Building and analysing cash flow statements - terms, ratios and calculations

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You’ll recall from module 2 that the main purpose of the cash flow statement is to show the amount of cash generated and spent by the company. The P&L statement records both cash sales as well as credit sales. If a majority of a company’s sales are done on a credit basis, the revenue is recognised, but there’s no subsequent cash inflow into the company. This can skew the perception of the company. 

Here’s where the cash flow statement of a company comes to the rescue. A cash flow statement helps you analyse and determine a company’s cash position for a specific period. Also, it helps you determine whether a company is liquid enough to handle financial emergencies or immediate debt obligations. 

That said, we’ll now move on to reading through the cash flow statement of a company to understand the various terms and their meanings. 

Reading through the cash flow statement

In keeping with the theme of this module, we’ll again take up the cash flow statement of Hindustan Unilever Limited for the year 2019-2020. Let’s first start with the layout of the statement.

The layout

The layout and the structure is quite similar to the P&L statement and the balance sheet. However, there are a couple of differences. Unlike the other two statements, the cash flow statement does not have a ‘note’ column. And it is split into three primary sections. Let’s take up each section of the statement and try to understand the terms in there, starting with ‘cash flow from operating activities.’

Cash flow from operating activities

Here’s a snapshot of the section on the cash flow from operating activities of Hindustan Unilever’s cash flow statement. Take a moment to familiarise yourself with the layout and the structure. 

As we discussed earlier, PAT (net income) of a company is not an accurate representation of the cash inflow in a company. This is because the revenue in the P&L statement is recognised as soon as it is earned, instead of when the money is actually received. Also, it contains non-cash income and expenditures which do not affect a company’s cash flow in any way.  

So, to calculate the cash flow from operating activities, the profit before tax (PBT) of a company is used. Several adjustments by way of additions and subtractions are made to the PBT to make it accurately reflect the cash position of a company. 

For instance, take a look at HUL’s cash flow statement for the year ended 31st March, 2020. Some of the following adjustments made to the PBT of HUL are as follows.  

Adjustments for non-cash items

Non-cash revenues are subtracted from the PBT, while non-cash expenses are added back to the PBT. For instance, in HUL’s cash flow statement, you’ll see that the first line item is ‘depreciation and amortisation expenses.’ Since it is merely an accounting entry and not a real cash expense that the company incurs in a year, it is added back to the PBT of the company. 

Adjustments for items accrued  but not received

Items that are due but not received are subtracted from the PBT, since such income has not really been received as money. For instance, in HUL’s cash flow statement, see the third line item: ‘government grant accrued (net).’ It has only been accrued and has not yet been received by the company. So, the value of such a grant is subtracted from the PBT. 

Adjustment for non-operating items

Non-operating items are also either added back or subtracted in this section, since here, we only want to arrive at the cash flow from operating activities. For example, although both the fifth and sixth line items, namely ‘finance income’ and ‘dividend income’ respectively, are both cash incomes received by the company, they’re not derived from its operating activities. 

And so, these incomes are subtracted from the PBT while calculating cash flow from operating activities.    

Adjustments for changes in working capital

Once all of the above adjustments are done, changes in the working capital and non-current assets and liabilities are accounted for. Since an increase in assets involves an outflow of cash, the corresponding entries are subtracted from the PBT. Conversely, a decrease in assets involves an inflow of cash, and so those entries are added back. Similarly, an increase in liabilities involves an inflow of cash, while a decrease involves an outflow.

The figure that you arrive at after making all these adjustments to the PBT is termed as ‘cash generated from operations.’ 

All the taxes paid by the company are then subtracted from this figure to arrive at ‘net cash (used in) or generated in operating activities.’     

Cash flow from investing activities

This section of the cash flow statement of a company consists of all the cash received and used by the company with respect to its investments. Since purchases of investments involve an outflow of cash and their sales involve an inflow of cash, both these kinds of transactions are netted off to arrive at the ‘net cash (used in) or generated from investing activities.’

Also, the ‘dividend income’ that was subtracted from the PBT in ‘cash flow from operating activities’ section will be featured here. Here’s a snapshot of the ‘cash flow from investing activities’ section of HUL’s cash flow statement.   

Cash flow from financing activities 

This section consists of all the cash sources and the cash payments with respect to capital financing activities of a company. Dividend payments to the shareholders and loan interest payments constitute an outflow of cash. Any new loans taken by the company and the proceeds from issue of shares constitute a cash inflow. 

Both inflows and outflows are netted off to arrive at the ‘net cash (used in) or generated from financing activities.’ In the case of HUL, there has been only outflows of cash from financing activities, as shown in the snapshot below.   

The net increase (or decrease) in cash

The net increase (or decrease) in cash for the specified period is arrived at by adding the net cash inflow or outflow from all of these three major business activities of a company.  Once that is done, the cash and cash equivalents held by the company at the beginning of the year are added to arrive at the ‘cash and cash equivalents at the end of the year.’ 

