How to read the cash flow statement: A beginner's guide

The cash flow statement is the final cornerstone of financial reporting. While the profit and loss statement reveals whether the business is profitable or not, and the balance sheet outlines its financial position, the cash flow statement answers a critical question: Does the company have enough cash to sustain and grow its operations?

Let's break this down with a simple example used in our previous stories. Imagine you run a lemonade stand. Your income statement might show a profit of Rs 1,000 from last year's sales, but your cash box contains only Rs 600. Why the gap? The cash flow statement is used to explain this discrepancy, as it compares paper profits with the actual money available for use.

In this guide, we dive into the structure of the cash flow statement, breaking down its three key sections: cash flows from operations, investing, and financing.

Why do we need a cash flow statement?

Accounting follows the accrual principle, meaning revenue is recorded when earned (not when cash is received), and expenses are recorded when incurred (not when cash is paid). This can lead to differences between reported profits on the P&L and the actual cash flow. For instance, if your neighbours buy lemonade on credit, your P&L reflects the sale, but the cash isn't in your hands yet.

The cash flow statement focuses on actual cash movements, cutting through the complexities of accrual accounting. It answers two critical questions:

• Can the business pay its bills?
  
• Does it generate enough cash to invest in growth?

The structure of a cash flow statement

A cash flow statement is made up of three components: Cash flow from operations, cash flow from investing, and cash flow from financing. These sections represent the three fundamental activities of any business—operations, investments, and financing. Together, they provide a complete picture of how cash is generated and used across different aspects of the company.

The sum of the cash flows from these sections results in the net cash flow for the reporting period, revealing whether the business experienced a net inflow or outflow of cash.

1) Cash flow from operations (CFO)

This section shows cash generated or consumed by a company's core business activities. It answers whether day-to-day operations produce enough cash to sustain the business.

How is CFO calculated?

• Direct method: This lists all cash inflows and outflows from operations individually—such as cash received from customers and cash paid to suppliers. While simple, it requires detailed bookkeeping and is rarely used.
  
• Indirect method: This starts with profit before tax (from the P&L) and adjusts for:
  
• Non-cash items: Depreciation, stock-based compensation, or impairment.
  
• Changes in working capital: Inventory, receivables, and payables.

Here's an example of the indirect method using our lemonade stand example:

Your P&L shows a profit before tax of Rs 1,000. Here's how it will be adjusted:

• Depreciation: Your Rs 1,000 juicer depreciates at Rs 100 per year. Since it's a non-cash expense, add back Rs 100.
  
• Changes in inventories: You stocked extra lemons and sugar worth Rs 200, which is a cash outflow. Subtract Rs 200.
  
• Changes in receivables: Rs 300 worth of credit sales hasn't been collected, which means no cash inflow. Subtract Rs 300.
  
• Changes in payables: You owe Rs 150 to the grocery store for lemons. Since you haven't paid yet, add back Rs 150.

CFO before tax = Profit before tax + non-cash adjustments ± changes in working capital

CFO before tax = Rs 1,000 + Rs 100 - Rs 200 - Rs 300 + Rs 150 = Rs 750

If you pay Rs 100 in taxes, your net CFO (inflow) is Rs 650.

Analysing operating cash flows offers crucial insights into a company's financial health and efficiency. Discrepancies between cash flows and net profit highlight issues like delayed receivables or rising inventory, signalling potential red flags. A sustained positive CFO is essential for covering expenses and funding growth. Ratios like CFO-to-EBITDA offer crucial insights into whether earnings are translating into cash. By evaluating cash flow trends, investors can determine if a company's core operations are self-sustaining or reliant on external cash, providing a clearer view of its financial viability.

2) Cash flow from investing activities (CFI)

CFI shows cash used for and received from long-term investments like purchasing equipment, selling assets, or acquiring other businesses. In your lemonade business, this would include spending Rs 300 on new tables and chairs for customers and selling an old bench for Rs 50.

How is CFI calculated?

Net CFI = Cash received from asset sales-cash spent on asset purchases

In our example, net CFI = Rs 50-Rs 300 = -Rs 250 (outflow)

Regular investments in new equipment or facilities (capex), often signal growth. However, if these fail to boost profits and cash flows over time, they may indicate poor capital allocation. Large, infrequent purchases can cause investing cash flow fluctuations, while frequent asset sales may signal financial distress. By analysing these trends, investors can distinguish between strategic growth investments and short-term cash flow measures, assessing whether a company's approach supports long-term growth or reflects resource management challenges.

3) Cash flow from financing activities (CFF)

CFF captures cash movements related to funding—how a business raises or returns capital. For your lemonade stand, this would mean borrowing Rs 500 from a friend to expand operations and paying Rs 100 as dividends to reward yourself.

How is CFF calculated?

Net CFF = Cash inflow from borrowing/issuing shares-cash outflow for loan repayment/dividends

In our example, net CFF = Rs 500-Rs 100 = Rs 400 (inflow)

Analysing cash flow from financing activities reveals a company's funding strategies and their sustainability. Frequent borrowing may signal stress on profitability, as healthy businesses rely less on loans and more on operating cash flow. Additionally, frequent share issuances can raise capital but also dilute shareholders' stake. Investors should assess whether equity or debt financing supports genuine growth or merely covers shortfalls.

Putting it all together: Net change in cash

When you add up the net amounts from all the above three sub-sections, you get the total net increase (or decrease) in cash over the reporting period. This reconciles with the change in cash and cash equivalents shown on the balance sheet.

In our example, combining all three sections gives us a net change in cash of Rs 800. So, if you started the year with Rs 600 in your cash box, you'd have Rs 1,400 by the year-end.

What is free cash flow?

Free cash flow (FCF) shows how much cash a company generates from its core business after covering its operational costs and capital expenditure. It tells whether the business has enough funds for reinvestment, debt repayment, or rewarding shareholders through dividends or buybacks. A strong FCF indicates financial health, operational efficiency, and the ability to grow or manage downturns effectively.

We calculate FCF from cash flow from operations (CFO) because CFO represents the cash generated by core business operations.

Free cash flow = Cash flow from operations-capital expenditure

Assessing cash flow statements made easy

You can readily access the cash flow statements of all listed companies at vro.in. Simply search the company's name in the search bar and navigate to the 'Financials' section on the company's profile. Here, you'll find detailed line-by-line financials, including cash flow statements, spanning multiple years. You can then easily track trends and compare performance.

The cash flow statement completes the financial puzzle by showing how cash moves in and out of a business. Together with the P&L and balance sheet, it provides a comprehensive view of a company's health. But various other parameters like efficiency, leverage, liquidity, and qualitative factors like market position, competition, and management quality are equally critical to assess. Stay tuned as we cover these in coming articles!

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Also read: What is margin of safety and why do you need it?

This article was originally published on January 08, 2025.