“Business runs on a cash basis, reported on accrual basis”
Many resources on financial accounting will start with the income statement (also known as profit and loss statement). But, as we discussed in the last post (link below) that for an entrepreneur, understanding cashflows is much more important than calculating profit.
Especially for a startup founder, a healthy profit and loss statement is what to strive for but business is managed based on cash-flows statement and the balance sheet (will be discussed in the next post).
WHAT DOES A CASH-FLOW STATEMENT SHOW?
A cash-flow statement shows you where the cash is coming from and where it is going. Cash coming into the companies account(s) is considered as positive cash flow and cash coming out of the business is considered as negative cash flow.
SOURCES OF CASH FLOWS
The cash-flow statement is divided into three parts based on sources of positive and negative cash flows. The sum of these three parts gives the aggregate change in the cash position of the company.
Note: I am going to avoid formulas here. For an entrepreneur, the challenge is to balance the cash flows, not calculating them.
1. Cashflow from Operating activities (CFO)
This part of the statement gives you an idea of whether your operations are generating cash or burning cash. For a startup, CFO is often negative and that is not a big concern as long as the company is building a strong foundation for sustainable operating cash flows in the future i.e. creating a loyal customer base and a competitive moat to defend the strategic position.
Revenue is a positive CFO whereas money spent to buy raw materials, pay salaries, pay for consumables and pay income tax payment are negative CFO.
2. Cash flow from investing activities (CFI)
So, what are the investments for a company? A company can invest in plant and machinery or buy securities of other companies (which can be as short term investment to acquisition of the company).
Acquisition of such long term assets means negative cash flow from investing activities i.e. negative CFI. A company may decide to divest some plants or machinery or sell securities of other companies. These divestitures will bring in cash and will be considered as positive CFI.
3. Cash flow from financing activities (CFF)
Buying plants and machinery costs money. For a matured business there is (hopefully) enough cash flow generated from the operating activities to support the acquisition and maintenance of plants and machinery required. For a new business, this is not the case and will require money for the capital expenses as well as support a cash-burning operation. Also, in a growing business, you need cash more than that is generated by the operations to support the growth.
This capital can be raised as equity (i.e. ownership in the company) or debt (contractual obligation to pay back).
A positive CFF involves the issuance of equity/ debt and receiving cash in return. A negative CFF involves making repayment of debt or buying back equity.
Note: The treatment of interest and dividends require special attention.
As per section 31 of Ind AS 7, interest paid is to be considered as a negative CFO in case of a financial institution but considered a negative CFF for other entities. Interest received is considered a positive CFO for the financial institution but a considered positive CFI for other entities.
Dividends received are considered positive CFO for financial institutions but considered positive CFI for other entities. Dividends paid are considered as negative CFF for all entities.