Cash flow statement and its usefulness

MANU

CONVERSATION BETWEEN

MANU AND VINU ABOUT

CASH FLOW STATMENT AND ITS USEFULNESS

VINU

Manu

Hi Vinu! How are you?

Vinu

Fine Manu!

Manu

How is your Financial Analysis Job going on?

Vinu

Manu, now I am in the process of analysing Financial Statements of a particular customer. His Financials vis-a-viz reality is taking me for a ride!

Manu

Why? What’s the problem?

Vinu

He is showing good progress in his business with Growth in Sales and Profits. But that’s on papers.

In reality,

- He doesn’t have sufficient funds to meet his expenses.

- He couldn’t service Bank Loans on time.

- Many of his cheques issued to suppliers get bounced.

- He pays salary to his employees with great delay.

How all these can happen if he is making so much profit? I have a doubt whether he is giving bogus financial report?

Manu

Vinu! I don’t know what the exact background of your customer is. But one thing I can tell you! It is not necessary that he should have cash to meet his expenses / requirements, since because he is making profit.

Vinu

That sounds strange!!!!

Manu

But that’s the reality! Profit is not cash!

Vinu

Come on yaar! What are you talking?

Manu

True Vinu! Profits are not cash and register it in your mind strongly!

Vinu

Ok! I understand that if you say something, it would be with logic. But tell me that logic!

Manu

Ok. Answer this simple question:

Let’s say you have the following Profit and Loss Statement:

What should be profit?

Vinu

Sales is 100.00 Crs

expenses are 80.00 Crs

So profits should be 20.00 Crs.

Manu

Fine! With this limited information, tell me what could be the cash balance?

Vinu

Sales             100.00 Crs

Expenses      80.00 Crs

So Cash Balance should also be 20.00 Crs

Manu

This is your mistake!

Don’t you remember Financials are prepared following accrual concept wherein

- Expenses will be accounted when accrued, whether it is paid or not;

- Income will be recognised whether it is received or not.

Vinu

Yes. Agreed. But here we don’t have any such item or you have not told me anything about that!

Manu

True! But you also didn’t notice the effect of depreciation. Whether depreciation has cash outflow?

Vinu

No! It is only book entry to account for fixed assets by charging against profits over the period of its life.

Manu

So what could be the profit before depreciation?

Vinu

It may be

Manu

Ya! That’s correct and that profit can be called as Cash Profit!

Vinu

Oh! Is this the cash balance?

Manu

Don’t jump for conclusion. Again I am repeating! Profit is not cash!

Vinu

Ok! Ok!

Manu

Do you think all the sales can be made for cash?

Vinu

No! In order to be competitive and attract new customers, credit should be given!

Manu

Correct! Let’s say, 75% of sales are on credit!

Vinu

Then in that case, 100 Crs x 75% = 75 Crs should be credit sales.

Manu

So, what is your Cash Sales?

Vinu

Manu

When you give credit, you can also get credit! Is it not?

Vinu

Sure!

Manu

But it happens in market that you give more credit to attract customers but you receive only less credit from your suppliers! Because, suppliers would be generally big players and they go by fixed norms! Your other expenses would be basically power, labour, and other operating expenses where you cannot have much credit.

Vinu

True!

Manu

So let us assume, 50% of your expenses are on credit.

Vinu

My total expenses are Rs.80 Crs. So 50% of it is................

Manu

Stop! Don’t consider all expenses. It includes depreciation also which is a non cash item.

Vinu

Correct! Total expenses are Rs.75 Cr (excluding depreciation of 5 Crs).

50% of 75 Crs is Rs.37.50 Crs

Manu

So, what is your Cash Payments?

Vinu

Manu

Now you have both your Cash Expenses and Cash Sales. Can you prepare a Comparison table?

Vinu

Ya! I can do that.

Manu

Look at the table!

You made sales of Rs.100 Crs where as you received only Rs.25 Crs.

You have incurred expenses of 75 Crs (excluding depreciation) where as you paid only 37.50 Crs.

So what is your cash balance?

Vinu

Cash balance?

I don’t have cash balance!!!!!!

Manu

But you had profit of Rs.20 Crs!

Vinu

Ha ha! I am caught! Now I understand profit has no relevance to cash balance or cash generation!!!

Manu

No! Modify that statement!

Profit has relevance but it alone does not decide cash balance or say cash generation!

Vinu

Ok! In this case, how come cash balance can be negative?

