CASH FLOW ANALYSIS

INTRODUCTION

Traditional financial statements comprised of a balance sheet portraying at the end of accounting
period, resources controlled by the reporting enterprise together with sources of funds used for
their acquisition and a statement of income, showing income, expenses and profit earned or loss
incurred by the reporting enterprise during the accounting period. It was however noticed that
due to use of accrual basis of accounting, recognition of financial elements, e.g., assets,
liabilities, income, expenses and equity, coincide with the events to which they relate rather than
with cash receipts or payments. For this reason, traditional financial statements fail to inform the
users the way the reporting enterprise has generated cash and the way these were utilized during
the accounting period. To a person, less accustomed with accounting practices, it may sometimes
appear perplexing to observe that despite earning large profit, an enterprise is left with very little
cash to pay dividends. The need for inclusion of a summary of cash receipts and payments in the
financial statements of the reporting enterprise was therefore recognized. The summary of cash
receipts and payments during an accounting period is called the Cash Flow Statement.

THE ESSENTIALS OF CASH FLOW

If a company reports earnings of $1 billion, does this mean it has this amount of cash in the
bank? Not necessarily. Financial statements are based on accrual accounting, which takes into
account non-cash items. It does this in an effort to best reflect the financial health of a company.
However, accrual accounting may create accounting noise, which sometimes needs to be tuned
out so that it's clear how much actual cash a company is generating. The statement of cash flow
provides this information, and here we look at what cash flow is and how to read the cash flow
statement.

What Is Cash Flow?

Business is all about trade, the exchange of value between two or more parties, and cash is the
asset needed for participation in the economic system. For this reason - while some industries are
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more cash intensive than others - no business can survive in the long run without generating
positive cash flow per share for its shareholders. To have a positive cash flow, the company's
long-term cash inflows need to exceed its long-term cash outflows.

An outflow of cash occurs when a company transfers funds to another party (either physically or
electronically). Such a transfer could be made to pay for employees, suppliers and creditors, or to
purchase long-term assets and investments, or even pay for legal expenses and lawsuit
settlements. It is important to note that legal transfers of value through debt - a purchase made on
credit - is not recorded as a cash outflow until the money actually leaves the company's hands.

A cash inflow is of course the exact opposite; it is any transfer of money that comes into the
company's possession. Typically, the majority of a company's cash inflows are from customers,
lenders (such as banks or bondholders) and investors who purchase company equity from the
company. Occasionally cash flows come from sources like legal settlements or the sale of
company real estate or equipment.

Cash Flow vs Income

It is important to note the distinction between being profitable and having positive cash flow
transactions: just because a company is bringing in cash does not mean it is making a profit (and
vice versa).

For example, say a manufacturing company is experiencing low product demand and therefore
decides to sell off half its factory equipment at liquidation prices. It will receive cash from the
buyer for the used equipment, but the manufacturing company is definitely losing money on the
sale: it would prefer to use the equipment to manufacture products and earn an operating profit.
But since it cannot, the next best option is to sell off the equipment at prices much lower than the
company paid for it. In the year that it sold the equipment, the company would end up with a
strong positive cash flow, but its current and future earnings potential would be fairly bleak.
Because cash flow can be positive while profitability is negative, investors should analyze
income statements as well as cash flow statements, not just one or the other.
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Meaning of the term cash for cash flow statements

(a) Cash in hand and deposits repayable on demand with any bank or other financial institutions
and

(b) Cash equivalents, which are short term, highly liquid investments that are readily convertible
into known amounts of cash and are subject to insignificant risk or change in value. A short-term
investment is one, which is due for maturity within three months from the date of acquisition.
Investments in shares are not normally taken as cash equivalent, because of uncertainties
associated with them as to realizable value.

Note: For the purpose of cash flow statement, cash consists of at least three balance sheet items,
viz. cash in hand; demand deposits with banks etc. and investments regarded as cash equivalents.
For this reason, the paragraph 42 of the standard requires enterprises to give a break-up of
opening and closing cash shown in their cash flow statements. This is presented as a note to cash
flow statement.

What Is the Cash Flow Statement?

There are three important parts of a company's financial statements: the balance sheet, the
income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a
company's assets and liabilities. And the income statement indicates the business's profitability
during a certain period.

The cash flow statement differs from these other financial statements because it acts as a kind of
corporate checkbook that reconciles the other two statements. Simply put, the cash flow
statement records the company's cash transactions (the inflows and outflows) during the given
period. It shows whether all those lovely revenues booked on the income statement have actually
been collected. At the same time, however, remember that the cash flow does not necessarily
show all the company's expenses: not all expenses the company accrues have to be paid right
away. So even though the company may have incurred liabilities it must eventually pay,
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expenses are not recorded as a cash outflow until they are paid (see the section “What Cash Flow
Doesn't Tell Us” below).

