\"Diving Deeper: Unveiling the Secrets of the Cash Flow Statement\"

Summary

this article describes what to look upon the most important financial statement of company- cash flow statement. It is easy to manipulate PnL statement but very difficult for cash flow statement. It gives various insights about company's finances. so let's see what we could analyse from cash flow statement

Cash flow statement  is most important financial statement that provide combined data for all inflows that a company receives from its operations. Mainly it has 3 different portions.

1. Cash from Operating expenses-

Cash from operating expenses cover all the cash flows that are coming from operating activities of company. It includes activities such as buying and selling inventory and supplies, salaries to employees and outflows such as investments.

2. Cash from Investing expenses-

Cash from Investing expenses cover the fixed assets purchased, any investments bought or sold by company and interest income by other sources like dividend etc received by company

3. Cash from Financing activities-

Cash from Financing activities provides  an overview of cash used in business financing such as proceeds from borrowings, repayments of borrowings, dividend paid to shareholders etc

Now lets see how an individual could assess from cash flow statements-

1. Does Profit and Loss statement cover all the insights?

Many investors tend to only judge a company’s financials by only analysing or looking upon their PnL statement, although PnL statement gives many insights upon company’s financials but still somewhat lacks the actual picture of company’s financials.

In India, the companies have to follow accrual based accounting rather than cash based accounting. To understand, let’s take an example of an wholesaler, suppose he gives products to an small retailer on credit basis, let’s say of Rs. 10,000 and retailer promises him to repay the amount in a year with profit of Rs. 11,000.

The wholesaler gives product to retailer and according to accrual method, it makes entry on its PnL statement the profit of Rs. 1,000 received by retailer, however the entry was made in same year that he gave product and not the actual year he receives his profit.

If the retailer’s business goes well, he would repay the amount to wholesaler next year, but what if the retailer fails to give amount to wholesaler? The wholesaler had made entry of profit previous year. The next year would result in loss as no amount was received

So to judge these situations, cash flow statement helps us, if wholesaler had gave product on credit basis, he would had done negative entry on cash flow statement, precisely in the receivables section in operating cash flow of the company, so from there we could analyse that company has gave credit to its customers and tend to receive cash in near future

So, one should compare the net profit of company by the operating cash flow of the company in same year. Or the ratio of operating cash flow to net profit should be greater than 0.7.

If you are analysing the companies for investment purposes, one should look upon this ratio for preceding 7 years

Note- This methods not work on financial companies such as banks and NBFCs

To show this, lets take an example of famous new age company- NYKAA. NYKAA announced their IPO in 2021 and surprisingly at the same year the company posted their positive net profit in years. Some investors would think that the company has done well and posted their net profit first time and would increase in next years to come

However if we look upon their Cash flow statement of same year, things would started to become clear

For the year 2021 itself the company’s financials looked promising, CFO stood at Rs. 101 Cr and Net profit at Rs. 62 Cr, but for next years the profit soon declined at so the CFO, in 2022 it is negative 354 Cr. The main increase in CFO was due to sudden decrease in inventory on same year and increase in share proceeds. This shows that the company is declaring profit, but no actual cash is coming to the company itself.

2. Increase in investments in fixed assets over years 

In cash flow from investing, we could see fixed asset purchased column, which suggests that how much company has invested in purchasing fixed assets, generally if company invests much of its profits to purchase fixed assets, it is considered good as it is reinvesting its profits to further increase their businesses.

However heavy investment of profits should be reflected in their financial performances also, if company is investing much of the profits into fixed assets, the profits should grow gradually in next years, if it is not, so this means that company is not utilizing their funds well and there is some problem

So to understand, here is example of Avenue supermarts (DMART) which operates retail chain of supermarkets in India. They mainly focuses on building their own stores rather that leasing it.

If we see their cash flow statement, we could analyse that their fixed asset purchases has increased gradually over the years, and so their investments become fruitful and net profits of company increased over the years, around 38% compounded annually in past 10 years.

On the second note, if we look upon the financials of motherson sumi,

From above, the company is investing much of their profits, almost all into acquisition of fixed assets, but this investments are not becoming fruitful to increase their profit growth, in past 5 years, the profit had seen negative growth of -2% This means that company is not utilizing their funds well

3. High Dividend: Good or bad for business 

Dividend can be defined as the portion of the profits which company gives to its shareholders. For normal shareholders, dividend is not fixed and can be varied on several factors, according to the dividend policy of the company. The companies are  also not obliged to give dividends and can not dividends.

For a growth company, the company mostly reinvests their profits into businesses and declare little to no dividend, mostly their reinvestments help company to grow much and that could reflect in their share price. For long term investors, this increases their wealth over the years.

However if company is declaring more than enough dividend or we can say giving much chunk of the profits as dividends, then we can say that the company is not much focusing on business and focusing on making investor’s wealth, or making promotor’s wealth

To further examine, let’s take example of COLPAL (colgate Palmolive) which is most famous FMCG Company in India, it has dividend payout ratio of 101%, meaning the company gives more than their profits as dividend to their shareholders, now regarding growth the company’s profits has grown at meagre rate of just 8% in last 10 years and sales grew at just 5%, meaning that the company had not much focused upon their business in recent years and not reinvested their profits to expand themselves.

If we look upon their shareholders, 51% of company is held by promotors and all of them are foreign subsidiaries of COLPAL, meaning that the 51% of the profits are going to promotors, and this money goes out to other nations.

Not COLPAL but many foreign companies in India has high dividend payout ratio such as Nestle India (88%), 3M India (212%), Oracle financial softwares (107%).

If investors are investing in high dividend companies, they should first analyse that whether the company is giving majority of profits as dividends or small portion of profits. If possible, investors should put money on companies which have lower dividend payout ratio than 40%, which gives much room for company to grow, else the company become cash cow for the promotors.

4. Free cash flow- what to judge from it?

Free cash flow is defines as the subtraction of cash from operating activities from fixed assets purchased. Free cash flow is the actual cash which company has. It is desirable for company to have positive cash flow as it could be used for further growth of the business, repayment of debts and further improving their financial health.

 However, companies which require high capital expenditure have lower FCF due to nature of the business, so they cannot be compared with companies which have low capital needs (such as IT Companies)

Above are 4 major parameters one could analyse from reading cash flow statements and profit & loss statements of the companies

In Nutshell, the things one should look in cash flow statement are-

1. CFO to Net profit ratio should be greater than 70%

2. Dividend payout ratio should be less than 40%

3. High investments in fixed assets should increase business growth of company

4. It is desirable to have high FCF