In the previous article of this series, we took a look at some of the key financial ratios associated with the profit and loss account and the balance sheet. In today's article, we shall take a look at the cash flow statement.
What is a cash flow statement?
In simple terms, a cash flow statement indicates how (and how much of) cash has left or entered a company during a particular time period. It helps the investor assess the ability of a company to generate cash.
Broadly, there are three ways a company can generate and use its cash. This is in fact how a cash flow statement is arranged. The first and most obvious way a company can earn money (or even lose) is through its basic business operations. The second way is through borrowing and repaying loans or by raising capital (through issuing shares and debentures). The third way is by selling or purchasing assets and investments. A cash flow statement is thus typically broken into three parts:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
These three aspects need to be looked at individually as they are all important to a firm. We shall discuss these topics one by one with the help of a few examples.
Cash flow from operations
As per Accounting Standard 3 (or AS3), "Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities."
As the name suggests, this head shows the amount of money the company makes (or loses) through its operations. However, it must be noted that only the "core" operations must be taken into consideration.
A cash flow statement begins with the profit before tax (PBT) figure. This is because this figure takes into consideration the revenues and expenses related it's a company's operations. This figure also includes depreciation and interest costs. However, PBT should be adjusted for non-cash items (such as depreciation) and financing expenses (such as interest costs), amongst others. The reason depreciation expenses are added back is that there is no actual outgo of cash. It is just an accounting entry that is recorded to recognise the cost of the asset over a period of time.
After making these adjustments, we arrive at a figure which is termed as the 'operating profit before working capital changes'.
Working capital is again, a part of the company's core operations. As such, any changes in the same needs to be accounted for. After arriving at the 'operating profit before working capital changes' figure one must account for:
- The decrease/ (increase) in sundry debtors
- The decrease/ (increase) in inventories
- The increase / (decrease) in sundry creditors
It helps in knowing how a company has unblocked or blocked a certain amount towards meeting its working capital requirements. It does the same by blocking less cash in current assets or by increasing its current liabilities. When the reverse takes place, it means that more money has been blocked in meeting working capital requirements.
Nestle's CY08 cash flow statement
| Source: Company's CY08 annual report
Let us take up an example to understand this well. Above, we have displayed Nestle's CY08 cash flow statement. After making the necessary adjustments, Nestle's 'operating profits before working capital changes' stood at Rs 8.7 bn at the end of 2008. However, as we move further down, we can see that the company's 'cash generated from operations' is higher. The difference between the two figures is Rs 550 m (Rs 9258.8 - Rs 8709.5 m). This means that the company was able to improve its working capital position over the year. In fact, it was able to unblock funds to the tune of Rs 550 m during CY08 as compared to the previous year. After we arrive at the 'cash generated from operations figure' we need to deduct the direct taxes.
In the next article of this series, we shall discuss one of the other two heads - cash flow from investing activities.