Cash Flow Statement

A firm can show a profit and still be unable to pay its wages. A cash flow statement shows what profit hides: how much cash actually came in, where it came from, and where it went.

Worked sorting. A cash sale of goods, payment to a raw-material supplier, salaries and income tax are operating. Buying a machine, and interest received on investments, are investing. Issuing shares at a premium, paying a dividend, interest on debentures and repaying a long-term loan are financing.

Non-cash transactions are left out. Buying a machine by issuing shares, or redeeming debentures by issuing shares, uses no cash, so it is not in the statement, although it should be disclosed elsewhere.

Same item, different class. The purchase of shares is an operating cash flow for a share broker, and an investing one for a manufacturer. The class depends on the firm’s business.

Don’t confuse profit with cash from operations. Profit is on the accrual basis and counts sales when made, not when paid. Cash from operations counts only money actually received and paid, so a firm that sells on long credit shows profit but little cash.

Where it breaks. Classification of interest and dividends differs between the Indian standards and between kinds of firm. The text above follows the usual treatment under AS 3 for a non-financial company. Check which standard (AS 3 or Ind AS 7) and which firm the question is about, since Ind AS 7 allows choices of classification in some cases.

For exams. Be able to sort items into the three activities, define cash equivalents, and say which items are excluded as non-cash.

Operating: the business. Investing: the assets. Financing: the owners and lenders.

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What each section tells you. Strong operating cash with large investing outflow suggests a firm that is growing out of its own earnings. Weak operating cash covered by new borrowing in financing is a warning: the business is not paying for itself.

A decision. A company reports a profit of ₹50 lakh, an operating cash flow of −₹10 lakh and new loans of ₹60 lakh. A lender is asked to extend the loan. What do these three figures say together?

The investing and financing sections are simple lists. The difficulty is the operating section, which can be built in two ways that must give the same answer.

The figures. Narmada Plastics has sales of ₹10,00,000, profit before tax of ₹2,00,000, depreciation of ₹40,000 and income tax paid of ₹60,000. Over the year its stock rose by ₹40,000, its debtors rose by ₹30,000 and its creditors rose by ₹10,000.

Both methods give the same result, because they are two routes through the same transactions. The rules for the adjustments follow one idea: money that is stuck in current assets is not cash, and money not yet paid out on liabilities is still in the bank.

Don’t add depreciation to the cash flow as if it were a receipt. Depreciation was deducted in arriving at profit without any cash leaving. It is added back only to undo that deduction. Losses on the sale of assets are added back, and gains deducted, for the same reason: the cash from the sale is shown in investing.

Where it breaks. The direct method needs cash records by category that many firms do not keep, and the indirect method hides the gross receipts. Most companies present the indirect method. Whether the direct method is required is a matter of the standard and the type of entity, so check the current notification.

For exams. Know both layouts, the rule for each current item, and the fact that only the operating section changes between the methods.

Asset up, cash down. Liability up, cash up.

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Working the tax. Tax in the P&L may differ from tax paid, because of a provision. Only the tax actually paid belongs in the statement. Here the two are the same by assumption (₹60,000 charged and paid in the year); with a provision, adjust by the change in the provision.

A decision. A firm’s sales rise 30% but its debtors’ days rise from 40 to 70. Using the indirect method as a guide, what happens to its operating cash flow, and what could the firm do about it?

Narmada’s working capital rose by ₹50,000 and its cash fell by ₹10,000, in the same year. Both statements are right. They measure different things.

Reconciling the two. Working capital rose by ₹50,000. Stock and debtors added ₹70,000, and neither is cash. Cash itself fell by ₹10,000, and the extra creditors took off another ₹10,000. The funds statement shows a year of growth; the cash statement shows that the firm’s cash went down, because the growth was tied up in stock and debtors.

Don’t treat the two as rivals. The fund flow statement shows how long-term money was raised and used, and the cash flow statement shows whether the firm can pay its bills. A good analysis uses both. In practice, companies covered by the standards present the cash flow statement; the fund flow statement is a management and exam tool.

Where it breaks. A cash flow statement for one year says little about the next. Cash can be changed by timing, such as paying creditors early. Look at several years, and at operating cash against profit.

For exams. Remember the difference in one line: funds are working capital, cash is cash. Know that the statements start from the same balance sheets and, for the same firm, agree on the long-term items.

Funds for the structure, cash for the survival.

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Free cash. A rough test of a firm’s strength is operating cash flow less the cash spent on fixed assets. Narmada generated ₹1,20,000 and spent ₹1,70,000 on machinery, taking ₹20,000 from the sale. Without the new shares its cash would have fallen from ₹1,10,000 to nil.

A decision. A bank sees two firms with the same rise in working capital. One has rising operating cash and the other has falling operating cash. Which would it lend to, and why can the funds statement alone not tell them apart?