During the last couple of years, therefore, there has been an increased focus on cash flows to assess business performance. A cash flow statement, when used with other financial statements, provides conclusions about the performance of a company and its investment patterns. It shows the debt capacity and cash generation patterns of the company..
Accounting principles have given considerable flexibility in the recognition of income, expenditure and profits. This gives to the managers an opportunity to bias the recognition of profits to suit their requirements. Even the audit process has not been able to control it. Cash flows, on the other hand, are less prone to the accounting manipulation.
It is useful to look at the cash flows from their generation point of view. Such information would make the companys working more transparent.
Operating activity: This part of the exercise shows whether the company has generated sufficient cash flows after meeting its operating expenses, and whether it is able to meet its repayment obligations, dividend outflows and future investment.
Investment activity: It represents expenditure that has been made on acquisition of assets which are intended to generate future income. It shows cash paid for assets whether outsourced or self constructed, and cash raised from sale of assets.
Financing activity: This part helps in predicting the claims on future cash flows by providers of capital.
Taxation: Due to grace period available for payment of taxes, it may be shown separately or along with operating flows.
Properly constructed cash flows will show the cash surplus or deficit arising from business activities adjusted for payments made to providers of finance. The operating cash flow is generally utilised to reinvest in the net working capital and fixed assets. The funds available after this and payment of taxes also known as the free cash flow is used to pay for the providers of funds first by way of interest and then in the form of dividends.
It is important to note that free cash flow is a key figure, and for a business that is not growing it must generate sufficient cash at this level. This is necessary not only to meet the service charges of the financiers but also to meet the repayment obligations. For a business that is at the growth stage, this figure is often found to be negative as new capital is constantly being invested in assets that will generate higher level of operating cash flows in the future. On the other hand, firms which cross maturity stage and approach towards decline, tend to generate substantial amount of cash but have few profitable investment opportunities. Such firms should ideally distribute surplus cash to shareholders as higher dividends or by repurchasing its shares. But usually managers choose to make acquisitions or mergers. Such companies due to their surplus cash also become takeover targets.
Financial planning is not only forecasting but also an exercise in probabilities and planning for unlikely events. A manager planning for what could go wrong is likely to observe danger signals that others may miss. It is the firms most unbiased performance data no accountant can manipulate.
(The author is director finance with Industrial Meters Ltd. The views expressed here are his own.)
