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:




In this case, they begin with net profit after tax of Rs 2004.67 million or Rs 200.46 crore and add back tax expense of Rs. 1000.81 million or Rs 100.08 crore from the income statement.


To this, they subtract interest income of Rs 349.65 million or Rs 34.9 crore, dividend income on current investments of Rs 56.97 million, gain on sale or fair value of investments Rs 37.05 million, sundry balances written back of Rs 3.04 million, profit on sale/discard of property, plant and equipment of Rs 0.83 million, and miscellaneous non-operating income of Rs. 1.86 million.


This is because these represent non-cash, non-operating incomes which should not form part of the cash flow from operations.


Where are these items taken from? One needs to check Notes to the Financial Statements, specifically Note 29 on page. 152 of the annual report.


They also add back all non-cash, non-operating expenses. These relate to depreciation expense, expense recognized in respect of employee share based compensation, finance cost, provision for impairment of trade receivables and advances, and so forth. The end figure is called ‘ Operating profit before working capital changes’.


This figure is then adjusted for any working capital changes. What do they mean by that?


Remember that working capital, as the words go, means the short-term capital that the company utilizes to fund its day-to-day operations. This short-term capital includes inventory, short-term loans or advances, trade receivables, trade payables, and such. For instance, the company may delay paying to its suppliers or insist on advance payment from customers in order to fund its operations well. Since these actions directly influence the operating activities of a company, any changes to the working capital are reflected in the CFO.


So, an increase in trade payables during the year is added to the CFO. Think of it this way: High trade payables may indicate better negotiation skills of the management, which allows the company to stretch the payment cycle with the suppliers. This is equivalent to an increase in cash available with the company (because the company receives raw materials now but pays later), which is why we add it to CFO.


On the flipside, however, high or increasing payables may also reflect the lack of cash to pay the suppliers. This is a bad sign.


So, in order to know whether an increase in trade payables is a good sign or bad, an investor must investigate the reason for this increase through reading elsewhere in the annual report or studying the management commentary in the concalls.


By the same logic, an increase in trade receivables is deducted from the CFO. This is because high receivables indicate the company’s inability to collect cash from customers on time. Receivables increase when the company sells goods but does not collect cash right away. Since this is equivalent to a cash outflow, an increase in trade receivables is deducted from the CFO. An increase in inventory is similarly deducted from the CFO since it represents a cash outflow.


How about any short-term (or current) loan taken to fund the operations? This is added to the CFO since it represents an inflow of cash for operational activities.




Once these working capital adjustments are made, any cash taxes paid are deducted from the final figure to arrive at the cash flow from operating activities or CFO. I mention ‘cash taxes’ because often the tax expense mentioned in the income statement is different from actual cash taxes paid during the year. This difference may arise, for instance, owing to the differences in taxable income (calculated as per the Income Tax Act) and accounting income (as per Companies Act).


Total cash generated from operating activities is Rs 2185.37million or Rs 218.53 crores. This is cash that was in turn utilized by the company in capital expenditures or financing activities as evident below.


Components of Cash Flow From Investing


Cash flow from investing activities, as the name suggests, contains an account of the sources and uses of cash in investing activities of the company. This includes cash paid for the acquisition of a plant or machinery, cash invested during the year in shares or debt instruments of another company, or cash received from the sale of a plant or a machinery.


It also normally includes the dividend or interest received on an investment made by the company because these are cash flows generated from the company’s investing activities.


The following is again an excerpt from Dr Lal Pathlab’s cash flow from investing activities.




As evident above, they spent Rs 348.45 million in cash towards purchase of property, plant, & equipment (shown in negative because it’s a cash outflow). This is a capital expenditure.

They received interest income of Rs 269.52 million, which is shown as a cash inflow. They also made payments for the purchase of mutual funds, shown as a cash outflow of Rs 2227.65 million, and sold mutual funds worth Rs 1921.86 million shown as cash inflow.


Total cash used in investing activities is Rs 997.37 million or Rs 99.73 crore.


Components of Cash Flow From Financing


By the same logic, cash flow from financing includes cash inflow from issuing equity or debt (such as non-convertible debentures or NCDs), including loans taken from a bank. It also includes an account of the repayment of principal and interest, and also payment of dividends. All these are part of the company’s financing activities and therefore included in this section.


The only major item in Dr Lal Pathlab’s cash flow from financing activities was the payment of dividends of Rs 551.9 million of Rs 55.19 crore, shown as a cash outflow. The total amount of cash flow from financing activities was therefore negative at Rs 552.61 million.




To now arrive at the net free cash flow, one must add the total of CFO, CFI, and CFF or Rs 2185.37 million + (-997.37 million) + (-552.61 million) = Rs 635.39 million.


This is the free cash flow generated by the company during the year.


This amount is then added to the cash balance at the beginning of the year (which is the same as end of last year), which was Rs 658.48 million, to arrive at the cash balance at the end of the year. This is Rs 635.39 million + Rs 658.48 = Rs 1293.87 million.


If you check the balance sheet, this is the same amount mentioned as ‘cash and cash equivalents’ under the Current Assets section.



The important thing to remember, when analyzing the cash flow statement of a company, is that CFO must only account for cash, operating transactions made during the year. Any non-cash, non-operating items should be removed from the profit. Non-operating transactions made in cash should either be accounted for in CFI or CFF.

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