During your studies or career, you may be asked to prepare a statement of cash flows and then comment on the statement and the entity’s cash position.
To do this, you should take each section and work through them one step at a time.
Cash from operating activities
This is the entity’s bread and butter, the operations, which should generate most of the revenue and expenses.
If you compare the cash flows from operating activities and the operating profits, they should be fairly similar.
- If the cash flows from operating activities is lower than the operating profit in the statement of comprehensive income, this could indicate a number of things:The company may be expanding, requiring more cash for inventory and for trade receivables. Compare the inventory and trade receivables balances to verify this.
- The company’s working capital management may be poor, this could create problems such as inventory obsolescence, increased bad debts and higher expenses for warehousing and insurance.
Cash flows from operating activities must be sufficient to cover its expenses, especially tax and interest.
Often businesses in financial difficulty will pay dividends to make shareholders believe everything is fine.
Remember, dividends are optional payments, the company can postpone them.
However, interest payments and tax payments must be paid, so look out to see if the entity has sufficient means to pay these.
The cash flows from operations should cover these payments.
Cash from investing activities
Cash flows from investing activities relate to the purchase and sale of non-current assets.
If we notice an outflow for these, it often indicates the purchase of new equipment which can be used to generate future revenue.
One thing to check, however is how the expenditure has been financed.
If the non-current assets are being purchased using the entity’s overdraft facilities, this may not be a good sign.
The company may run out of cash to facilitate its day to day trading.
Ideally it should match the source of finance with the type of asset it is purchasing, so long term, non-current assets should really be purchased with medium to long term loans.
Cash from financing activities
Take a look at how the entity is raising finance during the year, if any.
Did it sell additional equity shares?
If so, this could reduce the ownership percentage of the existing ordinary shareholders.
If it raises debt financing by obtaining bank loans, these require interest payments, can the entity afford those payments?
What does the entity require the additional finance for?
If it’s to fund expansion or increased revenue, this could be a good thing in the future.
However, if it’s to fund operating losses, this is prolonging the inevitable and may indicate the entity requires some form of restructuring or turnaround.
Cash balance movements
We sometimes automatically think an increase in cash inflows or a large cash on hand balance is a good thing.
This isn’t always the case.
Take a look at how the cash is being used, if it’s sitting in the bank account earning small interest, perhaps it could be used to repay a loan or invest in the business.
Otherwise, it could also be used to give a dividend to shareholders, who can decide what to do with the money themselves.
A decrease in cash may not always be a bad thing.
Take a look and see if it was being used to repay a loan or other borrowings.
It may also have been used to invest in future revenue generating opportunities.
Ensure the entity has enough cash on hand, or at least a sufficient overdraft limit to pay its current day to day bills and expenses.
Keep an eye on:
- Current liabilities
- Tax and interest payable
- Spending commitments
- Future expansion plans