How Cash Flow Statements Can Help You Unearth The Exact Financial Position

by | Nov 3, 2015 | Financial Management

Income statement can present a true picture of the operating profits of your business, while understanding what is happening with your cash flow can help you have a visual representation of your day-to-day operations.

This blog was written by CA N RAJA, B.Com., PGDBA, ACA and he was happy to share the article on cash flow statement that was published in CACLUB INDIA.

An interesting example to easily understand Cash Flow Statement and its Usefulness.

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 and 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 and 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 recognized 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?

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?

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.

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

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.

Satish Rajagopalan, CISA, ITIL Foundation
CEO & Founder at Spearhead EduOnline Pvt Ltd. (the company that owns and operates ApnaCourse.com). He holds a btech in Computer Science, an MBA in Strategy and Entrepreneurship and a post graduation in Finance. Read More.

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