A Statement of Cash Flows (or as formally called cash flow statement) provides an explanation in the movement of the actual cash inflow and outflow from different activities of the entity. There are three broad classifications under which cash flows are categories. We have provided brief explanation of each with abstracts of some of companies for the relevant sections.
- Operating activities
- Investing activities
- Financing activities
Cash flows from operating activities:
Refer to the operating aspects of the cash flows. This includes collection and payments to and from trade receivables and trade payables and even other payables and other receivables. Everything which is related to the main trading activity of the entity.
In order to calculate cash flows from operating activities under indirect method, the beginning figure is profit for the year. So, first put profit/(loss) for the year and then make following adjustments to it:
- Add back all non-cash expenses (like depreciation, amortization etc.)
- Exclude interest income and other income (these will be separately calculated on actual cash flow basis)
- Add all decreases in working capital and substract all increases in working capital (stocks, receivables and payables)
A positive figure of ‘net cash flows from operating activities’ indicate that the company has collected more than the cash it paid out, related to the operational activities of the entity. A positive figure generally is considered as good because it shows that company’s operations are cash sufficient. It will not need to arrange cash from financing or investing activities to support its operations.
However, a negative cash flow from operating activities cannot be blindly termed as something bad. We need to do a more in-depth analysis to find out the movement of items of cash flow statement and along with other business factors, it needs to be evaluated to find out whether a negative cash flow is actually bad or not for the entity. For example, a negative net cash from operating activities may have arisen to due increase in inventories (resulting in negative cash flows). These inventories may have been purchased to support expanding sales and market demand.
Direct method and Indirect method: These are 2 methods to prepare statement of cash flows. There is no difference in ‘investing activities’ and ‘financing activities’ under these 2 methods. The difference is only in the presentation of figures under ‘operating activities’.
Indirect method is more common and the begins the operating cash flows with ‘profit for the period’ however, in the direct method the beginning point is revenue from sales to customers. Then deduct all expenses like cost of goods sold and admin expenses. After that deduct increase and add decrease in working capital. Remove all non-cash items (like depreciation and amortization) and it will reach to the ‘net cash flows from operating activities’ using direct method.
So, how do you decide whether a cash flow is related to operating activity or an investing activity or a financing activity? So, the key deciding factor is like this, firstly check whether the cash flow is related to a financing activity or not? If it is a financing activity, then straight away classify it under financing activities. Secondly, check if it is an investing activity or not. If it is an investing activity then straight away classify it as investing activity. However, if a cash flow is neither an investing activity nor a financing activity, then as a residual bucket, put that cash flow under operating activity.
Cash flows from Investing Activities
Cash flow from investing activities usually includes capitation expenditure and doesn’t include cash flows of operational/routine nature. Unlike operating activities, these cash flows are not related to the operational running of the entity. This provides an idea to the investor that how much cash flow is invested or divested from the investment activities of the company.
This segment of cash flow focuses on the items which are related to long term investments of the entity like:
- Purchase or sales of property, plant & equipment
- Investments or divestment in subsidiaries or associates
- Purchasing of shares and debentures of other entities
- Receipt of dividends and interest generated the investments made
In order to prepare this section all investments/purchases in investing activities should be entered as negative value, because these are cash outflows. All collection of money under this section should be added as positive values e.g., proceeds from disposal of fixed assets.
The sum of all amounts under this category is called ‘net cash flows from investing activities’ (whether the net is positive or negative). But if net amount is negative then it may be labelled as ‘net cash flows utilized in investing activities’. If the net amount is positive, then it may be termed as ‘net cash flows generating from investing activities’.
Cash flows from Financing Activities
This section provides information about how cash flow movement in the financing activities of the company. Like how much loan is obtained by the entity or how much is repaid? Are there any new shares issued? Or how much dividend is paid. This section is about transactions (and their cash flow impact) of matters related to company’s own funding and financing. Has the company borrowed money? If so, then how much? Has it issued more shares? Has it repaid its loans? The details about all these transactions will be available in this section of the statement of cash flows. Therefore, this is an important section from investor’s point of view. A good risk assessment can be made from the company’s cash flow of financing activities whether this is a good choice for investment or not.