Some intelligent investors once questioned that if Tata Steel reports $10 billions as net profit after tax on Mar’11, then does it mean that it has $10 billions free cash in-hand on Mar’11?
To his surprise the answer was not yes, the net cash in hand at the end of the year will be reflected in cash flow statement and not in income statement. In cash flow statement, there is one statement of accounts called as “Net (decrease)/increase In Cash and Cash Equivalents”. The value indicated against this parameter indicated the net free cash in hand (net of collection and payments made) at the end of the financial year (Mar’11). For Tata Steel this value was $200,000.
The profits made by any organization are further used and get consumed. Re-investing of profits for expansion and modernization, payments of dividends to shareholders, payments made to vendors, salaries paid to employees, delayed payments (collection from customer) from customers contributes ‘less cash in hand’ then reported profits.
| Tata Steel | Net Profit after Tax (Billions $.) | Net increase in cash/cash equivalents as compared to last year(Millions $) |
| Mar’11 | 10 | 200,000 |
| Mar’10 | 7 | 150,000 |
| Mar’09 | 5 | 100,000 |
From the above tabulated figures you can see that has always been able to keep positive cash flow year after year. What does it mean, either the company is collect cash faster than it is spending or they are managing their creditors very well. In simple sentence we can say that Tata Steel is collecting enough cash to pay its current liabilities like salary, suppliers, utility bills etc.
It is important to understand that it is very important for a business to be both profitable (showing net positive income) and also be cash positive. If you are collecting enough cash to pay all your creditors then half battle is won. The next step will be to make profits. Cash flow management is every day/month activity which profits you will need to bother may be only at the end of the year. If thorough out the year you are able to collect enough cash (without depending on debts) than you are able to pay all your creditor, then it is good sign that a company may be profitable too.
A company may be profitable but in case it is not able to maintain positive cash flow it means it has to reply on debt financing. Though debts improves the immediate cash flow situation of the company, but in long run it reduces the profitability of the company (because of additional interest burden). It will not be wrong to highlight here that irrespective of the fact that debt reduces the profitability of the company, still majority of companies relies of debt to manage its cash flows.
This shows how important it is to maintain positive cash flow. If positive cash flow is not maintained for several years it means company is eventually going to close down. May the company is profitable but if they are not able to manage its current liabilities (like salary, vendor payment, etc) it will eventually close down.
A company has mainly these following areas which it manages when it comes to cash-outflow:
(1) Salary and perks of Employees
(2) Payments to vendors
(3) Payments to creditors
(4) Payments to acquire assets
(5) Payments to make investments (sometimes buying its own shares)
(6) Payments made to fight legal battles.
If company is not having enough cash in hand to make the above payments they will either raise their hands (declare bankruptcy) or they will go for debt financing.
Similarly when it comes to cash inflow, following areas of focus is important:
(1) Payments from client
(2) Cash inflow from banks
(3) Cash inflow from equity financing
(4) Cash inflow from debt financing (like bonds)
(5) Cash inflow from sale of companies assets (like real estate)
If a company is collecting (generating) enough cash to manage all its payments in a year (both in term of value and timing of payments) it means the cash flow is positive and company will go a long way in future. But simultaneous look into companies income/loss statements is also essential. May be company is managing cash flow well, but whether the company is profitable? If they are relying too much of on debt financing to manage its cash flow?
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I will give you a third case, where a company is both cash positive and making good profits but still as an investor you shall not consider it for investment. In order to do this you will have to open the balance sheet of a company. The capital reserves and assets are accounted for in balance sheet. By looking at the balance sheet you can judge how risky it for you to invest in this company.
Consider a case where due to some problem the owner decides to liquidate the company. In this case all assets and capital reserves will be sold by the owner and the collected capital is distributed among shareholders. A capital which has capability to generates huge capita upon liquidation (more than its market capitalization) is considered as a safe investment.
Liquidation is a worst case scenario for a business. Even in such a situation, if company is able to generate enough positive cash for shareholders then the company becomes liable for a good investment option.
So it is important for investors to look at following together before making an investment decision:
(1) cash flow statement (to see if company is cash positive),
(2) income statement (to see if company is profitable) and
(3) balance sheet (to see if company is profitable even under liquidation)
Fine prints of cash flow statement
Now we will dig slightly deeper (more than just “Net decrease/increase In Cash and Cash Equivalents”) into the cash flow statement to see if it provides some other key indicators for investors.
In a cash flow statement you will find the following statement of accounts
In a cash flow statement you will find the following statement of accounts
Cash flow from operating activities:
Suppose you have a manufacturing company which produces ball point pens. By looking at its cash flow from operating activities, you will understand that if company is generating enough cash to manage operation on its own (means debt financing is not required). In our example, a positive cash flow from operations means the company is selling ball point pens and generating collecting cash to make payments for activities required to run its manufacturing operations.
Cash flow from investing activities
Often companies uses cash to buy investments (like share of other companies, takeover of other companies etc.). The finance required to do this investing activity is reflected in this statement. Suppose a company ‘X’ wants to buy a company ‘Y’ at price of say $100 million. If company X has $110 million dollar worth of shares (of other companies) then they can sell these shares to generate $100 million and buy company Y. In this case the cash flow from investing activity will still be positive ($10 million) even after buying company Y at $100 million dollar.
Cash flow from financing activities
Financing activities like availing bank loans, issuing more stocks, issuing more bonds, selling of own companies stocks, payment of dividends etc are accounted for in this statement. In this statement a negative figure means either the company is paying dividends or buying its own stocks. Both of these conditions are a good sign for investors.
Conclude
To make an investing conclusion just on basic of cash flow statement is not wise. It is better for investors to see a global view of a business before investing. The global view can be obtained only by referring to all the three financial statements (cash flow, income and balance sheet). Cash flow statement on its shown will show you how well the company is managing its current liabilities. But important for investors is also to look at profitability and accumulated wealth of the company.
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