Chapter 18 – Cash flow statement (1)

Coming to the final financial statement that we look at while analysing a company – Cash flow statement. This statement shows the actual cash inflow and outflow for the period under study. We can visualize it as the sources and uses of cash for a business. It is categorised under 3 main headings:

  • Cash from Operating activities: This section shows the actual cash generated by the business from its operating activities, i.e. main business operations. For the hot dog owner, that would be total cash generated from selling hot dogs minus his cash outflow for ingredients, advertising, rent, salaries of staff etc.
  • Cash from Investing activities: This section primarily shows the cash used/received from investing in/liquidating assets of the business and upgradation of machinery or infrastructure. For the hot dog owner, this could mean buying more stalls, more kitchenware, more tables, buying a new shop and so on.
  • Cash from Financing activities: This section shows the total change in cash from payment of dividends, raising more capital (by issuing more stock or debt), buying back stock from market (resulting in Treasury stock), paying off debt etc. Effectively, this section involves the change in cash position due to financing from banks and capital markets.

We are concerned mainly about the cash from operating activities and cash from investing activities. The reason is – for a stable or a healthy business, normal operations should be able to generate enough cash for existing business as well to fund the expansion activities. If not, then the business would dip into Financing activities involving banks and capital markets which can result in dilution in stake of existing shareholders or taking on more debt. Also, to have access to capital markets for more capital (debt or equity), the business would need to show a good underlying business opportunity, else who would be really interested in investing? It does not mean that a company with troubled underlying business is not able to raise capital – it just comes at a higher price!

Why is cash flow statement different from the income statement?

Good question. Two major reasons:

  • Revenues: In accounting, the company can record revenues when the sale contract is signed. But the cash from this contract may not come until next year. So even though we see increase in revenues, we will not see the corresponding cash to hit the bank account. Remember the cash cycle we discussed in Chapter 10 where a part of revenues is captured as Receivables on the Balance sheet. Those receivables become cash when the customers pay up for the sale of products.
  • Investments: As a business invests in new assets, only a portion of the cash flow is recognised in Income statement using Depreciation (as discussed in Chapter 4). The cash flow statement helps us to understand the actual cash outflow for new investments in plants or property recognized at 100% of cash outflow.

A Cash Flow Statement can be constructed using a Balance Sheet and Income Statement together. We are not going to have that discussion here, as it would be a part of an accounting discussion rather than an investing discussion. But we will talk about some sanity checks or potential red flags when looking at a cash flow statement in the next Chapter.

Chapter 19 – Cash flow statement (2)

Chapter 17 – Key ratios

Chapter 2 – Income Statement basics

There are two main things that I will focus on in this section:

  • Main items in an Income Statement
  • Caution against drawing conclusions purely from Income Statement

I’ll touch upon the cautionary stance first. We should always see the Earnings along with the sources available to the firm, and that can be seen in the Balance sheet. A firm can be earning $100, but we need to understand what amount of assets is dedicated to generate that income. A firm using $100 to generate $100 is more preferable to a firm using $10,000 to generate the same income. This measure is called the Return on Invested Capital (ROIC). What consists of Invested Capital will be covered when we touch upon the Balance Sheet.

What does the income statement consist of?

A typical income statement will cover the following headings:

REVENUES Total value of sales during the period in consideration
COST OF GOODS SOLD Total cost of making the goods, raw material, processing etc
SELLING, GENERAL & ADMIN Mostly consist of marketing costs and operational costs in general
R&D Research and development for improving products
DEPRECIATION Entry used to capture the expense of acquiring an asset in the past
INTEREST EXPENSE Interest on borrowed capital
GAIN/(LOSS) ON SALE OF ASSETS Profit/loss on sale of existing asset/business line/patents etc
OTHERS Any other non-operating income

In a nutshell, we need to understand what the company is selling, what are costs of making the product, what are the operating expenses to keep the business running and what are the interest expenses on the money borrowed by company. Taxes are pretty much standard for most of the companies, but some tax subsidies might be applicable for industries that the government wants to promote going forward. Keeping these factors in mind, we will be in a better position to evaluate the underlying business.

In the chapters ahead, I will discuss how to read into these numbers.

Enjoy reading!

Chapter 3: Revenues Cost of Goods Sold and Gross Margins

Chapter 1: Types of Financial Statements