Cash flow refers to the movement of money into and out of a business over a specific period, typically monthly, quarterly, or annually. It's crucial for assessing a company's financial health because it reflects its ability to generate cash to pay bills, reinvest in the business, and distribute dividends to shareholders. Cash flow is often divided into three categories:
Operating Cash Flow (OCF): This represents the cash generated or used by a company's normal business operations, such as revenue from sales and expenses like salaries, rent, and utilities. OCF = PAT - Trade Receivable + Trade Payable + Depreciation/Amortisation.
Investing Cash Flow: This reflects the cash flow resulting from investment activities, such as purchasing or selling assets like equipment, property, or investments in other companies.
Financing Cash Flow: This tracks cash flow related to financing activities, such as issuing or repurchasing stock, taking out or repaying loans, or paying dividends to shareholders.
Analyzing cash flow statements helps investors, creditors, and managers evaluate a company's ability to meet its financial obligations, fund future growth, and generate shareholder returns. Additionally, it can reveal trends in a company's operations, such as increasing efficiency or declining sales.
Cash flow statement are different from Profit and loss statement as profit/loss statement does not take into account actual flow of cash. It follows accrual basis of accounting and takes into account trade receivable and payable etc. Neither it tells an account of source of cash flow ( operations/ asset sale or purchase / loan or equity increase or decrease )
Let us understand by example.
Let's consider a fictional Indian manufacturing company named "Techtronics India Pvt. Ltd." Here's an example of how cash flow works for this company in Indian currency (INR):
Operating Cash Flow (OCF):
- Techtronics India Pvt. Ltd. sells electronic components worth ₹1,00,00,000.
- It incurs expenses totaling ₹60,00,000, including manufacturing costs, employee salaries, rent, and utilities.
- Its operating cash flow is ₹1,00,00,000 (revenue) - ₹60,00,000 (expenses) = ₹40,00,000.
Investing Cash Flow:
- Techtronics India Pvt. Ltd. invests ₹20,00,000 in new machinery and equipment to improve production capacity.
- It sells old equipment for ₹5,00,000.
- Its net investing cash flow is -₹20,00,000 (investment) + ₹5,00,000 (sale) = -₹15,00,000.
Financing Cash Flow:
- Techtronics India Pvt. Ltd. issues new shares worth ₹30,00,000 to raise capital for expansion.
- It repays ₹10,00,000 of its long-term debt.
- Its net financing cash flow is ₹30,00,000 (issuance) - ₹10,00,000 (repayment) = ₹20,00,000.
Now, let's calculate the overall cash flow:
- Total Cash Flow = Operating Cash Flow + Investing Cash Flow + Financing Cash Flow
- Total Cash Flow = ₹40,00,000 + (-₹15,00,000) + ₹20,00,000
- Total Cash Flow = ₹45,00,000
In this example:
- If the total cash flow is positive (₹45,00,000), it indicates that Techtronics India Pvt. Ltd. has generated more cash than it has spent, suggesting financial strength.
- If the total cash flow is negative, it would imply that the company is spending more cash than it is generating, potentially raising concerns about its financial viability.
This analysis helps stakeholders assess Techtronics India Pvt. Ltd.'s financial performance, investment decisions, and financing activities in the context of the Indian manufacturing sector.
Important points to remember
1. If a company is expanding it will have negative investing cash flow ( buy assets ) and positive financing cash flow ( more loan or equity ) . Need to see the balance or quality of asset development. Negative cash flow should not be unsustainable.
2. Cash flow positive or negative both can be good . Purpose is to see how cash is used . Company should regularly expand itself at a rational pace. It should enhance its operating cash flow to meet requirement of investing cash flows.
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