The Use of Cash Flow Statements

Description: The case presents the cash flow statements of three companies drawn from
India and the U.S.
Learning Objective: To introduce analysis of cash flow statements.
Subjects Covered: Cash flow, financial reporting, financial analysis, security analysis

ThisJohn
case Mathew,
was prepared
by Prof
Vishwanath
S R andatPallavi
Goyal
(PGDM
08) of
Institute
a student
of the
MBA program
a premier
business
school,
had
joined of
a
Management
Technology,
India
for the
purpose
ofassigned
aiding classroom
discussion.
are
Bank as an
intern in the
summer
ofsole
2006.
He was
the task of
preparingCases
research
not reports
intendedontosome
servesteel
as endorsements,
or sources
data,
or illustrations
of effective
or
firms with whom
the bankofhad
a relationship.
As part
of a weekineffective
management.
long training in the analysis of financial statements he was provided the cash flow
statements of three companies (whose identities were disguised) and was asked to
comment on their financial performance.

123

In his eagerness to get the analysis right, John Mathew called Anwar Ali, a finance
professor at his business school, to ask if he could spend some time with him to guide
him. They agreed to meet over that evening.
The conversation
John Mathew went to see Anwar Ali that evening at 4 PM. Because of an undergraduate
degree in Engineering, John Mathew was not sure if he was particularly good at financial
statement analysis, which he thought came naturally to those with commerce and
accounting backgrounds. After asking a few questions about how John Mathew had fared
in the first year accounting and finance courses in the MBA program, Anwar Ali handed
over the cash flow statements of three companies drawn from India and the US and
started explaining.
Anwar Ali: A cash flow statement tries to explain the change in cash position between
two balance sheet dates. Thus, an increase in plant and machinery will be recorded as a
use in funds flow statement but may not be recorded in cash flow statement if it does not
involve a cash outlay during the period. In short, non cash transactions do not enter the
cash flow statement. The net cash flow is simply the net of all inflows and outflows
during the period. The cash flow statement is helpful in a number of situations where
cash flows are important. These include:

Analysis of credit proposals

Firms need for external financing and the use of its long term debt.
Firms ability to meet current and long term cash obligations
Ability of the firms operations to generate cash.

Thus,
Cash balance at the beginning of the year + net cash flow during the year = cash balance
at the end of the year.
John Mathew: Why focus on a cash flow statement?
Anwar Ali: Net income reported on the income statement provides an important measure
of performance. However, in the absence of cash flow, income does not pay the bills.
Interest and dividend payments, required principal reductions on debt, and capital
expenditures for plant and equipment and for expansion cannot be made without cash.
Cash provided by operating activities, also known as, operating cash flow, is a primary
source of cash to meet these needs. In the absence of operating cash flow, cash from other
sources can be used to cover cash requirements. For example, cash can be obtained by
new debt or equity issues or non recurring asset sales. These non operating cash flows
can be relied upon only in the short run. In the long run, operating cash flow is the only
reliable source of cash available to meet recurring needs.

124

Indeed, the cash flow statement provides more information than the balance sheet or the
income statement. It can help unearth valuable information relating operating, investing
and financing activities of the firm.
John Mathew: How is cash flow statement presented?
Anwar Ali: Items on the cash flow statement come from two sources: 1) income
statement items and 2) changes in balance sheet accounts. It is useful to classify cash
flows on the basis of activities. The standard practice for preparing the cash flow
statement is to classify activities into operating, investing and financing activities and
record cash flow under each heading.
+
+
+

Cash Flow from operations

Cash flow from Investment activities.
Cash Flow from financing activities
Net effect of exchange rate changes on cash

Net increase (decrease) in cash

Operating activities are related to the firms ongoing ability to generate cash from
operations. This includes information on cash receipts from customers for sales and
service, cash payments related to vendors, employees, taxes and interest. The net of all
these gives cash flow from operations.
Investment activities relate to change in non current assets. This includes information on
capital expenditure to acquire fixed assets and proceeds from sale of non current assets.
Only cash transactions get reflected. Cash flows from investing activities are cash flows
associated with purchases and sales of non current assets such as building and equipment
etc. The section also contains purchase and sale of short-term investments
Financing activities relate to changes in borrowings and owners equity. This includes
information on cash proceeds from issuing equity and short term and long term debt, and
cash outflow due to repurchase of shares. Dividend payment is also a financing activity.
Cash flows from financing activities include issuance and repayment of debt, issuance of
common stock, and payment of dividends. Interest on debt, however, is clubbed under
cash from operating activities. Key elements include:

Cash dividends paid

Increases or decreases in short-term borrowings
Long term borrowings and repayments
Stock sales and repurchases

John Mathew: What type of analysis can be done with cash flow statements? How do
we interpret the statement?

