Cash Flow Statement: Meaning, Components and Examples

Somewhere in the previous chapters, we studied that companies prepare their books of accounts using accrual concepts. Just to brush up, as per the accrual basis of accounting, for a transaction - revenues are recorded in the books of accounts as and when they are earned, and expenses are recognised when incurred, irrespective of the cash received or paid for the transaction.

Let’s take a scenario. Suppose A Ltd sold goods to B Ltd for ₹100 crores. Entire sales were on a credit basis. A Ltd usually has a net profit margin of 50%. So we assume A Ltd has earned a net profit of ₹50 crores. The sales will be reflected in the statement of profit and loss along with the net profit of ₹50 crores following the accrual concept of accounting.

But the question you need to ask is, did A Ltd receive cash against the sales? The answer is NO! Thus, although the statement of profit and loss shows you a rosy picture, the reality is different. And that’s where cash flow statements come into the picture.

Companies have realised the importance of cash on the books of accounts, so they focus immensely on maintaining a solid liquidity position. A reconciliation between reported income and cash flows from operating activities provides valuable information about when, whether, and how a company can generate cash from its principal operating activities.

There have been many instances in the Indian stock market history where companies used to inflate their sales and net profit using credit sales; however, when it came to actual cash receipts, the company had a zero balance against those sales. Ultimately, such companies will file for bankruptcy one day or the other. 

We hope the context for the cash flow statement is clear and you have realised the importance of this crucial financial statement. So, let’s begin with the details. 

Cash flow statement 

This financial statement provides information about a business's cash inflows and outflows over a specific period. 

The cash flows of all companies are categorised into operating, investing and financing activities. Therefore, the cash flow statement is also divided based on these three principal activities:

1. Operating Activities: These include cash inflows and outflows related to the company's principal business activities. The company’s day-to-day activities that create revenues are selling inventory and providing services. Cash inflows result from sales made in cash and from the collection of debtors. To generate revenue for the business, companies undertake activities such as manufacturing inventory, purchasing inventory from suppliers, and paying employees, resulting in cash outflows. Also, it is essential to note that operating activities include cash receipts and payments related to dealing / trading in securities.
2. Investing Activities: These include cash inflows and outflows from company investing-related activities, like purchasing and selling non-current assets and other investments. These assets and other investments include PPE, i.e. property, plant, and equipment; intangible assets; other long-term assets; and long-term and short-term investments in the equity and debt (bonds and loans) issued by other companies. Cash inflows in the investing category include receipts from the sale of non-trading securities, property, plant, and equipment; intangibles; and other long-term assets. Cash outflows have cash payments for the purchase of these assets.
3. Financing Activities: These include cash inflows and outflows related to the company's financing-related activities. Primary sources of capital are shareholders and creditors. Therefore, financing activities include all transactions associated with securing or repaying capital, such as equity and long-term debt. Cash inflows under financing activity have cash receipts from issuing stock (common or preferred) or bonds and cash receipts from borrowing. Cash outflows include cash payments to buyback shares and to repay bonds and other borrowings. 

It is important to note that companies may also engage in non-monetary investing and financing transactions. A non-cash transaction is a transaction that does not involve an actual inflow or outflow of cash. 

For example, no cash is involved if a company exchanges one asset for another. Similarly, no cash is involved when a company issues common stock either for dividends or in connection with converting convertible bonds or preferred shares. In this case, as no cash is involved in non-cash transactions, these transactions are not included in the cash flow statement. 

Detailed analysis of cash flow statement

Operating activities

• Consider a cash flow statement, a reconciliation between the firm's profit earned during the year and its cash balance at the end of the year. That’s why cash flow statements always start with profit. This figure is taken directly from the statement of profit and loss. In the statement, all the amounts in brackets are negative figures representing cash outflow. In contrast, the amount presented in the non-bracket format is considered an inflow of cash. 
• After starting with the profit figure, the adjustments for non-cash and non-operating activities are made. Please note that non-cash transactions included depreciation and amortisation expenses, loss on sale of assets, provisions-related items, etc. These are added back to profit as these transactions do not involve cash outflow. Non-operating activities transactions are also added as these are not related to operating activities and, therefore, are adjusted in investing or financing activities. 
• After adjustments for non-cash non-operating items, adjustments for working capital are made. From the previous chapters, we know that working capital includes current assets and current liabilities. Therefore, all the changes in current assets and liabilities compared to the previous year are recorded in the cash flow statement as either inflow or outflow. Always remember:
• An increase in current assets or a decrease in current liabilities is equivalent to cash outflow.
• A decrease in current assets or an increase in current liabilities is equivalent to cash inflow.

As you can see in the above image, all the working capital adjustments are made to arrive at the cash flow from operating activities. 

Investing activities 

Next comes the cash flow from the investing sections. As clearly visible, the transactions are direct here and self-explanatory. It includes cash inflows and outflows related to the buying & selling of long-term assets and also includes income from investments. Generally, investors prefer negative investing cash flow as they expect the company to spend cash on building assets that increase the future potential earnings capacity. 

Financing activities

The last and final portion of the cash flow statement includes cash inflows and outflows from financing-related activities. As clearly visible in the above image, it includes inflows from the issue of shares and short-term borrowings. Outflow includes payment of dividends and interest payments. 

Towards the end of cash flow statements, net of cash inflows and outflows from all three activities are added to arrive at the cash balance at the end of the period. 

Linkages of the Cash Flow Statement with the Income Statement and Balance Sheet

Recall the accounting equation that summarises the balance sheet: 

Assets = Liabilities + Equity 

Now we know that cash is an asset. The cash flow statement ultimately shows the cash change during an accounting period. The beginning and ending cash balances are shown on the company’s balance sheets for the previous and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash. 

Also, the balance sheet's current assets and liabilities sections typically reflect a company’s operating decisions and activities. Now, because a company’s operating activities are reported on an accrual basis in the income statement, any differences between the accrual basis and the cash basis of accounting for an operating transaction result in an increase or decrease in some short-term asset or liability on the balance sheet. 

For example, if revenue reported using accrual accounting is higher than the cash collected, the result will typically be an increase in accounts receivable. If expenses reported using accrual accounting are lower than cash paid, the result will typically be a decrease in accounts payable or another accrued. 

Not only in the balance sheet but in the detailed analysis of cash flow statements, we saw how statements of profit and loss and cash flow statements are related. Instead, cash flow statements start with profit as the first line item. 

So, this was all about the cash flow statement. By the end of this chapter, we have covered all three crucial financial statements. From the next chapter onwards, let’s dive deep into the world of ratio analysis.