It has been a long time since we saw an update on 'Decoding The Financial Statement' series. The next and obvious step is to analyze the cash flows of the company. The cash flows of a company help you to ascertain the liquidity of the company. It answers the following questions:
i. Does the company have enough cash to run operations for the next period?
ii. Does the company have enough cash to pay its finance costs like interests on loans in the future?
iii. Is the company capable of paying dividends to its shareholders for the current period?
Before we move on to understanding an actual cash flow statement of Bata India, it is important to know the difference between a cash flow statement and an income statement. There has been a need for two separate statements since accounting is widely done on an accrual basis than on a cash basis. This means an income or expense accrued in a particular time period is accounted for in the same time period whether the cash for it has been received/paid or not in the same period.
Let's say, Bata India Sold footwear worth 10 Crore in the month of March 2019, however it received cash only for Rs 4 Crore in the same month and the rest was received in April 2019 (in the next fiscal). However, since the goods were sold in March itself, the amount of full Rs 10 crore is accounted for in the income statement of FY 2018-19 itself. This may be misleading as the company does not have Rs 6 crore as actual cash in hand. Hence, the company may be less liquid than shown in its income statements. This anomaly is filled in by the cash flow statement which shows the actual cash the company has received or paid in the given fiscal. Hence, the cash flow of FY 18-19 would only account for Rs 4 crore as operating cash flows.
Cash Flow statement is a little tricky concept and it takes practice and a lot of reading to get a hang of it.
Here is the Cash Flow Statement of Bata India Ltd. for the year 2018-19:
A cash flow statement is divided into three parts,
1. Cash flows from Operations
2. Cash flows from Investing activity
3. Cash flows from Financing activity
The total of all cash flows gives us the net free cash flows of the company. An Income statement is made by adding up all the incomes and subtracting all the expenses made during the year which is the direct method, however, a cash flow statement takes a different and a reverse approach, also known as the indirect method.
A. First, the profit before tax is taken as the main item from which all the non-cash transactions are added or subtracted. Non-cash incomes are deducted and non-cash expenses are added back to remove the effect of non-cash items from the income statement. This gives us the operating profit before taking into account the working capital changes during the year. Next, all the changes made to the working capital in the income statement have to be reversed. Hence, the increase in current assets is deducted and the increase in current liabilities is added back to operating profit. Note that the changes in current assets and liabilities account for the cash that is yet to be received or paid in the current fiscal hence deducing or adding back that much amount from the profits. This finally gives us all the cash that has come in from the operating activities.
B. In the next part, the cash inflows from various investment items are added and cash outflows from investment items like buying of property, etc are deducted to get the net cash flow from investing activities. This is done through the direct method.
C. Lastly, all the cash inflows and outflows from financing activities such as paying interests, dividends, DDTs, taking loans, etc. are taken into account to give the net cash flow from financing activities.
In the end, amounts from A, B, and C are added to get the net cash flows of the company during the given year. When this amount is added to the cash and cash equivalents from the last year's balance sheet, it should provide us the cash and cash equivalents available to the company after the current fiscal.
In order to get an overview of the liquidity of the company, we usually look at the main items of the company (the A, B, and C). Positive cash flows from operations mean that the company has received cash more than it has paid through its operations. However, just having a positive cash flow is not enough, operations being the major source of cash, such cash flows should be enough to fund investing as well as financing activities to avoid the creation of debts.
It can be clearly seen that Bata has generated enough cash flows from operations to fund its investing activities and the financing activities from the current year. Moreover, it is left with a good balance of cash and cash equivalents to finance the working of its operations for the next fiscal as well.
Negative cash flow is not always a negative signal. Negative cash flow from investment shows that the company is investing to expand its operations (depending upon the sub-items under the head) which may result in added cash from operations from next fiscal. Hence, the sub-items under each heads are equally important to analyze. Bata India has to pay less yearly interest, but still its cash flow from financing activities is negative due to cash outflows from the dividends paid. this is a good sign as well, as it shows that the company has enough free cash flows to payout dividends to their shareholders.
Analyzing the cash flow statements differ from company to company as well as industry to industry. Having good industry knowledge is always helpful. For example, steel companies have a very long business cycle, hence their cash flows may or may not be strong for some fiscals. On the other hand, FMCG companies receive cash in not more than 3 months from their sales helping them show a strong cash flow statement.
Cash Flows of current period should also be compared from their previous fiscals in order to detect growth and consistency patterns. A declining cash flow but increasing sales may show an ineffective cash management system in place. Stable or growing cash inflows show a good cash and liquidity management system. Especially, during times like these (a forthcoming recession due to Covid-19) a company with strong cash flows has an edge over companies having weaker cash flows. This is because the companies will have to maintain a certain amount of liquidity for a few months until the revenues get back to normal.
Accounting students would relate to the fact that cash-flow statements have always been one of the trickiest parts of accounting as a subject. We have tried our best to break it down into a simpler language to help a layman understand it. However, you can reach out to us on Instagram or Facebook in case we did not do justice to explaining cash flows. However, our advice would stay the same, the more cash flow statements you read the more you would be clear with it!
Explaining the three main financial statements opens us to the world of financial ratios which are the basis of fundamental analysis. Financial ratios would be the topic of our next blog.
Till then stay tuned!
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