125

Anwar Ali: The cash flow pattern depends on the nature of business and the life cycle of
the company. Start up companies in high growth industries will have negative cash flow
because of high capital expenditure in relation to the level of earnings. The gap is to be
met by selling debt or equity. Established growth companies can meet their investment
requirements from internally generated funds. Mature companies will have modest
capital expenditure requirements. Their cash flow from Operations will be slightly more
than the reinvestments. Those firms in the declining phase will have surplus cash from
operations which could be returned to shareholders, pay off debt or revitalize product
lines. Turnarounds are characterized by cash inflows due to freeing up of assets and
income statement losses. Thus the cash flow pattern indicates the position of a company
in its business life cycle and the nature of its model. To start with, cash flow from
operations should be positive and growing.
Secondly, see whether the company is investing to grow i.e. whether investments are
more than depreciation. Healthy companies typically purchase more assets than they sell.
So cash flow from investing will usually be negative. To judge whether a company is
doing well or not one must use evidence from all pieces and put them together.
An analyst can prepare a checklist of major sources and uses as well as trends in cash
flow from operations, net income, dividend, and working capital accounts.
In evaluating the cash flow statement, you are evaluating many pieces of evidence to
produce an overall picture.
The best way to learn the analysis is to actually go through the statements of actual
companies. I have written out some questions to guide your analysis. You can apply this
framework to all the three companies. Meet me tomorrow with your analysis. After this
exercise you will be capable of handling your assignment at the bank.
John Mathew: Thank you.
Assignment Questions
Exhibits 1, 2 and 3 contains the cash flow statements of three companies drawn from
India and the U.S. After examining the cash flows of each company for three years,
answer the following questions for each company every year.

126

What were the major sources and uses of cash?

Compare cash flow from operations with net income and reconcile the difference
Was the firm able to cover capital expenditure with CFO? Similarly, compare
CFO with Capital expenditure and dividends
Did the firm invest the excess cash?
Examine the working capital accounts and check whether they are sources or uses
of cash

What are the other major items affecting cash flow?

Comment on the trends in:
Net Income
CFO
Capital expenditure
Dividends
Borrowing
Working Capital Management

What is your overall assessment of the financial position of the company?

Exhibit 1: Company J Statement of cash flows (in Rs Lac) for 2006, 2005 and 2004
A

127

Cash flow from operating activities

Net Profit Before Taxes
Adjustments for:
Depreciation/Amortization & stock obsolescence
(Profit)/Loss on sale of fixed assets (Net)
(Profit)/Loss on sale of investments/dividend on investment

72,226

58,213

17814

42,589
-27,037
-5,253

47,527
345
-1,380

53310
-3859
-408

Interest Expense
Interest on bank & other deposits
Excess Provision no longer required
Provision for doubtful debts no longer required
Provision for leave encashment and gratuity
Exchange difference on translation (Net)
Provision for doubtful debts
Bad debts written off
Inventory scrapped during the year
Operating Profit Before working capital changes
Changes in inventories
Changes in sundry debtors
Changes in loans and advances
Changes in liabilities and provisions
Cash generated from operations
Income tax refunded/paid
wealth tax paid
Net Cash from operating activities
Cash flow from investing activities
Capital Expenditure- aircraft and others
Proceeds from sale of fixed assets
Purchase of investments
Changes in fixed deposits with banks
Interest received on bank and other deposits
Deposit in escrow account
Advance paid as per share purchase agreement
Sale of investments
Dividend received
Net Cash used for investing activities
Cash flow from financing activities
Proceeds from issue of Share Capital
Preference share repayment
Premium on redemption of Preference shares
Share issue expenses paid
Increase/(Decrease) in Term loans and subordinated debt
Interest Paid
Dividend paid (including tax on dividend)
Net Cash from financing activities
Net Change in Cash (A+B+C)
Cash and cash equivalents at beginning of the year
Cash and cash equivalents at end of the year

24,160
-5,542
-4,101
-20
2,627
-1,468
247
14
2,325
100,767
-11,546
-18,427
-26,513
29,863
74,144
-13,392
-4
60748

