Benjamin Graham once said - ‘The individual investor should act consistently as an investor and not a speculator.’
A smart investor is not someone who can predict the future price or market fluctuations but h/she is someone who makes an investment decision based on analysis of financial statements.
A cash flow statement is a financial statement that enables you to extract useful conclusions regarding the financial health of a company. But, not every one of us is a finance geek or has expertise in interpreting financial statements, right?
So, to facilitate the complete understanding of the cash flow statement here is everything right from the basics to nuances of interpreting it.
Cash Flow is an essential part of financial statements. In the lay man’s language, it is the term that indicates the amount of money coming in and going out of a company or business. It tells that in a given accounting period how much cash a company has generated and spent.
The activities carried out by the company are well reported with the help of cash flow statements. While analysing this financial statement you get a clear picture of a company’s cash positions because the performance of any company is dependent on its cash flows and not the amount of profit it makes. You can understand this through the following example.
For instance, there is a company ABC that makes only slippers, worth 500 each. One fine day it sells 20 slippers. Out of those 20 slippers, the payments for 10 slippers were made immediately and for another pair of 10 slippers, cash payments were to be made after 5 days by the customers (sold on credit). Thus, the company made a revenue or total sale of ₹10,000 on that day indicated in the P&L statement.
Still, it does not give us a clear picture of the cash present in the company’s bank account. Actually, its bank account has a payment of only 10 slippers i.e ₹5000. The payment of the other 10 slippers is part of the credit sale and despite making a total revenue of ₹10,000 on that particular day the company’s account only has ₹5000.
Now, what if the company had to urgently pay ₹6000 for the marketing of its product on that day? It would clearly fall short of cash for it despite making a total sale of ₹10,000.
The entire information mentioned in the example above is indicated under the cash flow statement of a company because it employs a cash method of accounting instead of the accrual basis of accounting.
Not aware of these terms? Not to worry, here is the basic definition
Let us understand how these two financial statements differ from each other through a comparative table -
The term operating activities of a company mean the day to day running tasks carried out by it. It is related to the core business carried out by the firm and includes marketing, manufacturing, upgrading technology, sales, etc. This section of the cash flow statement indicates how well the core business is performing from a perceptive of income and expenses made.
Operating cash flow = Net income + Changes in Working Capital + Non - Cash Expenses.
Here, working capital can be computed by subtracting current liabilities from the current assets which you can easily spot in the balance sheet.
As the name suggests, the activities revolving around the investments made by the company fall into this category. This section can range from purchasing or selling property, assets, acquiring other businesses to long term investments made in equity or debt instruments.
Investing cash flow = Amount received from the sale of assets and money collected on loans - Expenditure made to buy assets
Do not confuse cash flow from financial activities with investing activities. Under this category, the activities involve all the financial transactions made by the company. It ranges from dividend distribution to issuing bonds, etc. This section of the cash flow depicts the structuring of the business and how strong is the company on the financial front.
Financial Cash Flow = CED - ( CD + RP)
CED - cash gained from issuing bonds, stocks, etc
CD - Dividends paid
RP - Repurchase of the equity & debt
So, each of the activities that a company carries out involves either inflow or outflow of cash which is why they can be easily categorised into sections mentioned above. If you wish to understand the categorisation of cash flow statements in an elaborative way then feel free to explore it through our course, fundamental analysis for beginners.
The direct method of computing cash flow statements depends on all the transactional information that had an impact on the company’s operations. One of the striking features of the direct method is that it tells you about the specific sources of cash receipts as well as payments. The knowledge of specific sources helps the investors to analyze the past performance of the company.
The indirect method of preparing the cash flow statement is dependent on the accrual method of accounting. In this method, the adjustments are made for non-operating items, non-cash items. As a matter of fact, through the indirect method of computing cash flow statements, you can spot the difference between cash generated from operating activities and net income.
As an investor before you put in your hard-earned money in any stock, analysis of the concerned company is very important. The financial statements are designed in a way that can provide a proper insight into the financial fitness of the business and where the company stands.
It answers your questions like - should I invest or not? Is this company worth investing in or not?
The only concern is that you must know how to interpret particular information mentioned in the company financials. Reading the cash flow statement is not a hassle-full task and you can easily understand it once you know what the mathematical signs and data depict.
Typically the cash flow is depicted as positive or negative. Read ahead to understand their significance.
If you find that the cash flow is positive cash flow then it simply means that more money is flowing into the company as compared to going out of it, during a given time period. Having a positive cash flow allows the company to re-invest to expand its operations, invest in new avenues of growth or settle debts as well.
This also implies that if in future the company faces any kind of upheaval then it has the means to overcome it without getting affected too much. Remember it is not necessary that a company with positive cash flow without even being profitable.
If you find that the cash flow is negative (the figure is mentioned in brackets) then it simply means more money flowing out of the company as compared to coming into it, in a given period of time. A negative cash flow does not always mean that the company is not profitable or it is not financially stable. Instead, it can be due to a company’s decision to put the cash for expanding its business. So, for proper analysis, you need to see the cash flows of different time periods and notice the changes.
To make your understanding more clear, you can visit the Moneycontrol website, look for the cash flow statement of any company and try to read it for practising.
Once you know how to interpret a cash flow statement and what is the concept of cash flow, you will be able to make smarter investment decisions. Investing in a company is like owning a portion of its business. So, it’s you who has to decide with the help of these financial statements whether you would want to invest in a company or not.