The following is a list of the various areas of the cash flow statement and what they mean:

Cash Flow from The Operating Activities: This section measures the cash used or provided by
a company's normal operations. It shows the company's ability to generate consistently positive
cash flow from operations. Think of "normal operations" as the core business of the company.
For example, Microsoft's normal operating activity is selling software.

Cash Flows from investing activities: This area lists all the cash used or provided by the
purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold
companies for a profit or loss, the resulting figures would be included in this section of the cash
flow statement.

Cash Flows from financing activities: This section measures the flow of cash between a firm
and its owners and creditors. Negative numbers can mean the company is servicing debt but can
also mean the company is making dividend payments and stock repurchases, which investors
might be glad to see.

When you look at a cash flow statement, the first thing you should look at is the bottom line item
that says something like "net increase/decrease in cash and cash equivalents", since this line
reports the overall change in the company's cash and its equivalents (the assets that can be
immediately converted into cash) over the last period. If you check under current assets on the
balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the
difference between the current CCE and last year's or last quarter's, you'll get this same number
found at the bottom of the statement of cash flows.

In the sample Microsoft annual cash flow statement (from June 2004) shown below, we can see
that the company ended up with about $9.5 billion more cash at the end of its 2003/04 fiscal year
than it had at the beginning of that fiscal year (see "Net Change in Cash and Equivalents").
Digging a little deeper, we see that the company had a negative cash outflow of $2.7 billion from
investment activities during the year (see "Net Cash from Investing Activities"); this is likely
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from the purchase of long-term investments, which have the potential to generate a profit in the
future. Generally, a negative cash flow from investing activities are difficult to judge as either

good or bad - these cash outflows are investments in future operations of the company (or
another company); the outcome plays out over the long term.

The "Net Cash from Operating Activities" reveals that Microsoft generated $14.6 billion in
positive cash flow from its usual business operations - a good sign. Notice the company has had
similar levels of positive operating cash flow for several years. If this number were to increase or
decrease significantly in the upcoming year, it would be a signal of some underlying change in
the company's ability to generate cash.
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Digging Deeper into Cash Flow

All companies provide cash flow statements as part of their financial statements, but cash flow
(net change in cash and equivalents) can also be calculated as net income plus depreciation and
other non-cash items.

Generally, a company's principal industry of operation determines what is considered proper

cash flow levels; comparing a company's cash flow against its industry peers is a good way to
gauge the health of its cash flow situation. A company not generating the same amount of cash as
competitors is bound to lose out when times get rough.

Even a company that is shown to be profitable according to accounting standards can go under if
there isn't enough cash on hand to pay bills. Comparing amount of cash generated to outstanding
debt, known as the operating cash flow ratio, illustrates the company's ability to service its loans
and interest payments. If a slight drop in a company's quarterly cash flow would jeopardize its
loan payments, that company carries more risk than a company with stronger cash flow levels.

Unlike reported earnings, cash flow allows little room for manipulation. Every company filing
reports with the Securities and Exchange Commission (SEC) is required to include a cash flow
statement with its quarterly and annual reports. Unless tainted by outright fraud, this statement
tells the whole story of cash flow: either the company has cash or it doesn't.

What Cash Flow Doesn't Tell Us

Cash is one of the major lubricants of business activity, but there are certain things that cash flow
doesn't shed light on. For example, as we explained above, it doesn't tell us the profit earned or
lost during a particular period: profitability is composed also of things that are not cash based.
This is true even for numbers on the cash flow statement like "cash increase from sales minus
expenses", which may sound like they are indication of profit but are not.

As it doesn't tell the whole profitability story, cash flow doesn't do a very good job of indicating
the overall financial well-being of the company. Sure, the statement of cash flow indicates what
 CASH FLOW ANALYSIS

the company is doing with its cash and where cash is being generated, but these do not reflect the
company's entire financial condition. The cash flow statement does not account for liabilities and
assets, which are recorded on the balance sheet. Furthermore, accounts receivable and accounts
payable, each of which can be very large for a company, are also not reflected in the cash flow
statement.

In other words, the cash flow statement is a compressed version of the company's checkbook that
includes a few other items that affect cash, like the financing section, which shows how much the
company spent or collected from the repurchase or sale of stock, the amount of issuance or
retirement of debt and the amount the company paid out in dividends.

Conclusion

Like so much in the world of finance, the cash flow statement is not straightforward. You must
understand the extent to which a company relies on the capital markets and the extent to which it
relies on the cash it has itself generated. No matter how profitable a company may be, if it
doesn't have the cash to pay its bills, it will be in serious trouble.