25,369
-3,064
-1,882
-6
735
-822
281
NA
3,446
128,762
-3781
-1,272
-853
17,317
140,173
-4,666
-3
135,504

28,914
NA
-54
NA
474
-1610
90
NA
1899
96,572
-4389
-1780
6737
-1148
105,477
93
-3
105567

-279457
46,282
-545424
34549
5367
150000
-50000
691527
NA
-247156

9871
52
-508116
35917
2596
NA
NA
372985
280
-177992

-23669
8637
-291047
273913
171

NA
NA
NA
NA
191738
-30005
-2950
158783
-27625
50401
22776

156696
-6983
-5852
-2103
-27558
-22668
NA
91533
49045
1356
50401

-31995

-46775
-30290
-77065
-3492
4848
1356

Exhibit 2: Company I Statement of cash flows (Rs crore1)

A

Cash flows from operating activities

Net Profit before tax and exceptional item

2006

2005

2004

2724

2184

1470

Currency units are usually quoted in crores and lakhs rather than millions in India. INR 1 Lakh = INR
100,000. INR 1 crore = INR 10 million. The cash flow statements are from CMIE Prowess and the
respective companies

128

Adjustments to reconcile
net profit before tax to cash provided by operating activities:
(Profit)/Loss on sale of fixed assets
Depreciation and amortization
Interest and dividend income
Provision for investments
Effect of exchange differences on
translation of foreign currency cash and cash equivalents
Changes in current assets and liabilities
Sundry debtors
Loans and advances
Current liabilities and provisions
Income taxes paid
Net cash generated by operating activities
Cash flows from investing activities
Purchase of fixed assets and change in capital work in progress
Proceeds on disposal of fixed assets
Investment in subsidiaries
Investments in securities
Interest and dividend income
Cash flow from investing activities before exceptional items
Income from sale of investment in Yantra Corporation
Less: Tax on the above
Net income from sale of investment in Yantra corporation
Cash Used in Investing Activities
Cash flows from Financing Activities
Proceeds from issuance of share capital on exercise of stock options
Dividends paid during the year
Dividend tax paid during the year
Net cash used in financing activities
Effect of exchange differences in
translation of foreign currency cash and cash equivalents
Net (decrease)/increase in cash and cash equivalents
Cash and Cash equivalents at the beginning of the year
Cash and equivalents at the end of the year

NA
409
-203
NA
-7

1
268
-109
NA
-4

-0.04
230.9
-100.28
9.67
6.59

-265
-94
221
-548
2237

-621
-110
33
-283
1359

-120.37
-1.34
245.5
-107.13
1633

-1048
NA
-31
484
203
-392
NA
NA
NA
-392

-794
1
-63
-238
109
-985
49
4
45
-940

-429
1.43
-83.49
-920.36
100.28
-1332
NA
NA
NA
-1332

646
-352
-50
244
7

441
-903
-118
-580
4

122.27
-192.14
-24.61
-94.48
-6.59

2096
1683
3779

-157
1840
1683

200.89
1638.51
1839.4

Exhibit 3: Company C Statement of cash flows ($m)

A

129

Cash flow from operating activities

Net Income
Depreciation/Depletion
Deferred Taxes
Accounting Change
Discontinued Operations
Unusual Items
Equity in Net earnings/loss

2005

2004

2003

-9939
585
-610
0
19
4245
13

-242
760
-226
0
-28
-352
40

282
833
150
-181
-25
-285
65

130

Other non cash items

Non cash items
Cash taxes paid, supplemental
Cash interest paid, Suppl
Accounts receivable
Other assets
Payables/Accrued
Changes in working capital
Total cash from operations
Cash flow from investing activities
Capital Expenditures
Acqisition of business
Sale of Business
Sale of fixed assets
Sale/maturity of investment
Investment, Net
Other investing cash flow
Other investment cash flow items, net
Total Cash from Investing
Cash flow from financing activities
Financing cash flow items
Issuance (retirement) of stock, net
Short Term Debt, Net
Long Term Debt Issued
Long Term Debt Reduction
Long Term debt, Net
Issuance (retirement) of debt, Net
Total cash from financing
Foreign Exchange effects
Net change in cash
Net cash-beginning balance/reserved for future use
Net cash-End Balance/Reserved for future use
Depreciation supplemental
Cash interest paid, suppl
Cash taxes paid, suppl

5153
9429
26
1316
-42
-117
-111
-330
-690

96
-245
23
939
-99
-214
232
-138
-19

136
-289
18
463
-221
-304
-112
-610
266

-774
0
0
2066
37
133
-544
1691
917

-1545
-188
85
1066
0
94
86
1144
-401

-1886
-7
0
207
0
0
-829
-629
-2515

-585
0
-173
1664
-1066
598
425
-160
0
68
718
786
760
1316
26

-456
0
-154
4611
-4712
778
623
167
16
-237
955
718
833
939
23

-153
16
-96
2199
-3234
2857
2761
2624
13
387
567
955
732
463
18