Cash flows

In my previous post, I explained extensively about the Balance Sheet in terms of the definition of each element in the Balance Sheet and how these elements are connected by using café operation as an illustration. If you are still confused on the Income Statement and the Balance Sheet, I strongly suggest that you read back my previous posts on Income Statement and the Balance Sheet. In this post I will be explaining the third and final key Financial Statement (i.e. Cash Flow Statement). Let’s begin.

If you remember about my very first article on the “Anatomy of Financial Statement: Overview”, I explained the 2 key accounting concepts that you need to know as far as reading the Financial Statement is concerned (i.e. Prudence Concept and Accrual Accounting) and also its implication whereby the Income Statement does not reflect the real cash movement within the business. As a result, the revenue and profit generated by a company does not imply that it has generated such amount of cash. For example, you may be incurring an expense when you purchase an iPhone but that does not mean that you’ve paid for it if you purchase it on credit. There is no real cash moving out from your savings account until you make the payment to your credit card company.

That’s why Cash Flow Statement comes in handy as it shows you a summary of the cash movement within a company. I’ve mentioned in my very first post that there are 3 sections in a Cash Flow Statement, let’s examine each of them:

Financial statement-Financial statement

A) Operating Cash Flow

As mentioned in my first post, operating cash flows is the cash movement in relation to running the day-to-day operation of the business. In a café operation, this means any cash movements from the time you purchase your inventories (i.e. raw materials) to the time where you use the inventories to produce your finished goods and selling it to your customers on daily basis.

CF - Overview-CF - Overview

There are 3 areas under the operating cash flow category that you need know:

#1: Adjustments to Profit before tax (“PBT”)

The Cash Flow Statement starts with Profit before Tax (“PBT”) and then there will be a list of income and expenses that needs to be adjusted in order to derive the cash generated from the business operation. Below is an extract of Padini Corporation Berhad’s Cash Flow Statement to illustrate what I mean:

cashflow Ops-Cashflow

These adjustments are mainly for non-cash items as you remember I mentioned that not all items in the Income Statement reflects the real cash movements. For example, expenses such as depreciation of machinery is added back to the PBT because there are no cash outflow here but simply a reduction of machinery’s value due to wear and tear.

income statement-income statement

In the case of café operation, the adjustment would be the depreciation and maybe tax expenses assuming you pay your tax the year after you filed your tax assessments to Inland Revenue Board.

#2: Working capital changes

Working capital refers to the cash used for its day-to-day operation. This means the cash used to replenish your inventories, the cash received from your receivables and the cash used for payables often it is the cash paid to suppliers for replenishing your inventories.

Working Capital-Working Capital

Inventories

So any increase in inventories against previous year balance, it simply means there is a cash outflow because you bought more inventories. Let’s assume in café operation, as of year ended 2017 there is an inventory balance of RM25,000 while in the year ended 2016, the inventory balance stood at RM36,000. As such, there is a decrease in inventory by RM11,000. Is this a cash inflow or outflow? The answer would be an inflow because you sold more inventories.

Receivables

Similar to inventories, assuming in year ended 2017 your receivables stood at RM20,000 while in year ended 2016 your receivables is only RM5,000. This would imply an increase of RM15,000 in receivables. This is a cash outflow since you are selling your product but not receiving any cash from customers yet.

Payables

This is the same as inventories and receivables, only this time any decrease in payables would mean cash outflow because cash is paid to the suppliers. In café operation, let’s assume in year ended 2017 there is a balance payable of RM15,000 while in year ended 2016 you have payables of RM5,000. This would mean there is an increase of RM10,000 implying that it is a cash inflow because no cash is paid to suppliers.

I think you are starting to get the picture here that most of the items in the Cash Flow Statement is really just the difference between last year’s balance sheet items and this year’s balance sheet items.

#3: Interest and tax paid

Sometimes you will see this interest and tax paid in the Cash Flow Statement. This is the actual cash paid by the company in relation to the bank borrowings and tax expenses incurred.

B) Investing Cash Flow

Investing CF-Investing CF

As the name suggests, any cash used for investments are classify under this category. This includes capital expenditure into the business such as the purchase of coffee machines, tables and chairs in the case of café operation example. This section is where you’ll know whether a company is capital intensive or not. For the sake of illustration, let’s assume you purchase the coffee machines, tables and chairs for a total amount of RM20,000 in cash. This would be the cash outflow.

C) Financing Cash Flow

Financing CF-Financing CF

This section relates to the financing of the business. In other words, how the assets and day-to-day operation of the business is being funded. As mentioned in my previous post, the assets and the business operation can be funded either through issuance of shares (“Equity”) or bank borrowings (“Liabilities”).

For illustration purpose, let’s assume you issued new shares worth RM5,000 to shareholders and you raised another RM15,000 through bank borrowings for your café operation. In addition, you also have a finance lease of RM7,000 in relation to the purchase of coffee machines.

Combining it all together

So if you combine all the above elements together, the Cash Flow Statement would look as following:

cashflow statement-detailed cashflow statement

Looking at the above Cash Flow Statement, you’ll notice that the café operation is actually generating a positive cash inflow of RM28,000 from its day-to-day operation (see “Net Cash Flows from Operation”). It also incurred capital expenditure of RM20,000 (see “Net Cash Flows used in Investing Activities”). However, do not get the wrong idea that the “Net Cash Flows used in Investing Activities” is the capital expenditure. Most of the time only purchase of non-current assets are known as capital expenditure (“CAPEX”). See the below extract of Padini’s Cash Flow Statement:

cashflow operating activities-cashflow

For Padini, its CAPEX is only on the purchase of intangible assets and property, plant and equipment.

One final thing that you should know is the “Cash and Cash Equivalents at the end of the period” of RM40,000 will always matched with the cash that the business have under its Balance Sheet:

cashflow links to balance sheet-cashflow links to balance sheet

The Cash Flow Statement shows the cash movement during the year while the “cash at bank” under the Balance Sheet shows the figure as at the end of a specific period. In other words, the Cash Flow Statement gives you a clear picture of how a company spend its cash until the cash balance remains at RM40,000.

MY INSIGHTS

So the next time when you see a company that consistently generates increasing net profit for the past few years, you must look at the Cash Flow Statement to ensure whether there are cash coming into the business as well. As a Rule-of-Thumb, you do not want to invest in companies that keep spending the cash raised but do not generate cash flows. I hope you learn something new about the 3 key Financial Statements.

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