8.1 - Outlook

The cash flow statement is an important financial statement because it shows how much cash the company actually generates. This information is not included in the P&L statements, you might wonder. The answer is yes, but also no.

Take a look at the following scenario.

Imagine a coffee shop that sells coffee and snacks. The shop sells coffee and snacks on a cash basis. Let's say that the shop sells Rs.2,500 worth of coffee and Rs.3,000 worth of snacks on a given day. For that day, the shop's income is Rs.5,500/. This is the revenue reported in P&L. There is no ambiguity.

Consider another company that sells laptops. Let's say that the shop only sells one type of laptop at a fixed price of Rs.25,000/- per unit. Let's say that the shop sells 20 laptops on a given day. The shop's revenue would be Rs.25,000 x 20, which is Rs.500,000/-. What if five of the 20 laptops were purchased on credit? Credit sales are when the customer buys the product now and pays cash later. Here's how the numbers would look in this scenario:

The Cash Sale:
15 * 25000 = Rs.375,000/ -

The Credit Sale:
5 * 25000 = Rs.125,000/ -

Total sales:
Rs.500,000/-

This shop would show its total revenue in its P&L report. It might seem impressive on the surface. It is unclear how much of this Rs.500,000/+ is actually in the bank account. What if the company had a Rs.400,000 loan that needed to be repaid immediately? The company is able to sell Rs.500,000 but only Rs.375,000/. The company is in a cash crunch because it can't pay its debt obligations.

This information is captured in the cash flow statement. The cash flow statement should be included in an entity's financial statements. In this context, the evaluation of the cash flows statement is critical because it discloses, among other things, the true cash position for the company.

Summarising, financial performance of any company is not dependent on profits made during a given period but rather on liquidity or cash flow.

8.2 - Activities for a company

Understanding the activities of a company is crucial before we can understand the cash flow statement. When you look at a company and its various activities, you'll see that you can classify the activities of the company under any one of three categories. This will be explained using an illustration.

Imagine a business. With a solid corporate structure. What business activities would you expect a gym to have? Let me list a few of these business activities.

1. Advertisements to attract new customers
2. Personal trainers can be hired to assist clients with their exercise routine.
3. To replace old equipment, purchase new equipment in the fitness category.
4. Bankers may offer you a short-term loan
5. To raise funds, issue a certificate de deposit
6. To raise capital for expansion, issue new shares to some friends (also known as preferential allotment).
7. Invest in a company that is developing innovative fitness programs
8. Place excess money in fixed deposits if possible
9. For the opening of a new gym, invest in a building in the area.
10. For a better workout experience, upgrade the sound system

The above-listed activities are all connected to the business. These activities can be classified as:

1. Operational activities (OA).Operational activities are activities that relate to core business operations. Operational activities can include marketing, sales, manufacturing, technology upgrades, hiring, and so on.
2. Investing activities (IA).The company may make investments with the intention of reaping benefits in the future. You can invest in equity shares, land, property, equipment and other non-current assets, or even park money in interest-bearing instrument.
3. Financing activities (FA).All financial transactions, including dividend distributions, interest payments, raising new debt, issuing corporate bonds, etc.

Each activity a legitimate business performs can be categorized under one of these three categories.

We will classify the three above activities into three types /baskets, keeping the three above activities in mind.

1. Advertisements to attract new customersOA
2. To help customers get fit, hire a fitness instructorOA
3. Purchase new equipment for your fitness center to replace old equipmentOA.
4. Bankers may offer a short-term loan -FA
5. To raise funds, issue a certificate de deposit (CD).FA
6. To raise capital for expansion, issue new shares to a few friends (also known as preferential allotment).FA
7. Invest in a company that is developing innovative fitness programs -IA
8. Place excess money in a fixed deposit.IA
9. For the opening of a new gym, invest in a building in the area.IA
10. For a better workout experience, upgrade the sound systemOA

Think about how cash moves in and out of your company and the impact it has on the cash balance. Every activity undertaken by the company has an impact upon cash. The company must spend money to buy a new sound system, for example. The cash balance will decrease. Interesting to note is that the sound system will be considered an asset of the company.

This will allow us to see how the cash balance and balance sheet would be affected by the activities we have just discussed.
 

The table is color-coded as follows:

1. Blue colour codes increase in cash
2. Red is the colour coded color for the cash decrease
3. The colour coded assets are in green
4. Purple is used to colour code liabilities

You will notice this if you examine the table and begin to correlate the 'Cash Balance’ and 'Asset/Liability.

1. The cash balance increases when the company's liabilities increase.
   1. This means that if the liabilities decrease, the cash balance also falls.
2. The cash balance drops when the company's assets increase.
   1. This means that if assets fall, the cash balance will increase.

This is the most important concept when constructing a cashflow statement. You will also see that the activity of a company is its operating activity and financing activity. This activity produces or decreases cash.

