What is a Cash Flow Statement and How Can Investors Use It to Their Own Advantage?
The cash flow statement is a statement produced by the public companies on an annual basis in order to identify the inflows and outflows of cash. As opposed to the income statement that identifies the profit for the year, the cash flow statement provides a true picture of the cash in hand of the business. Thus, this statement is useful for understanding the liquidity position of the company. The cash balance presented in the balance sheet is tied with the profit shown in the income statement and therefore the cash statement provides a link between the statement of financial position and statement of comprehensive income.
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What is a Cash Flow Statement?[/caption]The cash flow statement identifies various sources of inflow and outflow of cash which are categorized into three major aspects namely operating, financing and investing flows of cash. The operating activities measure the cash that arises as a result of business operations and this starts with the profit after tax as reported in the income statement. Non cash expenses such as depreciation are added back to the PAT whereas accruals of interest and tax expense are adjusted so that the cash outflow is determined.
Changes in the working capital are identified and these are also adjusted accordingly in order to arrive at cash generated from operating activities. The next component of the statement is the investing cash that largely pertain to the capital transactions of the business. Any purchase and sales of property, plant and equipment is recorded in this section in order to identify the net cash from financing activities. Lastly, the financing section highlights the business transactions that are meant to raise finance such as debt issue, equity issue or loan repayment. The financing section highlights the changes in capital structure that came about in a given year. The net result of the cash from operating, investing and financing activities is the cash flow generated during a given year. This is then added with the balance at bank at the year start so that the balance at the year end is computed. This is then verified with the balance shown in the current assets within the balance sheet.
The cash flow statement is of immense importance to the investors as they can identify transactions that are not depicted in the balance sheet and income statement. The company's cash position determines the liquidity of the firm and the change in cash from year start to the year-end would help the investors in identifying the change in liquidity position. An assessment of the liquidity would enable the investor to identify the ability of the business to pay off its debts with ease.
The cash flow statement can also be used by the investors to identify the free flow of cash within a business. This information is not presented by the income statement that is based on the concept of accruals and prudence. The free flow of cash within a business would help in identifying the true cash that's generated as a result of the operations after the deduction of any capital expenditure that is required to maintain the operations of the company. Low or negative cash flows would indicate the lack of operating efficiency of the business and therefore investors must analyze the FCF of a given firm over a period of time.
The cash flow statement is also an indicative of the current capital expenditure policy of the firm. The investing section would highlight the expenditure on equipment. A negative or a positive investing cash flow does not indicate the true position of the company. A negative cash flow might arise as a result of high capital expenditure in a given year whereas a positive investing cash flow could come about as a result of sale of equipment. These are one off items and must not be used as a means to assess the liquidity position of a company. An investor can therefore identify the underlying reasons for negative or positive cash flow and therefore ascertain the future stream of cash flows. For example, a large outflow in the present year might result in low or negative cash balance but it is likely to result in more efficient operations which would enhance profitability and thus earning per shares. The investor can therefore use this information to predict the future profitability and operating capacity of the organization.
Furthermore, the finance section depicts the financing activities of the business and allows the investor to ascertain the changes made within the capital structure in a given year. For example, an investor can analyze the increase in debt or equity in a given year and therefore ascertain the changes in financial risk that a firm faces. An investor would also be able to determine the true reason for the cash in hand. For example a low cash balance might indicate low liquidity at a glance. But in reality it might be as a result of debt repayment which is a one off item and therefore the investor would easily be able to conclude that the business at present does not face a shortage of cash due to inefficient operations but simply because of repayment of debt.
An investor is thus able to analyze the various inflows and outflows of cash from the cash flow statement and also ascertain the sources of cash. Investors are able to identify the free cash flows generated from operations and therefore are able to analyze the ability of the business to pay back its debt while also meet its interest payments. The growth prospects and the ability to pay out dividends can also be predicted from FCF. The investor is able to analyze the investment policy of the company for example a firm is likely to pursue an aggressive investment strategy if there are capital outflows over a period of time. Thus, the cash flow statement is of immense importance to the investors who can use it to ascertain the various sources of cash inflow and outflow.
If you would like to learn more about what a Cash Flow Statement is, I would recommend watching this 15 minute video from YouTube. The video provides some really good tips on how an investor should view the statement.
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