InvestorQ : Can you throw some light on the components of the cash flow statement? How to interpret the various types of cash flows?
Riya Dwivedi made post

Can you throw some light on the components of the cash flow statement? How to interpret the various types of cash flows?

rhea Babu answered.
3 years ago

There are three parts of the cash flow statement that you need to understand. Here is a quick take on each of them.

How to interpret Cash Flow from Operations

The Cash Flow from Operations is critical as it tells you the actual cash flows that are generated from your core operations. For example what is the cash flow generated from the steel business for a steel company? There are two important aspects of this component. Firstly, since it excludes the impact of extraordinary and non-core items, it gives a clear view of the performance of the core business. Secondly, as it ignores non-cash charges like depreciation, it measures actual cash generated rather than the income statement number, which is more of accounting standards compliance. A good business wants to see its cash flows from operations grow steadily so that its future expansion and inorganic growth plans can be financed through its core operating cash flows.

How to interpret cash flow from investing activities

When we talk in terms of manufacturing companies, investment refers to investments in the core business assets only. Therefore investment in plant and machinery, expansion of capacity, diversification, and inorganic acquisitions will all be part of the company’s investment activities. All these will be investing outflows. On the other hand sale of fixed assets, sale of business lines or sale of subsidiaries will all be categorized as inflows from the investment activity. Normally, a healthy company will have negative investment flows because any growing company will have to focus on growing by expanding its assets rather than by selling its assets. For typical software companies, there is very limited by way of investment outflows. Hence most of their positive operating cash flows go directly into enhancing their cash balances. Remember, most of these companies are also zero debt companies. That explains why Indian IT companies sit on such huge cash balances.

How to interpret cash flows from financing activities?

This segment refers to how the cash flows pertaining to your long term capital providers are structured. For example, issue of fresh shares, rights issue to existing shareholders, raising of debt through long term loans will all constitute inflows from financing activities. On the other hand buyback of shares, payment of dividends to shareholders and repayment of long term loans will all be classified as outflows from financing activities.

The combination of these 3 components is all about gauging your actual cash on hand. What it tries to understand is how the 3 components are interacting. How are the capital investments of the company being financed? The most preferred situation is when the capital expenditure is financed either entirely or substantially through operating cash flows. That will reduce the pressure on raising money through financing and leave greater room for rewarding shareholders with higher dividends. Cash flows, effectively, force the company to reveal a true and credible picture of the company’s financial health!