The company's total cash flow will therefore be:

8.3 - The Cash flow Statement

Now that you have an understanding of the cash flow statement you will be able to see why you should review it from a cash perspective.

Companies usually present their cash flow statements in three sections to show how much cash they have generated from each of the business activities. Following the example in the previous chapters,

here's Amara Raja Batteries Limited's cash flow statement (ARBL).

As most line items are self-explanatory, I won't go through them all. Nevertheless, ARBL has earned Rs.278.7 crores through its operating activities. A positive cash flow from operations is always a sign that a company is financially healthy.

Here's a snapshot of ARBL’s cash flow from investments:

ARBL has spent Rs.344.8 crores on its investments activities, as you can see. This is very intuitive, as cash is a common commodity in investing activities. Remember that healthy investing signals to investors that the company is serious about expanding its business. As we move through the module, we will learn how to determine how much is healthy and how little is unhealthy.

Here's a snapshot of ARBL’s cash balance after financing activities.

Through its financing activities, ARBL spent Rs.53.1Crs. You will notice that the majority of the money was used to pay dividends.ARBL could also take on additional debt in the future which would lead to an increase in cash balanceRemember that the increase in liabilities increases the cash balance. From the balance sheet, we know that ARBL didn't take on any new debt.

Let's look at the cash flow for all activities.

The company spent Rs.119.19 Crs total cash for the financial years 2013-2014. That's fair enough. But what about the cash from previous years? The company's activities in the past year have generated Rs.179.986 crores. Here's an extract of ARBL's cashflow statement:

The section highlighted in green is for the year 2013-14. The opening balance for the current year is Rs.409.46Crs. How could they have done this? This is the closing balance of the previous year. (Refer to the arrows). Add the cash equivalents for the current year (Rs.119.19 Crs) and a small forex exchange difference (Rs.2.58 Crs) to get the total cash position of the company, which is Rs.292.86 Cros. The company's cash position is Rs.292.86 Crs. This means that even though they spend a lot of cash each year, they still have enough cash thanks to the carry forward from the previous year.

The FY 2014-2015 opening balance will be the closing balance. This information will be available when ARBL releases its cash flow numbers for 2014-2015.

Let's now look at some interesting questions and answers:

1. What does Rs.292.86 Cros really mean?
   1. This shows ARBL's cash balances.
2. What is cash?
   1. Cash can be described as cash on hand or demand deposits. This is, obviously, a liquid asset.
3. What is liquid asset?
   1. Liquid assets can be used to convert assets into cash or cash equivalents.
4. Are liquid assets similar in nature to current items that we looked at in our Balance sheet?
   1. You can.
5. Should cash be considered a current asset if it is cash?
   1. It is exactly as it should be. Take a look at the extract from the balance sheet.

We can see that the cash flow statement, as well as the balance sheet, are interrelated. This is in line with the previous discussion.

8.4 - A quick overview of the financial statements

In the previous chapters, we discussed three key financial statements of the company, namely: The company's P&L, Balance Sheet and Cash Flow statements are all discussed. The Cash flow and P&L statements are prepared separately (representing the financial position for the year), but the Balance Sheet is prepared flow-based.

The P&L statement shows how much revenue the company made compared to how much it increased its expenses. The surplus, or retained earnings of the company, is carried forward to the balance sheets. The depreciation number is also included in the P&L. The balance sheet is carried forward the depreciation number mentioned in the P&L Statement.

The Balance Sheet outlines the company's assets as well as its liabilities. The company's liabilities are the funds of shareholders. The assets must always equal the liabilities. Only then can we call the balance sheet balanced. The cash and cash equivalents are a key detail on the balance sheet. This number shows how much money the company holds in its bank account. This number is derived from the cash flow statement.

The cash flow statement gives information to users of financial statements about an entity's ability to generate cash or cash equivalents. It also indicates the company's cash requirements. The cash flow statement provides historical information on cash flows, which includes cash and cash equivalents. This allows you to classify cash flows into operating, financing, and investing. The cash flow final number tells us how much money the company holds in its bank account.

So far, we have only looked at how to interpret financial statements and what you can expect from them. These numbers are not yet analyzed. Calculating some important financial ratios is one way to analyze financial numbers. We will be focusing on financial ratios in the following chapters.

To Summarize

1. The Cash flow statement provides a snapshot of the cash position of the company.
2. Three main activities of a legitimate company are operating activities, investing activities, and financing activities.
3. Every activity generates or drains money.
4. Net cash flow of a company is the result of all operating activities, investment activities and financing activities.
5. Investors should pay attention to the cash flow generated by the operating activities of the company.
6. Cash level rises when liabilities are higher and vice versa
7. Cash level drops when assets rise and vice versa.
8. The balance sheet also shows the net cash flow for the year.
9. A useful addition to financial statements is the Statement of Cash Flow. It provides information about the company's performance.