Out of balance sheet, profit & loss a/c and cash flow report, perhaps cash flow statement is the easiest report to read and comprehend. But in terms of effectiveness to judge fundamental strength of a company, this report is as valuable as the other two.
Cash is king for a company. If cash is flowing in and out at required times, the company will remain afloat. Cash flow statement gives us this clarity about the company. Hence, a cash rich company is always valued highly by the analysts.
But a cash rich company need not always confer with the idea of having ‘excess cash sitting in bank’. A company can be said to be cash rich if its overall cash position remains positive.
How to judge a company’s cash position? By looking into areas from where the company is earning and spending its cash.
[This article is a part of series of articles on fundamental analysis]
Cash Position Of A Company
To judge a company’s cash position analysts resort to estimating free cash flow (FCF). Based on the estimated FCF, intrinsic value of a company is estimated. The higher is the FCF (over time), higher will be the company’s intrinsic value.
When intrinsic value of a company becomes positive and is also increasing, it is a clear sign of a strong cash position.
Example of a weak & strong cash position – How cash is king
Consider this hypothetically. There are two companies A and B.
- Company A has reported Rs.1,000 crore profit in its profit and loss account. But it was unable to collect a single penny from its customers [all sale was on credit & no advance was received]. But the company had a total cash-out of Rs.850 crore. This company will have a negative cash flow. Net Cash Flow (-850) = Cash In (0) – Cash Out (850). Hence it has a weaker cash position.
- Company B has reported Rs.10 crore profit in its profit and loss account. It was able to collect Rs.8.0 crore from its customer. The total cash-out in the same years was Rs.6.6 crore. This company has a positive cash flow. Net Cash Flow (1.4) = Cash In (8) – Cash Out (6.6). Hence it has a stronger cash position.
What does this prove? Investor are often obsessed with profits (or EPS) of a company. But profits gives us only a part-picture of the company’s financial health. To develop the whole story, we must look at their cash position. Without enough cash, valuation of a company may fall to negative – hence cash is king. Where you will get information about cash? In cash flow statement.
Cash Flow Report & Bank Balance
Why companies do business? At the end of the day, the business is done to make money. How to quantify the money made by the company? One way of looking at it is through their “bank balance”. If the cash parked in the bank (cash, deposits, short term investments) is growing year on year, it is clear sign of company making money.
How company can increase its bank balance? By generating excess cash from its business. Here the term “business” is classified into three activities: (a) operating activity, (b) investing activity, (c) financing activity. At the end of the year, there should be a net cash-in flow from the combined effect of these activities.
When there will be a net cash-in flow, bank balance will go up. When there will be a net cash-out flow, bank balance will go down.
This is what’s actually represented in a cash flow statement, that at the end of the year, the cash position of the company has increased or decreased. The cash flow report also shows the activities which brought cash, and activities which consumed cash for the company.
Reading Cash Flow Statement?
To make more meaning of the cash flow report, it is better to read 3 or 5 years numbers at one go. Here is a snapshot of five year cash flow statement of Nestle India. You can see how it’s numbers behaved in last 5 years.
What you see in the above screenshot is a summarised version of the cash flow statement. But the actual report is much more detailed. What are the details? There are detailed break-ups of all the three activities: (a) Operating activity, (b) Investing activity, and (c) financing activity.
Net Cash Flow From Operating activity
Here will see all operating activities of the company which either has generated cash or consumed cash is last financial year.
#1. Start at the top
The statement of cash flow starts with counting how much cash the company’s operations has generated in the financial year. So the first line you will see will be “Cash Flow from Operating activities”.
Then the next line you will see is “Net Profit”. This value comes straight from the ‘profit and loss account’. In some statements it is also referred as “Net Profit before tax”. Please do not misunderstand it with Profit Before Tax (PBT).
So why in Cash flow statement it is pronounced as …before tax? Probably it means “net profit before adjustment for the actual tax paid as on date“.
We have already discussed that only actual cash flows are recorded in this report. But PAT is not a true representation of the actual cash flow. So why use net profit (PAT) in cash flow statement?
First things first, net profit is actually a result of cash flows happening in the company (actual or foreseen). How? Income is a cash flow. Expenses are cash flows. Interest & tax payments are cash flows. So net of all these cash flows is “Net Profit (PAT).
But the problem with PAT is that, some of these cash flows may not have actually happened. Example, all recorded income may not have been collected from customers. All expenses may not have still been paid.
So what is done in cash flow report is that, we take PAT in the first line, and then adjust it for the actual cash flows (in and out) which has happened in the financial year.
Please keep reading, this concept will become very clear in subsequent paragraphs.
Adjustments for operating activities (Before Considering Changes in Working Capital)
From here onwards we will start reading the cash flow report of a company from top to bottom. From the first line itself, there are activities which will be adjusted with PAT. What are the adjustments?