It is Negative 12.50 Cr.

Manu

Don’t say Negative 12.50 Cr.

Cash can never be negative figure.

What happened to you is you realised Rs.25 Crs from cash sales and PAID cash expenses of Rs.37.50 Crs.

You cannot pay 37.50 Crs without cash with you. Yes or No?

Vinu

Yes! I cannot pay 37.50 Crs without cash with me. But how I got 37.50?

Manu

You generated 25 Crs.

You had shortage of Rs.12.50 Cr

You should have managed that shortage with some other sources!

Vinu

Some other sources? How come?

Manu

Common yaar! Do you think, cash is generated or brought into the business only through sales? There are various other ways for mobilising cash for the business.

Vinu

Correct!

Cash can be brought into the business through

a. Raising Capital;

b. Raising Long Term Loans;

c. Raising Short Term Loans;

d. Selling Assets;

e. Selling Investments.

Manu

Good!

What was your Shortage from Operations?

Vinu

It was Rs.12.50 Cr

Manu

Now let us assume, you have funded this shortage by bringing in capital of Rs.25 Crs

Vinu

Rs.25 Crs??

Manu

Yes! Now arrive at your cash position

Vinu

It is

I have surplus of Rs.12.50.

Manu

Correct! Now also assume you purchase Plant and Machinery for Rs.20 Crs and work out your cash position.

Vinu

It should be

Again I am landing in shortage.

Manu

Don’t worry! Raise loan for Rs.7.50 Crs and work out your cash position.

Vinu

Manu

Did you noticed, your balance is Nil now.

Vinu

Yes! Now i understand.

I had shortage of 12.50 Cr from Operations.

But that was supported out of fresh capital of 25 Crs.

With the balance money available (25-12.50=12.50), I went for purchasing Plant and Machinery 20 Crs.

Again I faced shortage of Rs.7.50 Crs.

So, I had to finance the shortage through Bank Loan of Rs.7.50 Crs

Manu

Correct!

The cash you generated from running or operating your business is called as Cash Generated from Operating Activity. In your case, it is deficit of Rs.12.50 Cr.

Vinu

True!

Manu

To Support cash deficit in operations and also to support purchase of plant and machinery, you raised finance from two sources

Capital – 25 Crs

Loan – 7.50 Crs

They are Cash Generated from Financing Activity

Vinu

Correct!

Manu

You have invested Rs.20 Crs in purchase of P&M.

So you have not generated any cash from Investment Activity but rather consumed cash.

Vinu

Correct!

Manu

Can you capture all these cash flows as per activities

Vinu

Manu

Good! This is you abridged Cash Flow Statement. It tells that, you have mobilised 32.50 Crs and have used 20 Crs for Investing Activity and 12.50 Crs for Operating Activity.

Now you will appreciate why the companies can suffer despite making profits.

Vinu

Yes! In this case, though I have made profit but have not generated cash. I was functioning only with the support of capital funds provided by financing activity. Apart from that I also used all the balance capital funds for acquiring Plant and Machinery along with Bank Loan.

Manu

Correct! Now you are getting the pulse of it.

This is the purpose of preparing Cash Flow Statement. It would give much information which P&L and Balance Sheet will not give on the face of reading. That’s why Cash Flow Statement and its Analysis are given high importance by Investors and all stake holders. 

Vinu

So, how ideal Cash Flow should be?

Manu

In the initial period, cash can be provided by Financing Activity to Operating Activity and Investment Activity. But gradually, the cash flow from Operating Activity should become positive and it should provide for repaying financing cash flows and also support Investment activities.

Vinu

Ya! Cash flow from operating activity should be positive and it indicates the very purpose of running any business. If this cash flow is positive, we will have source for funding investment and financing activities.

Manu

Correct!

Vinu

But Manu, the cash flow statements which I have seen are lengthy in nature. It would not be like the one which we have discussed.

Manu

We have discussed the cash flow which can be prepared under direct method. But what we see in Industry would be cash flow prepared in Indirect Method.

Vinu

What was that?

Manu

Those cash flow statements are prepared from the information available in Profit and Loss Statement and Balance Sheet in Indirect Way.

Profit and Loss Statement will be perused to find out the cash profits.

Profits reported in P&L Statement are computed using accrual and matching concept. So, that profit is after providing for various non cash items.

Vinu

Non Cash items like?

