Positive cash flow crucial to survival of a company

Oct 23 2013, 18:11 IST
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This is most common for companies that are growing at a faster phase. Reuters This is most common for companies that are growing at a faster phase. Reuters
SummaryCash flow is an important indicator of a company's financial health.

Cash flow is an important indicator of a company's financial health. Even companies reporting profits may not survive in the long run without a positive cash flow. Of course, profits are incredibly important but cash flow is even more crucial.

It is possible for companies to report profit, but, at the same time, run out of cash. This is most common for companies that are growing at a faster phase. A cash-flow statement can tell us if this is happening. For any business, cash can come from both internal and external sources, and the cash-flow statement helps investors to separate and observe the differences and magnitude of the inflows and outflows.

A cash-flow statement is also known as “where got and where gone” statement. It is a statement that helps investors to know the sources from where the company got the cash and where that cash is being used during a period of a year. As the cash-flow statement is part and parcel of the annual statement of accounts, it is essential to understand it for informed decision-making.

Basically, cash flow statement shows how much the opening balance of cash, bank and cash equivalents is and how the cash is generated from various activities of the company and ends with the closing balance of cash, bank and cash equivalents. The statement of cash flows consists of three sections: cash flows from operating activities; cash flows from investing activities; cash flows from financing activities. Let us see each component in detail.

Cash flow from operating activities

This part of the cash-flow statement reports a company's cash flows from its core business operations, which it uses to reinvest in and grow its business. Items such as cash sales, collection from customers, payment to suppliers, selling, distribution and general expenses all come under operating activities of a company. Measuring the changes in cash flows from operations requires computation of the changes in account balances in the balance sheet between two accounting periods.

For instance, depreciation expense does not actually involve any cash outflow. So, depreciation expense for the period is added back to net income. In the same manner, changes in accounts receivable and stocks may either be added to the net income or subtracted from it, depending on whether the accounts increased or decreased. An increase in accounts receivable would be deducted from net income because while sales were recorded, cash was not yet received.

The changes in all of the operating accounts between two periods will be computed and listed accordingly on the statement of cash flows to arrive at a net cash flow from operating activities. A steady positive operating cash flow generally indicates that the company is healthy.

Cash flow from investing activities

This section of the cash-flow statement recognises the changes in equipment, assets or investments. Disposal of fixed assets is considered as cash inflow, while purchasing a fixed or short-term assets such as marketable securities is considered cash outflows.

Investing activities indicate the extent to which a company has spent on resources that generate future income and cash flows. Growing companies typically has negative net cash flow from investment activities, which occurs because it buys more assets than it sells. Growth-oriented companies regularly invest in new assets to expand their capacity, replace old equipment and keep up with new technology. A negative cash flow from investing activities generally indicates that the company is growth oriented.

Cash flow from financing activities

This section reflects cash flows from issuing and paying off outside financing, such as equity, debt, and paying dividends.

Issuing stock or increasing long-term borrowing is a cash inflow whereas paying dividends or reducing debt is a cash outflow. Generally, healthy companies report more often negative net cash flow from financing activities. A negative cash flow from financing activities suggests that the business is using its cash flow from operating activities to pay dividends and pay off its outside financing. A positive net cash flow from financing activities indicates the the company raises money from investors and creditors to finance its growth.

A cash-flow statement can be used by different users for a variety of objectives. Prospective investors can use the statement to determine whether the company has adequate cash to expand operations and pay dividends. The company can use the information in the cash-flow statement to measure the efficiency of operations.

* The writer is associate professor in finance & accounting in IIM Shillong

‘Where got and where gone’ statement

Cash-flow statement is a statement that helps investors to know the sources from where a company got the cash and where that cash is being used during a particular year. The statement of cash flows consists of three sections:

* Cash flow from operating activities: A steady positive operating cash flow indicates that the company is healthy

* Cash flow from investing activities: A negative cash flow from investing activities generally indicates that the company is growth oriented

* Cash flow from financing activities : A positive net cash flow from financing activities indicates the the company raises money from investors and creditors to finance its growth

* Prospective investors can use the cash-flow statement to determine whether the company has adequate cash to expand operations and pay dividends

* The company can use the information in the cash-flow statement to measure the efficiency of operations

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