9.5 Cash Flow Statement

Hanumant Dhokle

FINANCIAL STATEMENT ANALYSIS

While most investors who pursue a company's financials will look at its income statement and balance sheet, many overlook the third major financial statement: the statement of cash flows. A company's cash flow statement, which is also available in the annual report, does not speak of profitability but of something more tangible. It answers the question: Is the company a net user or collector of cash in its day-today activities? To gauge this, the cash flow statement will add up all of the cash that comes in a company's front door through its profits, its accounts receivable, and its inventories. Then, cash that routinely leaves the company in the form of obligations (like accounts payable), debt financing, and depreciation of plant, property, and equipment, are subtracted. What's left – if it's a positive figure – is considered a company's cash and cash equivalents for the end of a particular period. The bigger the number, the better it is. But just as important is the growth of this figure over time. So a company with dramatically rising cash flows but modest cash reserves could be seen as just as attractive – if not more so – than another firm with huge cash reserves which are only modestly growing. Why is cash flow important to begin with? While a balance sheet analysis will speak of the financial underpinnings of a firm, a company with a strong balance sheet (in other words, a firm that has far more assets than liabilities) could nevertheless land in financial trouble if, for even a brief moment in time, it experiences negative cash flow. This will be particularly problematic if more money is fl owing out of the business than coming in when major short-term obligations and bills must be met.

It's the sort of way consumers operate in the real world. You can have mountains of credit card debt, but as long as you have enough cash fl owing into your coffers each month to meet your basic obligations you may be just fine – at least for the moment. On the other hand, a person who owns substantial assets that are non-liquid – say, hundreds of thousands of dollars' worth of property in Noida that can't be flipped for months – may be seemingly healthy based in terms of a balance sheet analysis, but could run into huge financial troubles if he or she is bleeding cash every month and can't pay taxes on that property.

At the end of the day, cash is king for a company, because cash allows, at short-term flexibility, to do certain things. For example, even if a company is profitable, it might not be able to pay out substantial dividends if its cash flow is weak. The firm may need to retain that cash to pay creditors, rather than reward shareholders. This is why investors will often focus on a company's free cash flow. This is defined as the money left over once you take a firm's operational cash flow (the cash flow generated from its basic operations) and subtract dividend payments as also capital expenditures, which are investments in upgrading or adding to the plant, property, and equipment. Free cash flow represents the true financial flexibility a company has to do new things. It could use that money to invest in new projects, acquire competitors, acquire new types of businesses, buy back some of its shares in the open market, or pay out even bigger dividends.

The cash flow statement shows how much cash comes in and goes out of the company over the quarter or the year. At first glance, that sounds a lot like the income statement in that it records financial performance over a specified period. But there is a big difference between the two. Just because the income statement shows net income of Rs 10 does not means that cash on the balance sheet will increase by Rs 10. Whereas when the bottom of the cash flow statement reads Rs 10 net cash inflow, that's exactly what it means. The company has Rs 10 more in cash than at the end of the last financial period. You may want to think of net cash from operations as the company's ‘true' cash profit.

Because it shows how much actual cash a company has generated, the statement of cash flows is critical to understanding a company's fundamentals. It shows how the company is able to pay for its operations and future growth. Indeed, one of the most important features you should look for in a potential investment is the company's ability to produce cash. Just because a company shows a profit on the income statement doesn't mean it cannot get into trouble later because of insufficient cash flows. A close examination of the cash flow statement can give investors a better sense of how the company will fare.

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