Cash Flow Statements: Understanding How Do They Work?

You have just started a small café. At first, everything seems to be running smoothly. You have customers coming in, and the coffee machine is always busy. But as weeks pass, you notice that despite the busy café, you’re running low on cash. You’re not sure why, as you have steady sales.

This is where a cash flow statement becomes your best friend. It’s a financial document that tracks the cash flow in and out of your business, helping you understand where your money is going. Let’s dive into how cash flow statements work and why they’re crucial for any business.

A cash flow statement is a financial report that provides a detailed account of how cash moves in and out of a business. It helps business owners, investors, and analysts understand a company's liquidity and financial health. Essentially, it answers the question: "Where did the cash go?"

To understand the workings of this statement, it is important to look at its key components of cash flow.

Operating Activities

This section outlines the company's day-to-day operational activities. It focuses on the net income derived from core business operations, excluding any gains or losses from investing and financing activities. Essentially, it represents the cash generated through the company's primary activities, such as selling goods or services. Key components of operating activities include:

• Receipts from sales of services and goods
• Income tax payments
• Interest payments
• General operating expenses

Example: Imagine your café generates ₹50,000 in sales revenue during the month. However, you also need to account for cash payments, such as ₹15,000 for coffee beans, ₹5,000 for utilities, and ₹10,000 for staff wages. After adjusting for these expenses, the net cash flow from operating activities would be ₹20,000 (₹50,000 - ₹15,000 - ₹5,000 - ₹10,000). This amount reflects cash available from running the business.

Investing Activities

This section shows the investment gains and losses of a company. Specifically, it pertains to purchases or sales of an asset, loan payments to a lender, or payments related to acquisitions or mergers that can be undertaken through a Demat Account. 

Example: Suppose you invest ₹30,000 in a new espresso machine for your café. This expenditure is a cash outflow under investing activities. If you later sell an old piece of equipment for ₹5,000, this amount would be recorded as a cash inflow. The net cash flow from investing activities would be -₹25,000 (₹5,000 - ₹30,000), indicating a net outflow due to the purchase.

Financial Activities

This section measures the cash flow between the company, its owner/s, and its creditors. It also allows analysts to measure the finances the company gives out in dividends or share buybacks. Cash flow determines the changes in the size and composition of the equity capital (stocks, bonds, and dividends).

Example: To expand your café, you take out a ₹50,000 loan. This loan is recorded as a cash inflow under financing activities. If you also pay back ₹5,000 of the principal on an existing loan during the month, this amount is a cash outflow. The net cash flow from financing activities would be ₹45,000 (₹50,000 - ₹5,000).

Cash flow is the inflows and outflows of cash or cash equivalents of a company. There are two methods for cash flow calculation, namely:

• Direct Method: In this method of cash flow calculation, you consider all the cash influx from the operating activities and subtract the cash disbursements from the cash influx of the operating activities.
  
• Indirect Method: In this method, you take the value of the net income at the end of the reporting period (quarter, month, or year). Then, adjust the value of the net income by removing any non-cash expenses from the income statement.

The Cash Flow Statement is a crucial financial document that provides insight into a company's financial health and is essential for its future planning and growth. Key aspects it highlights include:

• Quality of Earnings: The Cash Flow Statement helps evaluate the quality of a company's earnings. If a company's net income is high but its cash from operating activities is low, this could indicate that the earnings are not as robust as they seem. Essentially, high-quality earnings are reflected by strong cash flow from operations.
  
• Investor Insight: For investors, the Cash Flow Statement offers valuable insights into a company's overall performance. It helps them understand how well the company generates cash, which is critical for assessing its ability to sustain operations, invest in growth, and return value to shareholders.
  

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​​​​​​​*Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. This is an information communication from HDFC Bank and should not be considered as a suggestion for investment. Investments in the securities market are subject to market risks; read all the related documents carefully before investing.