Manu

Non Cash Items like

a. Credit Sales

b. Credit Purchases

c. Outstanding Expenses

d. Accrued Incomes

Vinu

Correct!

Manu

These items will also have presence in Balance Sheet in the form of current assets and current liabilities in various names. So movement of those items will also be provided in Cash Flow Statement to know the exact cash generated from operating activity. 

Vinu

Ya! In our example

Sales were Rs.100 Crs. whereas Debtors created out of Sales is 75 Crs.

Our profit is 20 Crs, No No...Cash profit is 25 Crs but it is calculated based on Total Sales (cash & credit) and so it will not reflect cash generation.

So we have to deduct non- cash sales from Cash Profits which is in the form of Debtors - 75 Crs. Is that right?

Manu

You are right!

By deducting increase in current asset (in our case, debtors) from cash profits, we are communicating to the readers, that though our company has earned cash profit of Rs.25 Crs from Sales of Rs.100 Crs, please bear in mind we have not realised 75 Crs worth of Debtors. So we are deducting it!!!

Vinu

Very true!

Manu

In the same way, if we carry creditors, or say, creditor’s increases, then to that extent there is no cash outflow. So, that will be added with cash profits to communicate to the readers, cash position is more than the cash profits!

Vinu

Correct! In our case, cash profit is Rs.25 Crs. We also have unpaid expenses (creditors) of Rs.37.50 Crs. So this should be added to cash profits!

Manu

You are right! Can you tabulate cash generated from your operating activity based on our discussion?

Vinu

Ya!

Is it correct?

Manu

Very Much!

Also remember you will see some more additions and subtractions in real cash flow statements.

Vinu

Like?

Manu

Additions for

- Interest Expenses;

- Loss on Sale of Asset;

Deductions for

- Interest Income;

- Dividend Income;

- Profit on Sale of Asset;

Vinu

When these items obviously decide the profits, whey these should be added back or deducted?

Manu

I agree that they decided profits!

But they are not out of operational activities of the business.

In cash flow from operating activity, focus is on finding cash generated from operating activity.

So any activity, which is not part of operating activity, but already included in profits will be removed by either adding back or deducting!

Vinu

Ok!

Let me understand that!

Interest is paid on Financing Source – So it is a Financing Activity. But it is already considered as expense for arriving at profit. So, we remove this interest by adding back! Is that right?

Manu

Correct!

Loss / Profit on Sale of Asset are result of Investing Activity! So we remove them from profits either by adding / deducting under Cash Flow from Operating Activities.

Vinu

True!

Dividend / Interest income are also part of Investing Activity! So we should remove them from profits by deducting under Cash Flow from Operating Activities.

Manu

So remember, when you do this adjustment (adding / deducting) under Operating Activity, you are doing it, because you want to show them under respective activity!

Vinu

Ya!

Interest added back in Operating Activity should be shown as deduction in Financing Activity.

Dividend / Interest Income deducted in Operating Activity should be shown as addition in Investing Activity.

Manu

Very Good! So now you know how to prepare Cash Flow Statement too!

Vinu

How about the other activities Manu?

Manu

Other activities don’t involve much complication! You have to ensure only cash flows are captured and non-cash items are ignored.

Sometimes assets can be purchased by issue of shares instead of cash. Then in those cases, purchase of asset will not figure under Investment activity.

Vinu

Understood!

What would be the effect, if a company issues bonus shares?

Manu

In that case also, there is no cash flow.

Because of Bonus Issue, there may be increase in Share Capital but there will not be any cash inflow. So that will not find place in Cash Flow Statement!

Vinu

Understood! So the focus is on cash inflows and outflows and all non-cash items are knocked off!

Manu

Exactly!

Cash flow statement is a great tool for Investors, Bankers and other stake holders! It would communicate, whether you generate funds from business or you are dependent on Investment and Financing Activities for running your operations!

Vinu

True!

If business is run with support of cash inflows from Investment activities it indicates company is selling its assets to fund its operations! So it would raise serious question on Going Concern right?

Manu

Yes!

Similarly, if cash flows from Financing Activities continuously increases to support operating activity, it is also not a healthy sign because company is dependent on other funds to support its operations and it would become dangerous if the company is too dependent on borrowed funds.

Vinu

Ya! I think single reading of Cash Flow Statement would give complete cash flow movement of business.

Manu

Absolutely and it is very important for any stake holder to read cash flow statement before investing or lending, because

CASH IS KING.