Get a reality check with a cash flow statement!
If a company posts net profit growth of 100 per cent, would you be happy or doubtful? Well, if it is not backed by the cash flows, then it’s a good reason to be doubtful. Being an investor, it is of paramount importance to go through the cash flow statement of a company before making any investment decision. The cash flow statement is perhaps the most realistic statement of all. It consists of three parts: Cash flow operating activities, cash flow from investing activities, and cash flow from financing activities.
Cash flow from operating activities (CFO)
CFO is simply the proceeds from sales. Basically, when a company makes sales, it either receives cash or is sold on credit. The credit sales are still recorded in the profit and loss (P&L) statement as income and as accounts receivables on the asset side. Some parts of credit sales might turn out as bad debts in the future. Cash sales bring guarantees while credit sales bring uncertainty. If a company has reasonably higher credit sales than cash, it might be a red signal for an investor. A positive and strong CFO reflects the liquidity and efficiency of the company.
Cash flow from investing activities (CFI)
If a company makes capital expenditure (Capex), invests in financial assets, receives interest or dividends, then it is recorded in the CFI section. When a company is in an expansion phase and is making heavy Capex, then CFI would be negative. When cash from investment comes in, it adds to CFI. Having negative CFI is common since many companies are continuously investing, be it the purchase of PPE or investment in other companies.
Cash flow from financing activities (CFF)
A high and positive CFF might not be a favourable scenario for the company. Since all the financial activities such as proceeds from borrowings, loan repayment, interest payment, repayment of lease liabilities are included in CFI. And positive CFF indicates that the company is borrowing money while a negative CFF indicates repayment of the company’s liabilities.
All these three sections’ balance is added and what we finally get is the cash balance that goes in the balance sheet asset side. To conclude, a cash flow statement tells you what the company is earning. It does not consider the money that is yet to be received. It reflects the realistic financial position of the company at a particular point in time. So be watchful next time when you see high profits, check if it is backed with a cash in cash flow statement.