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The Big Number, Forget About Profit,
Cash Flow Is King
The ability to generate cash may be the most important measure of a business's health.
Plenty of companies with paper profits have failed because they lacked the cash to
keep operating. At the most basic level, companies improve cash flow by collecting
receivables more quickly and paying bills more slowly. If money is going out faster
than it's coming in, a company must find a way to fund operations for those days in
between.
Cash flow can also serve as the basis for calculating the corporate equivalent of
disposable income. Subtracting capital expendituresor critical investments in things
like plants and machineryfrom a company's cash flow shows how much of its
resources are left available for such purposes as paying dividends, financing
buybacks, making acquisition or funding other investments.
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Objective
Information about the cash flows of an enterprise is useful in providing
users of financial statements with a basis to assess the ability of the
enterprise to generate cash and cash equivalents and the needs of the
enterprise to utilise those cash flows.
The economic decisions that are taken by users require an evaluation of
the ability of an enterprise to generate cash and cash equivalents and the
timing and certainty of their generation.
An enterprise should prepare a cash flow statement and should present
it for each period for which financial statements are presented.
Links Balance Sheet and Income Statement elements to change in cash
position.
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Business Activities and Cash Flows
The Statement of Cash Flows focuses
attention on:
Operations
Cash received and paid
for day-to-day activities
with customers, suppliers,
and employees.
Investing Financing
Cash paid and received Cash received and paid
from buying and selling for exchanges with
long-term assets. lenders and stockholders.
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Statement of Cash Flows
Accounting
Standard
Difference
Accounting Standard Difference
(in millions)
Net cash provided (used) by Operating Activities 79
Net cash provided (used) by Investing Activities (38)
Net cash provided (used) by Financing activities 21
Net change in Cash and Cash Equivalents 62
Cash and Cash Equivalents, beginning of year 40
Cash and Cash Equivalents, end of year 102
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Rs. Rs.
Cash flow (A) Cash flow from operating activities:
statement Net profit before tax
Income tax paid 500
of ABC Ltd -250
Net cash from operating activities 250
(Indirect method)
(B) Cash flow from investing activities:
Purchase of fixed assets -200
Sale of fixed assets 100
Net cash used in investing activities -100
(C) Cash flow from financing activities :
Issue of equity shares 300
Repayment of bank loan -300
Dividend paid -50
Net cash used in financing activities -50
Net increase in cash (A+B+C) 100
Add: Opening Balance 50
Closing Balance 150
Rs. Rs.
Cash flow (A) Cash flow from operating activities:
Cash receipts from customers 2800
statement Cash payments to suppliers -2000
of ABC Ltd Cash paid for wages and salaries -100
Cash paid for overhead expenses -200
(Direct method) Income tax paid -250
Net cash from operating activities 250
(B) Cash flow from investing activities:
Purchase of fixed assets -200
Sale of fixed assets 100
Net cash used in investing activities -100
(C) Cash flow from financing activities :
Issue of equity shares 300
Repayment of bank loan -300
Dividend paid -50
Net cash used in financing activities -50
Net increase in cash (A+B+C) 100
Relevance of Statement of Cash Flows
Statement of cash flows (SCF) helps address questions such as:
The SCF reports cash receipts and cash payments by operating, financing, and investing
activities
How much cash is generated from or used in operations?
What expenditures are made with cash from operations?
Cash flows from operations (CFO) is a broader view of operating activities than is net
income. It is not a measure of profitability.
What is the source of cash for debt payments?
How is the increase in investments financed?
What is the source of cash for new plant assets?
Why is cash lower when income increased?
What is the use of cash received from new financing?
Where management committed its resources, Where it reduced investments, Where
additional cash was derived from 12
A 17 July report by Bhaskar N. Basu, research
analyst at Bank of America Merrill Lynch
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Example: Calculate the Cash from financing
activities
Solution
Decription Rs.
Add :
Cash proceeds from the issue of shares 100000
Securities premium 10000
Deduct :
Interest paid on debenture -10000
Redemption of debenture -50000
Cash from financing activities 50000
Cash Flows by Investing Activities
+ Collection on Loans
+ Sale of Debt Instruments
+ Sale of Equity Instruments
+ Sale of Productive Assets
- Purchase of Productive Assets
- Purchase of Debt Instruments
- Purchase of Equity Instruments
- Purchase of equity of other company
- Payment of interest on loan
- Investment in Mutual Funds
- Investment in fixed deposits
+ Receipt of interest income
+ Receipt of dividend from other companys
equity investment
+ Proceeds from fixed deposit maturity
= Total Net Cash Provided (Used) by
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Investment Activities
Cash flow of high-debt firms turns
positive after 10 years
In the last financial year, the total cash flow from operations for the country's top 560 listed, indebted
firms exceeded their capital expenditure and investment for the first time since 2004-05. A company has
a positive free cash flow when its operations generate more cash than what is used in financing capital
expenditure and investment.
