Whether you are an investor, entrepreneur, student, or a working professional, interpreting the cash flow statements enables understanding the company’s financial health.
If you are an investor, cash flows can help in making an informed investment decision. If you are an entrepreneur, it helps recognize the business performance and drive key initiatives. If you are a professional, it highlights the spending and revenues against the budget.
Here is everything you need to know on how to read a cash flow statement.
Overview of Cash Flow Statement
A cash flow statement is one that provides information on the cash receipts and cash payments of an organization during an accounting period.
As per the Indian accounting standards, all registered companies are mandated to prepare the financial statements – Balance Sheet, Income Statement and Cash Flow Statement at the end of each financial year.
The balance sheet shows the cash and cash equivalents at the beginning and end of the period, and it does not detail out how the company generated or consumed cash.
An income statement reflects revenues when earned rather than when cash is collected and expenses when incurred rather than when it was paid. Whereas a cash flow statement represents when and how cash is collected, and cash is paid.
Structure of a Cash Flow Statement
A cash flow statement is categorized into three parts as below:
- Cash flow from Operating Activities
- Cash flow from Investing Activities
- Cash flow from Financing Activities
Cash Flow from Operating Activities
Operating activities specifies the cash flows from the day to day activities of an
Cash inflow includes money received on selling inventory and providing services, collections from accounts receivable, royalties, commissions and other revenue.
Cash outflow comprises operational expenditures such as manufacturing inventory, purchase of inventory from supplies, rent payment, salary payment and taxes.
It also includes other activities not classified as investing or financing.
Cash Flow from Investing Activities
Investing activities denote cash inflow and outflow from purchasing and selling long-term assets and other investments in a specific accounting year.
Long term assets and investments include real estate, plant and equipment, intangible assets such as patents, long term and short term investments in equity and debt (loans and bonds).
This section represents any increase or decrease in the long term assets and investments of a business. Cash inflow is the receipts from the sale of these assets and investments, whereas cash outflow is the purchase of the same.
Cash Flow from Financing Activities
The last section of the cash statement represents cash flow stemming from both debt and equity financing, i.e., both owned and borrowed capital by an entity.
Cash inflows from financing activities include money raised from the issuance of stocks and bonds, whereas cash outflows encompass cash payments to repurchase stock, principal and interest payment on debts, dividend payments and interest on debentures.
How to interpret a Cash Flow Statement?
To evaluate an organization’s financial status, one should assess the sources and uses of cash between the three types of activities undertaken.
It is important to consider the stage of a company, whether it is a growing, mature or profitable company, as it gives a sense if the company is going through a transition or is in a state of decline.
The two major points to keep in mind for any stage are:
- Major sources of cash usage
- Is the operating cash flow positive and sufficient to cover capital expenditures?
Analysis of Cash flow from Operating Activities
This section highlights the major determinants of cash flows in the core operations of a company. It is important to focus on comparing the operating cash flow with net income as it is an indicator of earnings quality. The operating cash flows should ideally exceed the net income. If a company has a large net income but poor operating cash flow, it may be a sign of poor earnings quality. Also, examine the consistency of operating cash flows over a period to understand the future earnings of the company.
Analysis of Cash flow from Investing Activities
Cash flow analysis of investing activities gives a perspective on how much is spent on acquiring assets or companies and how much is kept aside for liquid investments like stocks and bonds. Along with that, it also provides clarity on sources of money used to purchase assets and investments and reasoning on the sale of the same.
Substantial spending on capital expenditure may be indicative of growth. Conversely, a company may reduce its capital expenditure without replacing them in order to generate cash showcasing an inability to sustain in the long run.
Analysis of Cash flow from Financing Activities
With the financing section, one should examine whether a company is raising capital or repaying capital, the sources of capital deployed and the overall strength of the capital structure. If a company is heavily borrowing, an analysis on when repayment is required and sources of revenue generation to repay the same is required to be undertaken.
A positive financing cash flow showcases higher capital inflows or may also indicate earnings are not sufficient to sustain operations; thus, it resorts to funding.
A negative financing cash flow implies the financial strength is eroding, and cash is used to repurchase stocks, retire debts and pay dividends.
Importance of Cash Flow Statement
A cash flow statement is crucial to gain deeper insights into a business’s financial footing and helps make smarter business and investment decisions.