Home/Blogs/What must investors look for in the cash flow statements?

What must investors look for in the cash flow statements?

stock market
11 Feb 20206 mins readBy MOFSL

There is a popular saying in markets that what matters are not the profits generated but the cash flows generated. We all know that a very important component of the balance sheet is the current assets and a very important component of current assets is cash and cash equivalents. This represents the total cash available with the business which the management can allocate to various activities including new investments, expansions, diversifications, fixed asset purchase, paying dividends, buying back stock etc. All these activities have an impact on the cash of the company and breaking them up gives us unique insights into the health of the business.

 

Some of the biggest bankruptcies were due to the fact that the income statement glossed over but the cash flow statements still gave a hint. Take the case of Satyam!  The massive implosion should have been obvious to any auditor who bothers to look at the cash flow statement. That is because the cash flow statement actually explains the reason for the difference between the cash balances between two years. Statutorily, Indian companies are required to provide a detailed cash flow statement, apart from the income statement and the balance sheet.

 

What does the cash flow statement comprise off?

Broadly, there are 3 components to a cash flow statement. The first component is the "Cash flow from operations". Here the starting point is the net profits and it removes any non-operating items and also removes non-cash items like depreciation and amortization. The result is the cash flow generated from operating activities. The second component is the "Cash flow from investing". Here the purchase of capital assets is considered as outflows and the sale of capital assets are considered as inflows. The third component is the "Cash flow from Financing". Here the flow of equity and long term debt are considered. This includes fresh equity issues, buyback of shares, dividends paid, long term borrowings, loans repaid etc. The combination of these 3 activities gives you the overall cash flows and it precisely explains the difference in the cash balance between the two years.

 

Understanding Cash Flow from Operations..

The Cash Flow from Operations is critical as it tells you the actual cash flows that are generated from your core operations. For example what is the cash flow generated from the steel business for a steel company? There are two important aspects of this component. Firstly, since it excludes the impact of extraordinary and non-core items, it gives a clear view of the performance of the core business. Secondly, as it ignores non-cash charges like depreciation, it measures actual cash generated rather than the income statement number, which is more of accounting standards compliance. A good business wants to see its cash flows from operations grow steadily so that its future expansion and inorganic growth plans can be financed through its core operating cash flows.

 

Understanding Cash Flow from investing activities..

When we talk in terms of manufacturing companies, investment refers to investments in the core business assets only. Therefore investment in plant and machinery, expansion of capacity, diversification, and inorganic acquisitions will all be part of the company’s investment activities. All these will be investing outflows. On the other hand sale of fixed assets, sale of business lines or sale of subsidiaries will all be categorized as inflows from the investment activity. Normally, a healthy company will have negative investment flows because any growing company will have to focus on growing by expanding its assets rather than by selling its assets. For typical software companies, there is very limited by way of investment outflows. Hence most of their positive operating cash flows go directly into enhancing their cash balances. Remember, most of these companies are also zero debt companies. That explains why Indian IT companies sit on such huge cash balances.

 

Understanding Cash Flows from financing activities..
This segment refers to how the cash flows pertaining to your long term capital providers are structured. For example, issue of fresh shares, rights issue to existing shareholders, raising of debt through long term loans will all constitute inflows from financing activities. On the other hand buyback of shares, payment of dividends to shareholders and repayment of long term loans will all be classified as outflows from financing activities.
Now let us put all these 3 items together. What are we trying to understand about the company? The combination of these 3 components is all about gauging your actual cash on hand. What it tries to understand is how the 3 components are interacting. How are the capital investments of the company being financed? The most preferred situation is when the capital expenditure is financed either entirely or substantially through operating cash flows. That will reduce the pressure on raising money through financing and leave greater room for rewarding shareholders with higher dividends. Cash flows, effectively, force the company to reveal a true and credible picture of the company’s financial health!
 

Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
Open Demat Account
I wish to talk in South Indian language
By proceeding you’re agree to our T&C
Click here to see your activities