This was largely because of a sharp cut in capex and investments rather than any material
improvement in cash flow generation from operations. Cash outgo on capex and investments
declined 19 per cent to Rs 4.15 lakh crore last financial year, while operations generated cash flow
worth Rs 4.7 lakh crore in 2014-15, down 1.5 per cent, year-on-year.
Companies in the sample generated free cash flow of Rs 54,000 crore in 2014-15 but it was not
sufficient to fund all expenses such as dividend, interest and loan repayment, leading to additional
borrowing and a further deterioration in the leverage ratio. The net debt-equity ratio (debt minus
cash and equivalent on books) rose to 1.2 in 2014-15 from 1.14 in 2013-14.
A turnaround in India Inc's cash flow is the result of a process that began four years ago. The cash
burn peaked in 2011-12 when capex exceeded internal cash generation by Rs 2.04 lakh crore. The
numbers have improved every year since, due to a combination of higher internal cash generation
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and slowdown in new projects.
Indian companies' cash situation saw a marked improvement in 2013-14: These
firms generated free cash flows (net pf capital expenditure) from their operations
for the first time since the Lehman crisis of 2008
The cash outgo on account of capex and investment declined 16.4 per cent in
2013-14, as companies lowered their capacity expansion in view of an economic
slowdown. This left them with free cash flows of nearly Rs 70,000 crore, against
a similar amount of net cash outgo in 2012-13.
At its peak in 2010-11, companies' cash burn rate exceeded their internal
cash generation by Rs 1.27 lakh crore, due to a mix of low internal cash
generation and faster rise in capital expenditure.
Metal and power companies, on the other hand, faced the problem of internal
cash generation falling short of incremental capex and investment. Companies
like Tata Steel, Hindalco, JSW Steel, SAIL, Jindal Saw and Bhushan Steel
reported negative free cash flows, as internal cash generation fell short of capex
and investment last year.
The bad news, though, is that companies in sectors that are capex- and working
capital-intensive - such as construction & infrastructure, power, metals, real
estate and gems & jewellery - continue to burn more cash than they generate
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from their operations.
Cash Burn Rate
Cash burn rate is the rate at which a company uses up its cash reserves or cash balance.
Its a measure of the net-negative cash flow. Cash burn rate is a big concern for funded
start-ups. The typical pattern is to get funded, use that cash to build the business, and then
aim to get to positive cash flow before the money runs out. This is sometimes expressed
as a cash runway.
The burn rate metric for a selected period is calculated first by determining the difference
between the starting and ending cash balances for the period. That shows whether the
company lose or gain cash. Then we divide that total by the number of months in the
selected period. The result is a monthly burn rate value. Its often best to have a negative
burn rate. That means you are building your cash reserves, not using them up.
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Example
Additional Information: Ritts sold land during the year for $9,500 and purchased land
for $20,100. The company did not sell any buildings, equipment, or patents. Ritts paid
cash dividends of $33,000 during the year, and its interest expense was all paid in
cash. From its financial statements and other information, Ritts intends to prepare the
cash flow statement, using the indirect approach.
Description $ $
(A) Cash Flows from Operations:
Profit Before Tax 63500
Adjustments:
Depreciation and amortization of patents 20,600
Gain on sale of land -3,000
Income Tax paid -19,100
Interest Expenses 8,200
Decrease in accounts receivable 1,500
Increase in inventory -14,700
Increase in accounts payable and accruals 700
Increase in taxes payable 500
Cash provided by operations 58,200
(B) Cash Flows from Investing Activities:
Sale of land 9,500
Purchase of land -20,100
Purchase of buildings and equipment -82,700
Cash flows used in investing activities -93,300
(C)Cash Flows from Financing Activities:
Issuance of long-term debt 50,000
Issuance of capital stock 27,500
Dividends paid -33,000
Interest Expenses -8,200
Cash provided by financing activities 36,300
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Kidsn Caboodle
Statement of Cash Flows
Cash received from customers $155,000
Cash used in operations (146,900)
Cash flow from operations $8,100
Cash used for investments in equipment purchase (10,500)
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Net loss $(11,000)
Depreciation 26,400
15,400
Accounts receivable (reduced) 17,600
Relate it with the
Accounts payable (increased) 8,800
Working Capital
Accrued salaries (increased) 3,300 Logic.
Other accruals (increased) 2,200
Cash flow from operations 47,300
Investments 0
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Impact of Product Life Cycle on Cash Flows: Strategic Finance
Introductory Phase: To support asset
purchases the company may issue stock or
debt. Expectation: cash from operations to
be negative cash from investing to be
negative. cash from financing to be
positive.
