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How should investors read the cash flow statement of a company?

When an investor studies a company’s financials, he looks at three primary statements. These comprise the income statement (which shows the revenues, expenses and the net profit of the company during the year), the balance sheet (which contains an account of the total assets and liabilities that help generate revenue and profits), and the cash flow statement (which contains an account of the sources and uses of cash by the company).

The last of these, or cash flow statement, is the subject of this article.

Most of you may have some familiarity with the income statement and the balance sheet. Cash flow statement, on the other hand, is somewhat underrated either because many find it difficult to read or they fail to understand its significance.

But the truth is, it is the cash flow statement that throws light on the quality of profits. In other words, it helps us understand whether the profit figure (also called PAT or ‘profit after tax’ in financial parlance) as it appears on the income statement is real. What do I mean by that?

Consider the usual constituents of the income statement. Items such as depreciation expense or gain on the sale of an equipment are not necessarily cash transactions. In other words, these transactions may not involve an outflow or inflow of cash from the company’s accounts.

Take the case of a “gain on the sale of an equipment”, for instance. The total proceeds from sale, and not just the gain portion, is an inflow of cash. Therefore, these proceeds are recorded in the cash flow statement. The effect of the gain on the sale proceeds, on the other hand, is removed from the net profit figure in order to avoid double counting.

This is what the cash flow statement seeks to illuminate. Since it contains only cash transactions, investors can decipher exactly how much cash (as opposed to simply net profit, which also contains non-cash transactions such as depreciation) the company has generated from its day-to-day operations.

By studying the cash flow statement, Investors can also know how much cash is left over, after paying for operational expenses such as salaries and raw materials, to either reinvest in the company or distribute to investors in the form of interest and dividends.

This explains why an investor must religiously study the company’s cash flow statement while evaluating a potential investment.

With that in mind, let’s dig into the technicals.

Digging Into the Cash Flow Statement

The cash flow statement is divided into three sections: (1) Cash flow from operating activities or CFO in short, (2) Cash flow from investing activities or CFI, and (3) Cash flow from financing activities or CFF.

For ease of writing, I will be using these abbreviations going forward.

Cash flow from operations or CFO includes only cash transactions relating to the operational activities of a company. Cash and operational are the key words to remember here. To put it another way, CFO excludes the effect of all non-cash transactions and also those transactions that have nothing to do with the core activities of the company.

Take, for instance, a cement manufacturer. Since its primary activities are manufacturing and selling cement, all non-core incomes – or incomes received from activities other than from selling cement – must be excluded from the CFO. These non-core incomes may comprise, for instance, the interest or dividend received from investment in the bonds or shares of another company.

Building the Cash Flow from Operations

To build the CFO, the company first takes the ‘profit before tax’ figure from the income statement and adds back all the non-cash as well as non-operating expenses. It also deducts all non-cash and non-operating incomes.

Take a look at the CFO components from Dr. Lal Pathlab’s latest annual report (pertaining to FY18-19), page 124: