The Cash Flow Statement is a detailed statement of changes in cash and cash equivalents during the year. The cash flow statement is divided into three parts:
- Cash Flow from Operating Activities
- Cash Flow from Investing Activities
- Cash Flow from Financing Activities
Cash Flow from Investing Activities
Cash flow from Investing activities highlights the usage of the capital of business in terms of capex done, investment in securities etc. Cash Flow from Investing Activities is an indicator of how businesses employ their cash. The cash could be employed by investing in assets such as new plant and machinery suitable for increasing the operational productivity and business profits, or in non-principal activities by investing in securities or giving loans and advances to third parties etc. In case of finance companies, investment in securities or other investment products could be a core business activity.
It may be noted that investment in securities or other assets, unrelated to the core business of the company, is not always an indicator of an unfocused growth strategy but in some cases, indicates that the funds are being parked or kept aside for future expansion plans or for the purpose of diversifying risk in the business.
1. Source of investments made during the year
Cash flow from Investing activity is generally a negative cash flow component of the cash flow statement. One should observe whether the investments made by the company are coming on the back of sufficient cash flow from operations or retained earnings, or whether the company has borrowed money or raised additional capital to raise the money needed for the investments made. In any case, what is important is that the return on investment is greater than the cost of capital. Going a step further would be to understand how that return is then distributed amongst various stakeholders, a component of cash flow from financing activities.
2. Qualitative nature of the investments made by the company
Imagine a non-finance company employing capital raised from external sources for making non-current investments in debt or equity securities rather than investing that capital in buying core business growth assets such as plant and machinery etc. It raises a couple of questions regarding the attractiveness of the industry in which the company operates, the growth and expansion strategy of the company, the possibility of expansion, company’s ability to expand and the appropriate timing for the same etc.
The inter-period and intra-firm pattern of investments made by companies in an industry read with management discussion and analysis not only draws a picture about the company’s future plans but also indicates the prospects of profitability in the industry and direction of development of business at an industry level considering all players in that industry.
In case of capital- intensive industries wherein huge capex is needed for expansion and maintenance, one must observe that a persistently large negative cash flow from investing activity component over many years could indicates that the company is undertaking expansion in the business and must further analyse the nature of such an expansion. This can be observed in case of other businesses as well wherein there is surge in cash outflow from investment activity.
3. Does business have high capital expenditure requirements?
In the book “Investment Checklist” by Michael Shearn, he gives a detail account of how one can approach this question. He emphasises that “if the capital requirements are high, then the cash flows of the business need to be continually reinvested in the business just to maintain existing assets. High capital expenditures reduce cash flow, which is what the value of a business is based on”. One can observe this by looking at the ratio of capital expenditure to sales. One must also observe the capital requirements in terms of maintenance capital expenditure and growth capital expenditure and determining how long the assets last before they need to be replaced, as highlighted in the book.
4. Capitalisation of Operating Expenses
Capitalisation of operating expenses not only shows higher earnings but also a higher cash flow from operations. These capitalised expenses are shown under cash flow from investing activities. In the book “Financial Shenanigans” by Howard M Schilt, he gave the example of WorldComm, where some senior executives classified billions of dollars (a whopping 58.588 billion dollars) of normal operating costs as capital equipment purchases, thereby inflating profits and cash flow from operations.
He also recommends that one must keep an eye on growing fixed asset accounts or “soft” asset accounts (eg. Other assets), which may show signs of aggressive capitalisation. Another recommendation by him was to keep a check if some companies are classifying inventory purchases under investing activity.
5. Inorganic Expansion of Business
Cash flow from investing activities includes cash payments made to and received from inorganic expansion and development of business in the form of merger and acquisitions, takeovers etc. It is pertinent to observe the efficiency of such inorganic acquisitions and synergies resulting from such deals. Inorganic acquisition of a business which is unrelated to the core business of the acquiring company should be further investigated and evaluated for value to shareholders and other relevant stakeholders. One can also look at the pattern of acquisitions and mergers by the company and how effective they have been in the past.
One classic example of such an inorganic expansion was the acquisition of Sterling Drugs, a pharmaceutical company by Kodak, an imaging and photography company in 1987. The acquisition was a massive failure and eventually resulted in a big loss of value to the shareholders, ending up with sale of Sterling Drugs to the Sanofi Group and partly to SmithKline Beecham in 1993 and 1994.
6. Churn in Business and Sale of Business Units or Assets
While the cash flow from investing activities is an indicator of how new cash or existing cash is employed to generate future profitability, it also includes the cash flow from sale of assets, sale of business units etc. One should note the strategic direction of the company as well as the implication of such divestitures on the value of the shareholders. Under the Companies Act, 2013, there are specific provisions regarding sale of assets and business units to related parties especially directors of the company. One must pay attention on whether the transactions have taken place at a fair price and that all necessary compliances are in place.
7. In-house expenditure and research and development
In terms of the accounting standards, Investing Activities refers to “acquisition and disposal of long-term assets and other assets not included in cash equivalents”. It must be noted that only those expenditures that result in recognition of an asset in the balance sheet are eligible for classification as investing activities. Therefore, expenditures such as advertising and promotional activities or research and development, especially in-house development expenditure, typical in case of pharma or technological companies warrant special attention.
The information herein is used as per the available sources of bseindia.com, company’s annual reports & other public database sources. Alpha Invesco is not responsible for any discrepancy in the above mentioned data. Investors should seek advice of their independent financial advisor prior to taking any investment decision based on this report or for any necessary explanation of its contents
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