Growth Phase: The company is striving to
expand its production and sales.
Expectation: small amounts of cash to be
generated from operations. cash from
0 investing to be negative. cash from
financing to be positive
Maturity Phase: Sales and production
level-off. Expectation: Cash from
operations to exceed investing needs cash
from investing to be neutral cash from
financing to be negative
Decline Phase: Sales and production
declines Expectation: cash from
operations to decline, cash from investing
to possibly become positive, cash from
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financing to possibly become negative
Typically, large companies have a consistent negative working
capital since they have the muscle power and can demand longer
Firms with low working capital credit periods from their fragmented suppliers. They are also able
to make sales in cash or collect payments within a few days.
can be good investment bets
ET Bureau Nov 26, 2012, 08.00AM IST
The negative working capital phenomenon not only depends on
the size of the company, but also on the kind of business.
"Negative working capital is visible in companies with strong
brand and consumer franchise, which is why it is mostly seen in
the consumer sector,"
Telecom companies: Capital-intensive sector, the sector does not
require raw material, most of the capital requirements like licence
fee, spectrum cost, tower installation cost, etc, are taken care of at the
initial stage. Finally, these companies collect money from prepaid
customers in advance
Aviation industry: that has a high negative working capital because
airlines collect the money at the time of booking, months before they
spend it to transport you. "Since the sector is heavily in debt
A negative working capital need not always be a bad thing. currently, the negative working capital may not be of much
Along with the negative working capital, investors relevance,
should also check whether the company can generate FMCG sector : known for generating fast cash and may have a
free cash flow. Some capital-intensive businesses high negative working capital. This may be because their strong
that don't offer very high operating margins may brand loyalty, low inventory, generate speedy sales, high
have negative working capital. bargaining power, favourable terms from their suppliers.
Analysis of Cash Flows
The SCF is useful in identifying misleading or erroneous operating results or
expectations
Feasibility of financing capital expenditures.
Cash sources in financing expansion.
Dependence on external financing.
Future dividend policies.
Ability in meeting debt service requirements.
Financial flexibility to unanticipated needs/opportunities.
Financial practices of management.
Quality of earnings.
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Cash Flow Performance Ratios
Ratio Calculation What It Measures
Cash flow to revenue CFO Net revenue Operating cash generated per
dollar of revenue
Cash return on assets CFO Average total assets Operating cash generated per
dollar of asset investment
Cash return on equity CFO Average shareholders Operating cash generated per
equity dollar of owner investment
Cash to income CFO Operating income Cash generating ability of
operations
Cash flow per share (CFO Preferred dividends) Operating cash flow on a per-
Number of common shares share basis
outstanding
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Infosys Ltd has lagged peers on revenue and profit growth in six of the past seven years. But even when its
competitive position rapidly deteriorated, it held on to the pole position for one important metriccash flow
generation.
In the past seven years, cash flow from operations amounted to 23.3% of revenues for Infosys, compared to
19.8% in the case of Tata Consultancy Services Ltd (TCS) and 16.2% for Cognizant Technology Solutions Corp.
Cash may be king, but it is clearly no emperor. Investors far prefer strong growth accompanied by a reasonable
amount of cash generation to exceptional cash generation accompanied by sluggish growth.
Is TCS now falling into the same trap? It has closed the gap with Infosys considerably in terms of cash
generated from operations19.3% of revenues in FY16 versus 19.6% for Infosys. Besides, it has curtailed
capital expenditure. As a result, it has overtaken Infosys in free cash flow generation in the past two years. The
amount spent by TCS on capital expenditure and acquisitions accounted for just 12.5% of cash flow from
operations in the past two years, compared to 28.7% in the case of Infosys.
Another reason cash flow generation has improved in recent years is that the company has reduced its exposure
to some emerging markets such as India. Working capital needs are typically higher in these regions, and the
lower exposure has meant that overall cash generation has improved.
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Cash Flow Coverage Ratios
Ratio Calculation What It Measures
Debt coverage CFO Total debt Financial risk and financial
leverage
Interest coverage (CFO + Interest paid + Taxes paid) Ability to meet interest
Interest paid obligations
Reinvestment CFO Cash paid for long-term Ability to acquire assets with
assets operating cash flows
Debt payment CFO Cash paid for long-term debt Ability to pay debts with
repayment operating cash flows
Dividend payment CFO Dividends paid Ability to pay dividends with
operating cash flows
Investing and CFO Cash outflows for investing Ability to acquire assets, pay
financing and financing activities debts, and make distributions to
owners
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Cash Flows from Operating Activities - Indirect Method
The indirect method adjusts net income by analyzing noncash items
+ (decrease in current assets like receivables, inventory, prepaid
expenses) or increase in trade payable