The Hindu Business Line : How money flows

Besides the balance-sheet and profit and loss account, the statement of cash flows is also a key disclosure forming part of a company’s annual report. It is a summary of receipts and payments disclosing the movement of cash during the period under consideration.

The CFS assumes significance as it reflects the liquidity and solvency position of a company. It throws light on the ability of the company to generate cash from its core operations, and where from it sources funds for expansion. Also, unlike the profit and loss account, which is based on the accrual method of accounting, the CFS discloses the actual movement of cash. Hence, it is also a useful tool to gauge a company’s ability to effectively manage cash. For example, while profit figures by itself may not help the company plan for repayment of debt and replacement of assets, an analysis of the cash flows will provide information on the funds available for the same.

Operating activities

Cash flows are classified under three heads — operating, investing and financing activities. Operating activities are defined as ‘the principal revenue-producing activities of an enterprise’. Cash sales, receipts from debtors, payment to suppliers, payment of salaries, selling and distribution of expenses, all fall under this head.

Actual cash flows differ from profits. A company may be low on cash but reported good earnings and vice-versa. The CFS explains the reason for this divergence. Consider this case. A company that has sold its goods on credit (captured as debtors) may take time or have trouble realising the cash. This may elongate the company’s working capital cycle and force it to resort to other funding options to keep the production cycle moving. Similarly, a company may have produced goods but piled them up as inventory without quickly converting them into revenues.

Here again the cost of holding such inventory instead of converting it into cash would affect operations. Both these may also be indicators of a slowing demand (in case of inventory build up) or higher risk of debtors becoming bad. Thus, a study of operating cash flows may be a key indicator of a company’s health or provide cues for any impending trouble in its business or financial position.

Investing and financing

While purchase and sale of fixed assets, investments, interest income/dividend received are examples of cash flows from investing activities, receipts from the issue of shares and debentures, repayment of loans, payment of dividends fall under financial activities. These are disclosed under separate heads in the CFS. Investing activities indicate the extent to which a company has spent on resources that generate future income and cash flows. Flows from financing activities indicate the various avenues from which a company’s funds are sourced and the debt servicing and repayments made to such sources.

Negative cash flows

Theoretically, positive operating cash flows are considered an indicator of efficiency. But does that mean that operating cash flows should not be negative? Take the case of GMR infrastructure: In its annual report for 2007-08, the company reports a negative cash flow of about Rs 56.5 crore in its stand alone operations. At the same time, cash inflow from financing activities was a whopping Rs 4,095 crore as the company raisedfunds through issue of shares.This is typical of companies in the growth phase which raise money to expand operations and generate future cash flows (after a lag) whether directly or through subsidiaries.

Negative cash flow in one year should not be immediately misconstrued for trouble. An analysis of cash flows from one period to another may provide a better indicator of performance.

Negative cash flows from investing could suggest that the company is incurring capital expenditure, which would generate income in future. When a company is repaying debt or buying back shares or paying dividends, cash from financing operations tends to be negative. However, in this case, there is often sufficient cash generated from operations to make the above-stated payments.

Cash-rich companies

Sometimes, we read about companies sitting on several crores of surplus cash. This may be used for investing in new assets, expanding capacities, repaying debt or pay hefty dividends. It may also be used to fund inorganic growth plans (acquisitions). Some cash-rich companies also actively scout for short term investing opportunities and generate substantial treasury income.

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