At the same time, while investing in a company that shows positive cash flow is desirable, there
are also opportunities in companies that aren't yet cash-flow positive. The cash flow statement is
simply a piece of the puzzle. So, analyzing it together with the other statements can give you a
more overall look at a company' financial health. Remain diligent in your analysis of a
company's cash flow statement and you will be well on your way to removing the risk of one of
your stocks falling victim to a cash flow crunch.
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Illustration 1

Ms. Jyoti, accountant of Divya Finance has collected the following info for preparation of cash
flow statement. (Rs in Lacs)

Profit Before Tax 25,000.00

Dividend (Including Dividend Tax) 8,535.00
Provision for Income Tax 5,000.00
Income Tax Paid During The year 4,248.00
Loss on Sale of Assets 40.00
Book value of Asset Sold 185.00
Depreciation Charged to Profit and Loss Account 20,000.00
Amortization of capital grant 6.00
Profit on sale of Investment 100.00
Carrying Amount of Investment Sold 27,765.00
Interest income on Investment 2,506.00
Interest Expenses 10,000.00
Increase in the Working Capital (Excluding Cash and Bank) 56,075.00
Purchase of Fixed Assets 14,560.00
Investment in Joint Venture 3,850.00
Expenditure of Construction (WIP) 34,740.00
Proceeds from Calls in Arrear 2.00
Capital Receipt from Government Grant 12.00
Proceeds from Long term Borrowings 25,980.00
Proceeds from Short term Borrowings 20,575.00

Opening Cash & Bank 5,003.00

Closing Cash & Bank 6,988.00

Prepare cash Flow Statement as Required under Accounting Standard 3 (Revised)

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Solution:

Cash Flow statement for the year ended ………... of Divya Finance

Particulars Amount Amount

Cash Flow from Operation Activities
Net Profit before Taxation (25000+5000) 30000.00
Adjustments for Non-Cash and Non-Operating Items
Depreciation 20000
Loss on sale of Assets 40
Amortization of grant (6)
Profit on sale of Investment (100)
Interest income on Investment (2506)
Interest Expenses 10000 27428.00
Operating Profit Before Working Capital Changes 57428.00
Changes in Working Capital (Excluding Cash and Bank) (56075)
Cash Flow from Operation 1353
Income Tax Paid (4248)
Net Cash Flow from Operation (A) (2895)
Cash From Investing Activity
Cash from Sale of Assets 145
Sale of Investments (27765+100) 27865
Interest income on Investment 2506
Purchase of Fixed Assets (14560)
Investment in Joint Venture (3850)
Investment in Construction (WIP) (34740)
Cash Flow from Investing Activity (B) (22634)
Cash From Financing Activity
Call in Arrear 2
Receipt from Government Grant 12
Proceeds from Long term Borrowings 25980
Proceeds from Short term Borrowings 20575
Interest paid (10520)
Dividend paid (Including Dividend Tax) (8535)
Cash Flow from Financing Activity (C) 27514
Net Increase/(Decrease) in Cash and Cash Equivalents 1985
Opening Cash and Cash Equivalents 5003
Closing Cash and Cash Equivalents 6988

Illustration 2

From the Following Summary of cash account of Divyang Capital, prepare cash flow statement
as per AS 3 (Revised)
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Summary of Cash Account Transaction

(Rs in Lacs)

Particulars Amount Particulars Amount

Balance as on 01.04.2009 50 Payment to Suppliers 2000
Issue of Equity Shares 300 Purchase of Fixed Assets 200
Receipt from Customers 2800 Overhead Expenses 200
Sale of Fixed Assets 100 Wages and Salaries 100
Taxation 250
Dividend 50
Repayment of Bank Loan 300
Balance as on 31.03.2010 150
Total 0 Total 0

Solution:

Cash Flow Statement of Divyang Capital for the year ended 31.03.2010

Particulars Amount Amount

Cash Flow From Operation Activities
Cash Receipt from Customer 2800
Payment to Supplier (2000)
Paid to Employee (100)
Payment of Overhead Expenses (200)
Net Cash Flow from Operation (A) 250.00
Cash From Investing Activity
Purchase of Fixed Assets (200)
Proceeds from sale of Fixed assets 100
Cash Flow From Investing Activity (B) (100)
Cash From Financing Activity
Proceeds from Fresh Issue 300
Bank Loan Repayment (300)
Dividend paid (50)
Cash From Financing Activity (C) (50)
Net Increase/(Decrease) in Cash and Cash 100.00
Equivalents
Opening Cash and Cash Equivalents 50.00
Closing Cash and Cash Equivalents 150.00