How to read the Cash Flow Statement – Part 1

Have you heard the statement: Cash is king? A business needs cash like a car needs fuel. If there is no regular generation of cash from the day-to-day operations, the business will need to resort to debt and share issues to survive. Seems logical that investors would first look at the Cash Flow Statement in an Annual Report – right?

Unfortunately, most investors in the stock market – even those who have been investing for many years - do not understand or know how to interpret the Cash Flow Statement. Just looking at the Balance Sheet, Profit and Loss statement and the Management Discussion and Analysis is not enough. The real state of a company’s finances is hidden in the Cash Flow Statement and the Notes on Accounts.

With another accounting year coming to a close on Mar 31, 2011, this is as good a time as any to learn the basics of the Cash Flow Statement:-

The Cash Flow Statement allows you to check the different sources of cash inflows into a company during a particular year vis-a-vis the prior year, how much cash was spent, and what it was spent on. Cash inflows are positive, cash outflows are (negative). The three parts of a Cash Flow Statement enable you to understand what a company’s management is doing with the cash at its disposal, by comparing the figures with those appearing in the Balance Sheet and Profit and Loss statement.

Part 1: Cash Flow from Operating Activities

The Net Profit before tax and exceptional items from the Profit and Loss statement is adjusted with depreciation, interest, provisions, profit/loss on investments, debtors, inventories, creditors to arrive at the cash generated from operations. Tax and exceptional items are then adjusted to arrive at the Net Cash from Operating Activities.

Though it may seem counter-intuitive to non-accountants (like me), depreciation is considered an inflow (it is an expenditure in the Profit and Loss statement, but the cash is not paid to any one and remains within the company); creditors/accounts payable is an inflow (because they haven’t been paid yet); debtors/accounts receivable is an outflow (because a ‘sale’ has been accounted in the Profit and Loss statement but the money hasn’t been received yet).

Net Cash Flow from Operating Activities should preferably be positive, and greater than the previous year’s if the net profit has gone up. Newly set-up companies, particularly those in high growth fields like Information Technology or Bio-technology, often have negative cash flows from operations in their initial years. They need to ramp up operations quickly to meet demand but may not be able to negotiate good payment terms from their clients.

Negative cash flows from operations of established companies, if over prolonged periods, indicate that there is something amiss with the business model, or the management has questionable integrity and is diverting cash to unlisted subsidiaries or to related parties.

Investors need to be particularly wary of companies that show good top-line and bottom-line growth year after year, and pay taxes and dividends but show negative cash flows from operations. Where is the cash to pay the taxes and dividends? It comes from regular borrowings and share issues. If such a situation continues for a few years, the debt burden will eventually sink the company. Many realty and high-flying infrastructure companies, and investor favourites like Bartronics, Cranes Software fall within this category.

(Note: The next two parts of the Cash Flow Statement will be covered in Thursday’s post – so please stay tuned.)

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About assets, liabilities and the curious case of HUL

Dissecting balance sheets and getting to the root of financial statements are not really the stuff that gets me all energised. Assets, liabilities, inventories, cash and bank balances are insipid compared to the engineers' arsenal of double derivatives (no pun intended) and triple integrals.

But as uninteresting as brushing one's teeth, or eating 'karela' (bitter gourd) may be, they are a necessity for good hygiene and health. Likewise, being able to read between the lines of balance sheets, Profit & Loss and Cash Flow statements is a necessity for better health of one's stock portfolio.

Today's discussion was triggered off by reader Rishi's query last week. Why is it that a stalwart company like HUL is showing negative Net Current Assets on its balance sheet year in and year out? I was taken aback. How could that be possible? A market bellwether and leading FMCG multinational has more liabilities than its assets? After generating huge cash flows and paying continuous dividends?

Unfortunately, I could not locate last year's Annual Report. It came more than a year back and after a quick review to check every thing was in order, I didn't need to refer back to it any more. So I checked up at the Rediff money site, and guess what? Five straight years of negative Net Current Assets.

Now, any semi-intelligent high school graduate will be able to tell you that Net Current Assets (i.e. Current Assets - Current Liabilities) should be zero at worst, never negative. In other words, any company should own enough readily accessible assets to cover what it owes to others in the near term (within the financial year).

Ideally, the ratio of Current Assets to Current Liabilities should be 2 or more. But 1.5 is an acceptable number. That would indicate that a company has more than enough money to pay off the loans due and its creditors.

Unable to locate the HUL Annual Report to check the details, I checked up ITC's report instead. Sure enough, the Current Assets to Current Liabilities ratio was a respectable 1.58. Cummins India's? 1.67. Glaxo Pharma's? 1.91.

Now I was getting a bit jittery. Without the Annual Report, how will I respond to Rishi? Suddenly, I remembered my friend Nasir, who is an experienced Chartered Accountant in a multinational company. He had kindly offered to help me out with accounting intricacies if I faced problems.

Nasir's response was prompt and detailed. HUL's modus operandi is unique in corporate India. At the beginning of the year, they collect advance payments from their distributors. No distributor has the temerity to say 'No'.

These substantial advance payments are reflected in their books as a "Current Liability", though the company has no intention of paying back the money. What they do instead, is to supply their various products to the distributors throughout the year against the advance payments.

Consequently, the 'Debtors' figure under the head of "Current Assets" is negligible or nil. And the company is always flush with cash. Funny thing is, I knew about all this because an acquaintance used to be a HUL distributor.

Why do the HUL distributors effectively fund the company's operations? This is what happens when a company becomes so large and so popular, that it almost becomes a monopoly and can negotiate advantageous business terms with its suppliers and distributors.

Does all this smack of sharp business practices? Not at all. The company has worked hard over the years to create good products and establish strong brands. They spend hundreds of Crores in advertising to maintain their leadership position in the FMCG segment.

Why shouldn't they cut the best deal possible for themselves, and their shareholders? Microsoft does it. I would do it if I was able to garner that kind of market domination.

After all, a company exists to make profits. Not to win popularity contests. If it can do so without violating the law of the land, more power to them. Whether its Current Assets are more or less than its Current Liabilities.

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