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In this article, you will everything about Cash Flow Statement & its Analysis. It is very important concept in Fundamental Analysis & helps an Analyst in taking important decisions.

Learn how to analyze Cash Flow Statement here.

Learn about Cash Flow Statement & its Analysis

Cash Flow Statement AnalysisThe cash flow statement is a record of the company’s cash inflows and outflows.

This is an important financial statement that gives an idea about the liquidity situation of the company.

While some might argue that the profit and loss statement also reveals this similar info, the truth is that the profit and loss statement gives an overview.

In contrast, the cash flow statement provides a detailed account of all cash transactions from different sources.

How are Cash Flow Statement & Profit and Loss Statement different?

Before you learn about Cash Flow Statement Analysis, it is important to learn about the difference between Cash Flow Statement & Profit & Loss Statement.

This is better explained using the following illustration:

Suppose a company sells on both the cash and credit basis. The profit and loss account shows the total revenue of INR 50000 for the week. However, just by looking at this figure, it is impossible to determine its bank account balances.

This is an important consideration since most of the day to day operations are covered by cash or bank only. If the cash inflows are better, it indicates better efficiency in terms of sales and collections.

It would not be wrong to say that a company’s overall financial position depends as much on cash and liquidity as it does on total profits and losses.

This makes interpretation of the cash flow statement a crucial task in the process of fundamental analysis.

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    Important Headings in Cash Flow Statement

    In order to understand & analyze the cash flow statement, it is essential to know about its components first. The cash flow statement of any organization comprises of three main sections:

    Cash Flow from Operating Activities:

    All the transactions of cash inflow and outflow on account of daily business operation activities, are recorded under this head. Some examples of transactions recorded in this category are:

    • Sales related income and expenses
    • Technology up-gradation and depreciation expenses
    • Hiring and firing expenses
    • Rent payments
    • Tax payments

    In short, any activity that relates to the day to day core business activities of an organization is categorized under this head.

    Cash Flow from Investing Activities:

    All the cash outflows that the company undertakes to reap capital gains at later stages fall under this head.

    The cash inflows from such transactions in the future also come under this category. Some examples of transactions recorded in this category are:

    • Investing in land
    • Buying fixed assets like property, or intangible assets
    • Investing in equity shares
    • Loans received from customers.

    Usually, substantial cash inflows and outflows are involved in investing activities.

    Cash Flow from Financing Activities:

    All the activities of cash inflows and outflows related to a company’s financial transactions come under this head of the cash flow statement. Some examples of transactions in this category are:

    • Payments of dividends
    • Raising debt
    • Paying off debts

    All the transactions which affect the capital account of the company are recorded under this head.

    The sum total of all these heads’ cash balances is recorded in the balance sheet as cash and cash equivalents. To arrive at this final figure, the opening balance is also taken into consideration. This can be said as:

    The cash flow of the company = Net cash flow from operating activities+ Net cash flow from investing activities+ Net cash flow from financing activities

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    Relationship between Assets/ Liabilities and Cash Flows

    There is a direct relationship between the cash flows and liabilities, i.e. when liabilities increase, cash flow increases. On the other hand, when liabilities decrease, cash flow declines.

    For example, when a company raises new debt, it leads to cash inflow (Recorded under financing activities). At the same time, there is an increase in the liabilities of the company’s balance sheet.

    Another example is a payment to creditors. When the payment is made to the company’s creditors, the creditors decrease, indicating a decrease in liability. At the same time, there is a decrease in the cash balance.

    There is an inverse relationship between assets and cash flow. This means, when the assets increase, cash flow decreases. Similarly, when the assets decrease, cash flow increases.

    For example, when a company purchases new equipment, the assets increase. But since the payment is made in cash, the cash balances decrease.

    Another example is the receipt of payments from debtors. In this transaction, the debtors decrease, indicating a decrease in assets. Whereas, the amount received from debtors increases the cash balance.

    The above relationship is significant to build an overall understanding of the cash flow statement.

    By looking at the above explanation, it can also be concluded that any business activity leads to an increase in cash balance or reduces the cash balance.

    The nature of the activity that is, operating, investing, or financing does not change this basic understanding.

    Analysis of Cash Flow Statement of a Company

    Most of the items in the cash flow statements are self-explanatory. So, in order to derive meaningful conclusions, one needs to look at the overall picture.

    Below are the pointers to keep in mind while analyzing the cash flow statement for any company during the process of fundamental analysis:

    Financial Well Being of a Company

    A positive balance of the net operating activities indicates financial well-being. This is because, under this head, all day-to-day business activities are recorded.

    A company that is able to maintain a cash inflow greater than outflow is said to be more efficient.

    Business Plan for Expansion

    A healthy amount of investing activities indicates a business’s plan for expansion. For an investor, this is a good sign to invest in that particular company.

    It shows that the business is serious towards increasing its scale of operations in the coming time, and hence, the share prices might rise.

    However, what is a healthy amount of investment would vary from business to business.

    It is important to remember that investing activities drain a lot of cash, and hence, prudent decision making related to this is essential.

    Verify Financing Activities with Balance Sheet

    Financing activities need to be verified with the balance sheet. A simple example is that issue of new debt will increase the cash balance, and the net financing activity will be positive.

    However, the issue of more debt can increase the risk factor. The net equity ratio needs to be maintained.

    This can only be verified by taking a closer look at the balance sheet of the company.

    Compare all figures with the previous year for a better understanding. The cash flow statement shows the closing balances of the last year as well.

    This facilitates easy comparison between the two years. Better conclusions can be drawn by doing so.

    Reporting of Operating Cash Flow

    Companies can use either direct or indirect methods for reporting their operating cash flow. Under the direct method, all cash inflows are recorded at source, and outflows by use.

    This is most commonly used by small firms who do their accounting on a cash basis rather than an accrual basis.

    Whereas, under the indirect method, the data is derived from the income statement and balance sheet.

    The data is recorded in these statements on an accrual basis. In the cash flow statement, the information is recorded based on the change between the years.

    Conclusion – Cash Flow Statement & its Analysis

    The company’s cash flow statement gives the investor an idea about a company’s cash generation and usage capacity.

    The balance of cash and cash equivalents includes the balance a company has in cash and bank accounts.

    In this financial statement, all the activities leading to cash inflows and outflows are categorized under three main heads – operating, investing, and financing. A net of all these three figures is considered the total cashflow during the year.

    The cash flow statement is used along with the balance sheet and profit and loss statement. This statement gives a clearer picture of the company’s efficiency and cash management.

    However, a negative balance in the cash flow statement should not be immediately considered as a red flag, because sometimes this is a part of the expansion strategy of the company.

    Thus, all three financial statements must be analyzed well by the investor, and then only a decision to invest should be made.

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