- Cash-in adjustments: All cash-in flows which has been accounted for in P&L a/c (as income), but has not actually happened will be subtracted from Net Profit (PAT).
- Cash-out adjustments: All cash-out flows which has been accounted for in P&L a/c (as expense), but has not actually happened will be added to Net Profit (PAT).
Details on how to read & interpret these numbers:
- D&A Expense: Rs.3,529 crore has been added back to PAT for Mar’20. This has been done because D&A expense is only an accounting adjustment. The actual cash out may have happened few year back itself. [Note: Rs.3,529 Cr, will appear in P&L a/c under the head “D&A Expense”]
- Bad debts, advances, payments: Rs.144 crore has been added back to PAT. These debts, advances, etc which were actually paid in the past has become ‘bad’ in this FY. So no actual cash-out has happened in this FY.
- Tax Expense: Rs.9,801 crore has been added back to PAT. This is done because it’s adjusted again at the end of operating activities as “Taxes paid (net of refunds = Rs.-5,846 crore. [Note: Rs.9,801 Cr, will appear in P&L a/c under the head “Total Tax Expense”]
- Net Gain on Investments: Rs.-214 crore has been deducted from PAT on account of loss upon sale of the investment (example: shares of a company sold at a loss of -214 core).
- Interest Income: Rs.-3,562 crore has been deducted from PAT. This is because the interest has accrued in FY’19-20 but the same is still not credited into the bank account. [Note: Rs.-3,562 Cr, will appear in P&L a/c under the head “other income”]
- Dividend Income: Rs.-10 crore has been deducted from PAT. This is because it has accrued in FY’19-20 but the same is still not credited into the bank account. [Note: Rs.-10 Cr, will appear in P&L a/c under the head “other income”]
- Finance Cost: Rs.924 has been added back to PAT. This is done because it’s adjusted again at the end of financing activities as “interest paid”. There in financing activity you will see a negative number (Rs.-924 crore).
So you can see, the next resultant number after adjusting for the above cash flows to Net Profit (PAT) is Rs.42,882 crore (calculation shown below).
What does the number Rs.42,882 crore mean? It means, after adjusting for all actual cash-ins and cash-outs, the cash position of company has actually improved compared to PAT (Rs.32,447).
But this position might soon change when we will take working capital in consideration. Why? Because this is where the bulk cash handling takes place.
Adjustments for operating activities (Considering Changes in Working Capital)
Like above, now we will see how changes in working capital items will effect the net profit (PAT) recorded in P&L account. Please note that all values shown here are represented as “Net Change in…” (This year Vs last year).
Again, if the item has caused a net cash-in flow for the company, it is recorded as positive. If the item has caused a net cash-out flow for the company, it is recorded as negative.
[Please note that all items indicated under the head “working capital” are either current assets or current liabilities (as recorded in company’s balance sheet). But the value indicated here are change in each items compared to last year. Any changes in these items will either cause a cash-in flow or cash-out flow for the company.
Negative numbers (Cash out flows)
- Trade receivables change: Rs.-3,295 core is added to PAT. Negative value means, compared to last FY end, the company’s trade receivables has increases. When it will increase? When the company sells more than it collects (payments) from its customers. Hence it is considered as a negative number.
- Un-billed receivables change: Same explanation as above.
- Loan receivables change: Rs.-2 crore is added to PAT. This is because compared to last FY, the quantum of this item has increased in this FY (by Rs.2 crore). It means, more loans are pre-paid (like inter-company or advance to employees etc).
- Change in Other assets: The quantum of ‘other assets’ has increase in the current FY by Rs.3,492 crore compared to last FY. This is the reason why, it is recorded as a negative number. In simple words, this line item has consumed cash worth Rs.3,492 extra this year.
Positive Numbers (Cash in flows)
- Inventories Change: Rs.5 core is added back to PAT. This means that compared to last FY end, the company has reduced its inventory by Rs.5 core. How inventory can be reduced? By sale of the item. Hence it is considered as cash-in.
- Trade Payables: Rs.446 core is added back to PAT. It mean, compared to last FY end, the company has increased the a/c payables by Rs.446 core. How a/c payables increase? When more vendors invoices are waiting to be paid. More cash stays in bank and is paid later.
- Other financial liability: Rs.1208 crore is added back to PAT. When the quantum of financial liability increases (like a bank loan), its net result is increase in cash for the company.
So this is all about cash flow from company’s operations. If one wants to know about how much ‘actual net cash’ is generated by the company’s operations, we need to add all the numbers back to PAT (see the screenshot of calculation shown below).
Rs.32,369 is the real cash generated by operations. Now it is on the company how they want to use this cash. They can consume it for ‘investing activities’. They can also consume it for ‘financing activities’.
