The cash flow statement explains the flow of cash and cash equivalent during the year. The importance of the cash flow statement cannot be emphasized enough. The cash flow statement not only depicts the cash generating muscle of the business but also paints a picture about the sources of cash raised to run the business and the investments that generate cash during the year.
It is a detailed statement containing the inflows and outflows of cash in a business under different categories as mentioned below. The cash flow statement comprises of three segments namely,
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities.
Cash Flow from Operating Activities:
The cash flow from operations depicts the cash generated by the principal revenue generating activities in the business. The key difference between Net Income from the Statement of Profit and Loss and Cash flow from Operating Activities is that the former depicts the money generated by business on an accrual basis while the latter depicts the money generated on cash basis.
Cash flow from operating activities is reported either using the direct method or the indirect method. Under the direct method, gross cash receipts and gross payments made are disclosed. Under the indirect method, the starting point is Net profit before tax as per the Profit and Loss Account. The Net Profit is then adjusted for all non-cash items, other items which would fall under investing and financing activities. Working capital changes during the year to accounts such as accounts receivable, accounts payable, expenses payable etc. are considered to obtain cash flow from operations before tax. Lastly, net cash flow from operating activities is calculated after deducting actual tax paid during the year.
1] Working Capital Changes form a significant part of Cash Flow from Operating Activities:
Working Capital Changes have a significant effect on cash flow from operating activities and one should pay close attention to which items lead to substantial increase in cash flow from operations- whether it comes from receipts from debtors or due to deferred payment of payables, accrued expenses etc. A positive figure of the net working capital changes means that less money is tied up in day-to-day business operations. This is a positive sign for the business. One needs to observe caution if the net working capital changes came on the back of rise in current liabilities on account of lack of liquidity on the firm’s part to pay them.
In “The Investment Checklist”, Michael Shearn highlights that one should note if the working capital changes are consistent and sustainable over period of time. If the cash flows are temporary, you would have to adjust the cash flows to normalise them in your valuation forecast workings.
2] Intra and Inter-Period Trend Analysis of Cash Conversion Ratio:
On a comparison of the Profit and Loss Account and the Cash Flow Statement, whether it is done on a category basis or through ratios such as CFO/EBITDA, one can observe how much cash is generated out of the profit for the year. A consistently low CFO/ Net Profit ratio coupled with longer receivable cycles, shorter payable cycles or sticky inventory rotation, could point to existence of grave business challenges. Peer-to-peer comparison would highlight the cash conversion ability of the company against its competitors.
3] Focus on amounts passing through Reserves and Surplus v. Cash Flow from Operating Activities:
Observe the disconnection between what flows through cash flow from operating activities and what flows through reserves. Line items such as bad debts, inventory obsolescence, warranties etc. may get covered up in working capital changes. It is pertinent to note the impact of such accounts on working capital changes.
4] Capitalisation of Operating Expenses:
Another focus point is capitalisation of operating expenses. When operating expenses are capitalised, cash flow in connection with these expenses would fall under cash flow from investing activities and it would make cash flow from operations seem higher. Such capitalisation is also common in research and development expenses incurred year on year. It would help to observe the bifurcation of research and development expenses in terms of recurring expenditure and capitalised R&D cost.
5] Usage of Cash Flow from Operating Activities:
Note if the operating cash flow covers cash required for investing activities. The focus point here is to check what finances the investments made by the company – whether it is operating cash flows or external sources of financing. Further, one can check the percentage of operating cash flows that cover working capital and percentage of cash flows that cover investments in assets and others.
6] In House Expenses Charged and Restructuring Expenses:
In the book “The Five Rules for Successful Stock Investing”, Pat Dorsey talks about paying special attention to non-cash charges for restructuring or acquisition related charges, including in-house research and development etc. These form a part of the income statement but are added back to calculate cash flow from operations.
7] Recurring v One Off Cash Flow Transactions:
Another check point is intra-period comparison of cash flow from operations. This should be seen in conjunction with how revenue is generated in the business- whether it’s recurring or whether these are one-off transactions. This comparison will also help in understanding revenue recognition policies adopted by the company over a period of time.
8] Cash Tax Rate v. Tax Charged in Profit and Loss Account:
Cash Tax Paid and Tax Charge as per Profit and Loss Account can be significantly different in some cases. The reasons for such a difference could be reversal of DTAs recognised in the previous periods, changes in tax rates or other accounting changes made during the year. In the book “Gurus of Chaos”, Saurabh Mukherjea highlights the importance of checking cash tax rates of the company and mentions that “genuine profits have to sooner or later, result in a tax rate close to 34 percent unless the ﬁrm in question has been given a tax exemption by the Government of India”.
At the end of the day, focus on substance over form. And like Sherlock Holmes says, pay attention to what isn’t there!
While observing the cash flow from operations, comparative checks with how the amounts flow through the Profit and Loss Account and Balance Sheet vis-à-vis the Cash Flow Statement throws light not only on the cash generating ability of the company but also highlights what does not result in cash flows to business. It’s important to understand the substance of each component of the cash flow statement to understand any vulnerabilities and red flags.
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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