Have you ever checked the profit after tax (PAT) as reported by the company and its cash, cash equivalent and bank balance in its balance sheet? When you check it next time, you will get a shocking surprise! Because the company’s reported PAT and its cash, cash equivalent and bank balance will not be in agreement. Let us try to understand the answers for the above question and assess the relevance of cash flow statement in investing.
Why no agreement?
As mentioned earlier, why there is a disagreement between reported PAT and cash and bank balance of the company? Well, the answer goes back to the basics of accounting wherein the companies are maintaining their books of accounts on an accrual basis. Accordingly, expenses are matched with the relevant revenues and are reported when the expense occurs irrespective of the fact whether cash is paid or not. Thus, there will always be mismatch between these two numbers.
Why cash flow statement?
There is no doubt that reported profit is important for investors, but so is the cash flow. Profit is an indicator of financial performance whereas the cash available with the firm alone helps to manage its day-to- day operations, to invest in capital expenditure, diversification, acquisition of other companies, investment into research and development activities, etc.
According to Indian Companies Act, 2013, cash flow statement is part and parcel of the ‘financial statement’ of the company. Cash flow statement acts as a kind of reconciliation between profit made by the company and its cash and bank balance. It records the actual movement of all the cash in the company. It is prepared as per the disclosure requirements governed under Indian Accounting Standard (Ind AS) 7.
How to use cash flow statement?
Cash flow statement measures the movement of cash from three different business activities such as operations, investments, and financing. Cash flow from operations is an important and integral part ofcompnay from investment point of view as this shows how much cash is generated internally by the company from its operation. It considers the non-cash charges and impact of working capital of the firm.
A positive cash flow from operation is a good and healthy sign for a company. Cash flow from investment activities depicts companies’ investment in assets such as plant, machinery, buildings, etc. Any such expenses incurred by the company indicate that they are growing. Investments in these assets are going to generate future production and thereby increase the income of the company. Thus, a negative cash flow from investing activities is a green signal to invest.
Cash flow from financing activities essentially consists of fund raising and related activities of the company. Accordingly, debt, equity issuance and payment of interest and dividend dominate this part.
Investors who are looking for dividend could pay more attention to this part to assess how often companies borrow and repay their debt and what is the dividends paid out in cash to the shareholders. Dividends are paid out of cash, not out of profits.
To conclude, the purpose of analysing cash flow statement is not to understand what has happened in the past but also to project what cash flows may look like in the future. These projections will help investors to make an informed decision.
The writer is associate professor of finance & accounting, IIM Shillong