

It identifies where the cash has gone to and where it has come from and it is very powerful tool for explaining movements in various liquidity ratios.

Many operating cash movements do not appear in the profit & loss account. One reason is that the P&L account uses the accruals concept to adjust a company’s cash flows to bring them into line with revenue earned and costs incurred for a specific period. These adjustments sometimes hide important aspects of a company’s affair.

The cash flow statement collates information from the profit and loss account and the balance sheet and puts them together from a perspective of actual cash coming in and going out of the business. The cash flow statement eliminates all accounting entries to give the actual picture of whether the company is generating cash or drawing down on cash.

The cash flow statement has three main categories

1. Cash flow from operating activities
2. Cash flow from investing activities
3. Cash flow from financing activities

Cash flow from operating activities

Operating activities starts with profit before tax from (IS) & adjustment have to do with the increase or decrease of relevant (BS) adjustments:

• Account receivable in increased (debited) when sales are made on credit.
• Inventory asset account in decreased (credited) when recording cost of goods sold expenses.
• Account payable in increased (credited) when recording expenses that have not been paid.

Cash flow adjustments to profit before tax are based on 2 consecutive balance sheet changes and summarized as:

• An asset increase during the period decreases cash flow from profit.
• A liability decreases during the period decreases cash flow from profit.
• An asset decrease during the period increases cash flow from profit.
• A liability increase during the period increase cash flow from profit.

The cash flow from operating activities gives the quality of earnings of a company and not the quantity of earnings. The cash flow from operating activities, if higher than reported income signifies that the company is generating cash while if reported income is higher than cash flow from operating activities, investigation is required.

Britannia industries has shown a sharp decrease in net cash from operation activities in 2016-17 from 2015-16. The net cash generated from operating activities for 2016-17 is also lower than reported profit, while it was higher for 2017-16. A closer look at the cash flow statement reveals that the reason for the sharp drop in cash generated from operations was due to trade and other receivable and inventory levels going up in 2016-17 while they were down for 2015-16.

Trade receivables when negative means that goods were sold on credit and the company has not received cash in the accounting year for the goods sold though revenues were booked for year. Inventories when negative signifies that the company had unused goods on its books, which is cash flow negative as the company had used up cash for the production/procurement of the goods.

Britannia industries will see cash coming in for 2017-18 on account of the negative trade receivable and inventories, which should improve cash generation for the next accounting year. It is not a time to worry about Britannia industries on its cash generating capabilities, but if the trend of higher receivable and inventories continues then more investigation must be made into the credit period the company is extending to its buyers and the time taken for drawing down on inventories.

Cash flow from investing and financing activities  

The cash flow from investing activities gives the inflow/outflow of cash on account of acquisition of fixed and financial assets. The details of fixed asset and financial assets sold or acquired will be given in the balance sheet.  Returns on investments such as interest and dividends are brought under this category, separating it from normal operations. Inflows or outflows on account of loans and equity are listed under financing activities.

A net positive cash flow from financing implies that the company had accessed the loan market or equity market for funds while a negative cash flow could mean higher dividends and higher interest paid or repayment of loans or share buybacks.