There are companies who may come short in ‘cash generated from operations’. Such companies has the option to generate cash from investing activities (like sale of investments etc) and form financing activities (like issue of new shares, bonds etc).
Net Cash Flow From Investing activity
Few cash consuming investing activities
- Bank deposits placed: Rs.7,663 crore worth of new bank deposits has been bought by the company. This also yields ‘interest income’. This is a cash consuming activity hence shown in negative. Hence it has caused a negative value in cash flow. Out of all cash generated by operations, Rs.7663 crore was used for FD.
- Inter-corporate deposit placed: This is also like FD, but instead of bank, company deposit (CD) has been bought. Rs.14,905 worth of new CD’s has been purchased. This also yields ‘interest income’. CD’s cause a cash out hence a negative value in cash flow. Out of all cash generated by operations, Rs.14905 crore was used by CDs.
- Purchase of investments: Rs.80,002 worth of new investment was cash purchased by the company. Hence it has caused a negative cash flow.
- Purchase of Property Plan & Equipment (CAPEX): This is what is classified as Capital Expenditure (CAPEX) of the company. While doing price valuation of a company using DCF, Capex number is used. The company has spent cash worth Rs.2,538 in Capex for FY ending Mar’20.
Few cash generating investing activities
- Proceeds from Bank Deposits: Rs.11,965 crore worth of bank deposits was redeemed by the company. This has increased the bank balance of the company by the same value, hence written as a positive number.
- Proceeds from inter-corporate Deposits: Rs.14,432 crore worth of inter-corporate deposit was encashed by the company. This has increased the bank balance of the company by the same value, hence a positive number.
- Redemption of investments: Rs.84,089 worth of investments has been sold by the company. This has increased the bank balance of the company by the same value, hence a positive number.
- Disposal of Capital Assets: Rs.162 crore worth of capital assets has been sold by the company for cash. Hence it caused the cash balance of the company to increase by the same value. Hence a positive number.
- Interest & Dividend received: Rs.3,729 crore and Rs.8 crore cash has been earned by the company on account on interest and dividend respectively. Hence it’s a positive number. [Note: Rs.3,729 Cr, & Rs/8 crore will appear in P&L a/c under the head “Other income”]
So to check how much net cash generation has been done the by the investing activities of the company, all values are added (see the screenshot shown below).
Generally, a growing company invests huge amount of money in CAPEX (purchase of property, plant, and equipment). Hence for such company net cash from investing activity will mostly negative. Hence, a negative number is not a bad sign. You just have to see which activity is consuming cash.
Net Cash Flow From Financing activity
- Buy-back of equity shares: Rs.16,000 cash was used by the company to buy back its shares from the market in FY ending Mar’19. Hence this value is shown in negative. If the company issues new shares in the market, the value will be in positive. How? By issuing shares, the company generates cash. But when the company is buying back its shares, it is doing the opposite.
- Borrowings (short-term or long-term): A negative Rs.181 crore for Mar’19 means, the company has paid back its loan dues. Had they taken new loan, the value would have been in positive. For Mar’20, the company has not borrowed any money.
- Dividend Paid (including DDT): Rs.37,634 crore worth of dividend was paid by the company in Mar’20. Hence this value appears as negative. This is a cash-out flow.
- Repayment of lease liabilities: When a company renews its lease (like long term rent agreement for an office space), it has to pay an upfront cash. In this case an Rs.1,062 crore was paid in FY ending Mar’20. Hence this value is shown as negative.
- Interest Paid: Rs.924 is a cost originating on account of interest payment on lease, loans etc. You will see this cost appearing as “Finance Cost” in operating activities. There it has been shown as a positive number, and in turn adjusted here as a negative number (Rs.-924 crore) – after the cash out has actually happened.
Net Change in Cash Position
The company has generated an extra cash of Rs.1019 crore from its operating, investing and financing activities at the end of Mar’20. This cash number ultimately gets added to the cash position of the company which was at the beginning of Mar’20 (Rs.7,224 crore). As a result, the cash position of the company improves to Rs.8646 core by 31-Mar’20.
The cash position of the company has increased year-on-year. This is the the whole crux of doing a business. The company should be able to improve its cash position.
Here is the snapshot of what important things the company did in FY’2020. This is a good example of running a business:
- Operating Activities:
- It generated a PAT of Rs. 32,447 crore.
- Net cash generated from operating activities was Rs.32,369 crore.
- Investing Activities
- Net cash generated from investing activity was Rs.8,565 core.
- This net cash was generated by redemption of deposits, investments, sale of assets, interest income, dividend income etc.
- New deposits and investments were also purchase in the same time.
- Financing Activity (here the company used the cash generated from above two activities)
- Dividend was paid to shareholders amounting to Rs.37,634 crore.
- Lease liability (Rs.1062 crore) and interest payments on loans (Rs.924 core) was also made here.