Over the last few weeks we have been trying to understand the three main financial statements at the high level. We covered Income Statement (https://rajshankar.wordpress.com/2013/11/01/finance-for-entrepreneurs-what-is-a-profit-loss-statement/ ) and Balance Sheet (https://rajshankar.wordpress.com/2013/11/08/finance-for-entrepreneurs-what-is-a-balance-sheet/ ) over the last two weeks, and now we shall turn our attention to the third of the statements – Cash Flow Statement.
In my opinion Cash Flow Statement is probably the most important for an entrepreneur to track almost on a daily basis. Why not? It is after all like checking if we are breathing and have access to enough oxygen to breathe in the near future as well! Cash is the oxygen for a business. Without cash a business, however viable, fails. The way to track cash professionally and in a structured manner for any business is using the Cash Flow Statement.
Similar to an Income Statement, the Cash Flow Statement is also read top down. There are typically three sections, namely: Cash Flow from Operations Activities, Cash Flow from Investing Activities, and Cash Flow from Financing Activities. Each section contains cash inflows, cash outflows, and net cash contribution (nil or positive or negative). This gives an idea from where the cash is actually coming into the system and is also finding its way out of the system. We will take a quick look at what each section contains.
Cash Flow from Operations Activities: This is probably the most important of the three sections. It talks about the cash flow with regards to operational activities of the enterprise. Since this includes the primary business (core) activities of a business, it shows the inherent strength of the business. An operationally positive cash flow indicates that the fundamental economics of the business is healthy and functioning well. It also indicates the amount of cash available to the company for investing and growth initiatives. An operationally negative cash flow need not make one immediately look at the company in pain, it could be because of many growth related decisions that the company may have taken in recent times.
Cash Flow from Investing Activities: These contain as the name suggests contains all cash related transactions because of either investment into assets or divestment of assets. Whenever there are changes during the period under consideration in the asset base, it will result in cash movements as well. Investment into assets (mainly for long term growth) results in cash outflow from the system. Divestment of any assets results in cash inflow. The net cash flow from investing activities speaks a lot about the decisions the company has taken during the period, with regards to its growth.
Cash Flow from Financing Activities: This section contains cash flows pertaining to any financial instruments and their implications. They are mainly debt / equity and the resultant charges that are paid on them (interest or dividend). Whenever a company raises money either through debt (loans) or equity it results in cash inflow and when interest or dividends are paid out, it results in cash outflows.
A study of the cash flow statement gives us an idea of the source from where the cash required to keep the system running comes from. If there is positive net cash flow from operations and it can cover the negative cash flow from investing and financing activities, then it is really indicative of a healthy business system. At times the company may need to raise money from financing activities to fund its investing activities, since operations may not have too much excess cash to fund internally – which is also not an uncommon situation amongst growth related firms. But if money is being sourced from financing activities to fund operational activities, it is a cause of concern and it needs to be handled at the earliest. Many possibilities exist and hence there are no standard rules to reading these statements – it depends on the business under consideration and also the various other non financial parameters.
While these are just initial thoughts on reading a Cash Flow Statement, we shall go into depth in our forthcoming lessons to analyze the statement in great detail.