For a very long time, the two principal financial statements for Indian companies were the Income Statement and the Balance sheet. While the income statement took stock of the income and expense flows during the year, the balance sheet captured the assets and the liabilities of the company at the end of the year. They why do we need cash flow statements at all?
Understanding the challenge of Accrual Accounting
The income statement provides a record of all revenues and expenses based on transactions but these transactions are recorded on an accrual basis. The moment an expense is due or an income is due it is immediately recognized in the income statement. But not everything in the income statement results in cash flows. For example, the company may have sold goods but the collections may still be pending. That means your income statement shows the revenues but the cash has not come into the business. That is the gap that the cash flow statement fills up. It basically takes into account all the cash flows under various heads and the net figure will be the change in cash in the balance sheet over the last 2 years. Let us first look at a sample of a cash flow statement…
Sample Cash flow statement (For the fiscal year 2017-18)
|Cash Flows||Specific items of Cash Flow||Amount|
|Cash Flow from Operations||Cash received from customers||Rs.12,00,000|
|Cash paid for inventory||-2,00,000|
|Wages and Salaries||-3,00,000|
|Net Cash From Operations (A)||+2,00,000|
|Cash from Investing activities||Sale of property and assets||Rs.5,00,000|
|Purchase of plant & machinery||-6,00,000|
|Net cash flow from Investing (B)||-1,00,000|
|Cash from Financing activities||Debentures issued||Rs.1,00,000|
|Net Cash flow from Financing (C)||-50,000|
|Net Increase in Cash Balance (A+B+C)||+50,000|
This net increase in cash balance will be the difference between the cash balance last year and the cash balance in the current year as shown in the balance sheet. The real value of a cash flow statement comes from the classification of the cash flows into operating, investing and financing activities. This is what gives us analytical insights into the performance of the company. Here is how.
Cash flow statement tells you where the money is going
This is perhaps the most important role of a cash flow statement as it tells you where the money is going. For example, the P&L does not talk about principal repayments on loans but that has a major bearing on your cash flows and therefore the solvency of the company. There are various risks that this statement highlights. Your operating profits could be healthy but too much money may be going towards payment of interest on loans. Alternatively, your sales may be growing rapidly but then collections may not be keeping pace leading to higher debtor levels. From a decision making point of view cash flow captures everything that the income statement does not capture. For example, if you locked more money into inventories, the cash flow captures that. If your debtors are increasing or if your debtor period is increasing then the cash flow statement catches that. That is the big advantage of the cash flow statement.
Are you generating enough cash and how to generate more cash
Cash flow statements are very useful as a decision support system. Are the cash flows from operations enough to cover your outflows from investing? It also helps you pin point areas you need to work on. For example, the success of a manufacturing business lies in maintaining optimal inventory of raw materials and finished goods. Too much of working capital may be getting locked up in inventories and that will be immediately highlighted by the cash flow statement. Same applies to debtors. When the company seeks to increase sales by giving more liberal credit terms, it is immediately evident in the cash flow statement. The cash flow statement, therefore, draws your attention to where you need to focus.
Companies can use cash flow statements to evaluate their senior managers
This is an interesting sidelight of the entire cash flow statement. For example, if two divisions in the same company are generating the same level of operating margins, how do you compare their performance? The answer lies in cash flows. Break up the OPMs into cash flow items and you get a clear idea of the strategy employed by the manager. Is the manager just being more liberal on credit? Is the manager merely postponing expenditure decisions? Are the inventory additions justified? These questions will help you better understand their relative performance.
Should the company finance externally or internally?
This is an important decision most companies are required to make. You need to invest in machinery but are not sure whether you should use your internal resources generated or fund it externally through debt or opt for a mix of the two methods. Here again, the cash flow statement can come in handy. There are a few basic questions that the cash flow will answer. Is the coast of outside debt reasonable? If the company funds the investment internally, then is the ROE attractive enough to justify? Or is the company better off distributing dividends to shareholders. These are the kind of critical decisions that can be taken with the help of the cash flow statement.
The point is that while Income Statement and Balance Sheet are key to external presentation, it is the cash flow statement that is very useful to a company from an internal decision making perspective.