Important financial numbers, ratios, and calculations

As an investor, to be able to analyse the cash flow statement of a company, you need to know the key cash flow ratios and numbers. Here are some of them. 

Operating cash flow ratio

The operating cash flow ratio determines a company’s ability to pay off all its current liabilities with the cash generated from its operating activities. A high operating cash flow ratio (greater than 1) is favourable, since it indicates that a company has generated more cash than its debt obligations. It can be calculated using the following formula. 

Operating cash flow ratio = cash flow from operating activities ÷ current liabilities

Let’s apply this ratio to HUL to find out the operating cash flow ratio of the company. 

Operating cash flow ratio of HUL (for the year 2019-2020) = 0.802 

(Rs. 7,305 crores ÷ Rs. 9,104 crores)

An operating cash flow ratio of 0.802 signifies that HUL hasn’t generated enough revenue to cover all of its current liabilities.  

Cash flow margin ratio

The cash flow margin ratio establishes a relationship between the operating cash flow and sales. The ratio is expressed as a percentage, and it determines the percentage of sales that’s converted into cash. A high cash flow margin ratio indicates that a company is efficient when it comes to converting sales to cash. 

The ratio can be calculated using the following formula.

Cash flow margin ratio = (cash flow from operating activities ÷ sales revenue) x 100

By applying this formula to HUL, we get the following.

Cash flow margin ratio of HUL (for the year 2019-2020) = 19.08% 

(Rs. 7,305 crores ÷ Rs. 38,273 crores) x 100 

This effectively means that HUL converts around 19.08% of its sales to cash. 

Cash flow coverage ratio 

The cash flow coverage ratio is a liquidity indicator that determines the ability of a company to pay its debt obligations when they’re due. A high cash flow coverage ratio (greater than 1) is generally preferable since it means that the company is capable of paying off all of its debts using the cash generated by it. 

The ratio can be calculated using this formula. 

Cash flow coverage ratio = cash flow from operating activities ÷ total debt 

Here, total debt is the same as total liabilities. In the case of Hindustan Unilever Limited, the cash flow coverage ratio is as follows. 

Cash flow coverage ratio of HUL (for the year 2019-2020) = 0.63 

(Rs. 7,305 crores ÷ Rs. 11,571 crores) 

External financing index ratio

The external financing index ratio determines just how dependent a company is on the cash flow from financing activities. A lower external financing index ratio (preferably negative) is favourable since it indicates that the company is less reliant on debt and external financing. The ratio can be calculated as follows.

External financing index ratio = cash flow from financing activities ÷ cash flow from operating activities

With respect to HUL, the external financing index ratio for the current year is as follows. 

External financing index ratio of HUL (for the year 2019-2020) = -0.914 

(-Rs. 6,676 crores ÷ Rs. 7,305 crores)

The negative external financing index ratio essentially means that HUL is non-reliant on external financing, which is a good sign.   

Wrapping up

So, that’s how you read and analyse a cash flow statement. But what do you do after reading and dissecting all of these numbers? That’s what advanced fundamental analysis deals with. And that’s exactly what we’ll look at in the last chapter of this module. Keep reading to find out more. 

A quick recap 

  • A cash flow statement helps you analyse and determine a company’s cash position for a specific period. Also, it helps you determine whether a company is liquid enough to handle financial emergencies or immediate debt obligations. 
  • It is split into three primary sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities.
  • To calculate the cash flow from operating activities, the profit before tax (PBT) of a company is used. Several adjustments by way of additions and subtractions are made to the PBT to make it accurately reflect the cash position of a company. 
  • Adjustments are made for non-cash items, items accrued but not received, non-operating items and for changes in working capital. 
  • Cash flow from investing activities consists of all the cash received and used by a company with respect to its investments. Since purchases of investments involve an outflow of cash and their sales involve an inflow of cash, both these kinds of transactions are netted off to arrive at the ‘net cash (used in) or generated from investing activities.’
  • Cash flow from financing activities consists of all the cash sources and the cash payments with respect to capital financing activities of a company. Dividend payments to the shareholders and loan interest payments constitute an outflow of cash. Any new loans taken by the company and the proceeds from issue of shares constitute a cash inflow.
  • The net increase (or decrease) in cash for the specified period is arrived at by adding the net cash inflow or outflow from all of these three major business activities of a company. 
  • Once that is done, the cash and cash equivalents held by the company at the beginning of the year are added to arrive at the ‘cash and cash equivalents at the end of the year.’ 
  • Operating cash flow ratio = cash flow from operating activities ÷ current liabilities
  • Cash flow margin ratio = (cash flow from operating activities ÷ sales revenue) x 100
  • Cash flow coverage ratio = cash flow from operating activities ÷ total debt 
  • External financing index ratio = cash flow from financing activities ÷ cash flow from operating activities
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