With passage of time for many of us Cash Flows Statement has become just a component of Financial Statements that need to be prepared or verified. However in the recent times, with advent of COVID-19 pandemic around the globe Cash Flows Statement along with other components of financial statement is becoming extremely important for prospective investors, bankers , auditors and all other stakeholders.
In the Indian context preparation of Cash Flows Statement is governed by IND AS-7 for companies who have adopted IND-AS and for other entities AS-3.
Cash Flows Statement (CFS) or Statement of Cash Flows helps us to understand cash flows in an organisation. CFS bifurcates movement of cash flows in three broad categories viz Operating Activities , Investing Activities and Financing Activities. Profits or losses depicted by Statement of Profit & Loss may or may not be realised in Cash , this is the reason we see many well performing organisations having huge profits are unable to meet their loan obligations and ultimately default.
According to famous Management consultant Peter F. Drucker
“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”
Operating Activities: As per IND-AS 7 “Cash flows from operating activities are primarily derived from the principal revenue producing activities of the entity“
In Simple terms , whatever an organisation earns purely from its business activities can be termed as operating activities.
For example- For an IT Company , consultancy & development of software can be termed as operating activity.
What constitutes operating activities differ from business to business.
Investing Activities: As per IND-AS 7 “The cash flows represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Only expenditures that result in a recognized asset in the balance sheet are eligible for classification as investing activities”
In other words , whatever a business invests today to generate future income or for growth or for expansion or for replacement of existing resources with new one can be termed as investing activities.
For example- Investment in Plant & Machinery , replacement of obsolete plant and machinery etc. can be categorised under investing activities.
Financing Activities: As per IND AS-7 “Activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.”
In other words whatever a business borrows , repays or raise capital and their related payments (like interest , dividend etc) to manage Operating and Investing activities can be termed as financing activities.
For example- Repayment of loans , Borrowings from banks , Issue of Debentures , Equity shares etc.
Cash and cash equivalents: As per IND AS-7 “Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.”
For example- Fixed Deposits.
Cash Flows Statement can be prepared using Direct Method or Indirect method. However in Indian Context , organisations follow Indirect method.
Let’s take a illustration to understand Cash Flow Statement in a better way:
|Profit & Loss|
|Particulars||Amount CY||Particulars||Amount CY|
|Direct Expenses (Paid)||125.00|
|Gross Profit||475.00||Closing Stock||800.00|
|(Due & Paid -45 )|
|Admin & Selling||5.00|
*Profit & Loss Statement is prepared in T Format for ease of understanding.
As we can see Profit Depicted by Profit & Loss account is Rs.245. Now let’s assume entity purchased plant & machinery worth Rs 1000.
Let’s see how Cash Flows Statement will look like
* Here Cash Flows Statement is prepared using direct method for ease of understanding:
|CASH FLOWS STATEMENT|
|Admin & Selling||-5.00|
|Cash Flows from Operating Activities||445.00|
|Purchase Plant & Machinery||-1,000.00|
|Cash Invested in Investing Activities||-1,000.00|
|Issue of Equity Shares||100.00|
|Borrowings from Bank||500.00|
|Cash Flows from Financing Activities||555.00|
|Net Cash Flows||–|
From above we can see that Cash generated from operating activities of business is Rs 445 as compared to Profit of Rs.245 as depicted in Profit & Loss. To finance its investing activities entity used cash of Rs.445 generated from operating activities and remaining amount was borrowed through financing activities.By analysing above Cash Flows a prudent person can say that an entity is running smoothly and is generating enough amount of cash from operating activities.
Initial Stage:Generally, In the start we may see losses also in the Profit & Loss of the entities which require heavy initial investments in assets because Depreciation will be debited in P&L without actual cash outflow with negligible revenue. Hence initially what is important is to check whether entity is able to realize cash from its operating activities.
Growth Stage:In the growth stage , Profit & loss of entities may show profits depending upon company’s ability to generate revenue, in this stage it is important to check what steps entity is taking to continue growth which can be checked through investing activities and financing activities.
Generally replacement of obsolete assets with new ones , repayment of loans with cash available , raising equity for expansion or diversification can be considered to be a sign that entity is in growth stage.
Declining Stage: Consistent positive Cash Flows from Investing Activities and negative cash flows from operating activities depict that entity is selling its assets to run business and to pay financing activities. However the same is required to be carefully analysed by going through the other information available in Financial Statements & in Public Domain.
Cash Flows Statement can give a real picture of an entity , a entity may manage its Profits through various means but cash flows cannot be window dressed to a great extent. Further it is not necessary that an entity having millions or billions of turnover will always succeed if it cannot realize its revenue in cash , much of which depends upon ability & excellence of its management and its policies.
In these hard times when every organisation barring few exceptions is facing huge challenge in running & sustaining their businesses Cash Flows Statement can be a Powerful Tool. Cash Flows of an entity of current year compared with last year can provide useful insights about entity’s performance , however Cash Flows alone cannot help to form a judgement , they need to be read and analysed along with other information.