Chapter-9: Value Investing Course

UNDERSTANDING CASH FLOW STATEMENT

Why analyze the cash flow statement?

The cash flow statement tells you how much cash went into and out of a company during a specific time frame such as a quarter or a year.

You may wonder why there’s a need for a cash flow statement because it sounds very similar to the profit and loss statement, which shows how much revenue came in and how many expenses went out?

After all, if a company makes money, it makes money, right?

The difference lies in a confusing concept called “Accrual Accounting”. Here’s how it works. Companies record sales when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably certain that the buyer will eventually pay the bill, the company can post the sale to its income statement.

Accrual basis of accounting means that sales are booked at the time of delivery irrespective of whether payment from the customer is received or not. Similarly, the purchase is booked at the time of receipt of goods irrespective of whether the payment to the supplier is made or no. This creates a difference between the profits shows in the business and the actual cash with the business.

If a business does all-cash purchase of say Rs. 80,000 and cash sales of Rs. 100,000, there would be a profit of Rs. 20,000 and business would be able to touch that cash as money has already come in. However, think of this business where the purchase is done in cash and sales are done on credit; the P/L statement would show a profit of Rs. 20,000 but the fact is that there is no money. 

Indeed, if the business is not able to collect the dues from its customers, there will be no profits and even the capital of the company, Rs.80,000 is likely to be lost. Therefore, along with the P/L statement and Balance Sheet, the cash flows generated by a business also needs to be assessed. In the absence of cash, while there may be profits, they would be more paper profits and not the real profits.

Let us take an example,

If Colgate sells a few cases of toothpaste to Investor Diary General Store for ₹ 1,00,000/- on February 20 but gives him 60 days to pay because he’s a regular customer with a good track record of paying his bills on time. March 31 rolls around, Investor Diary General Store hasn’t paid yet, and Colgate closes its books for the quarter.

Colgate shows ₹ 1,00,000/- in sales on its income statement because it delivered the toothpaste to Investor Diary General Store, according to the income statement, the sale is complete, regardless of whether Colgate has received payment. 

But because  Investor Diary General Store hasn’t paid cash yet, Colgate will post an entry on its balance sheet to show that Investor Diary General Store owes Colgate ₹ 1,00,000/-. This entry goes into the accounts receivable line on its balance sheet.

As you can see, a company can show roaring sales growth without receiving a cent of cash. In fact, if Colgate produces and sells toothpaste faster than its customers pay for the toothpaste, sales growth would look fantastic even though cash is flowing out the door, which is why we need a statement of cash flows. 

Therefore, along with the P/L statement and Balance Sheet, the cash flows generated by a

business also needs to be assessed. In the absence of cash, while there may be profits, they would be more paper profits and not the real profits.

Where the Money Goes?

To understand the concept further, there are cash inflows and cash outflows in every business

as money comes in and money goes out. For simplicity and understanding purpose, cash flows

are broadly divided into the following three categories:

• Operating cash flows – Cash flows from business operations (P/L items). Cash that comes in is positive and outgoing cash is negative. The net profit of a company can be converted into the operating cash flow number by adding back non-cash expenditures such as depreciation and amortization and changes in account receivables and payables. This section shows how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing.  Investors should look at how much cash a firm generates from its operating activities because it will give you a better picture of how well the business is producing cash that will ultimately benefit shareholders.
• Investing cash flows – Cash flows on account of assets (B/S items). Buying assets is a negative cash flow and selling assets is a positive cash flow. This section shows the amount of cash firms spent on investments. Investments are generally classified as either capital expenditures–money spent on items such as new equipment (Plant & machinery) or anything else that is needed to keep the business running or investments such as the purchase or sale of money market funds.
• Financing cash flows – Cash flows on account of liabilities (B/S items). Borrowing money or issuing/expanding equity is a positive cash flow and redeeming debt and/or equity is negative cash flow.  The financing section includes any activities involved in transactions with the company’s owners (shareholders) or debtors. For example, dividends paid to investors or cash proceeds from new debt would be found in this section.
• Free cash flow: It represents the amount of excess cash a business or company generated, which can be used to enhance shareholders or invest in new opportunities for the business without hurting the existing operations; thus, it’s considered “free.” Although there are many ways of determining free cash flow, the most common method is taking the net cash flows provided by operating activities and subtracting capital expenditures (you will find this in the “cash flows from investing activities” section).

                      Cash from Operations – Capital Expenditures = Free Cash Flow

If a business is continuously running negative operating cash flows for several years, there is an

alarming signal of risk. A business, which is continuously running negative operating cash flows

would need continuous doses of stimulus in terms of cash (borrowing or equity expansion) to

keep going. 

Needless to state that over a period of time, either it will turn into a positive operating cash flow business or die down in the absence of cash stimulus (when investors and/or lenders refuse to pump in further cash). Kingfisher Airlines had negative operating cash flows for years. 

Here are the financials of Kingfisher Airlines taken from moneycontrol.com:

The Airline was borrowing money to pay interest as EBIT was much lower than interest

obligations for several years in the past. At a point in time, it stopped as lenders refused to

pump in further cash and the business did not turn positive operating cash flow even after

infusion of capital. It should be clear that no business can run on the continuous expansion of

borrowed money.

Whenever a business is expanding, it would need cash. Negative investing cash flows (capital expenditures) are financed either from positive operating cash flows or accumulated positive operating cash flows (bank balance) or positive financing cash flows (borrowing and issuance of equity).

Businesses that depend excessively on borrowed funds for expansion have to be seen with

caution. The assets that appear in the balance sheet may realize lower than their book value as

shown in the B/S but the liabilities have to be met in total.

Some of the points to be kept in mind in case of cash flows are:

• Looking at net cash flows could be deceptive
• Each of the cash flow streams Operating, Investing and Financing has to be analyzed independently.
• The purpose of cash flow analysis is to focus on sustainable and recurring cash flows
• Extraordinary or non-recurring items that impact the cash flows should be recognized and adjusted

Bottom Line: Cash flow statement records all the cash that comes into a company and all the cash that goes out. The statement of cash flows ties the income statement and balance sheet together.