INTERPRETATION OF CASH FLOW STATEMENTS

INTERPRETATION OF THE CASH FLOWS STATEMENTS

Having prepared the cash flow statement, the next step is to interpret it. This requires a keen eye to capture the sources of cash for the company and the uses of cash for the company. The direct method gives an explicit view of the actual sources of cash while the indirect method derives its figures from the accruals adjustments.

A healthy business should be able to generate its cash flows from its operations so as to support its investment and financing polices. It is important to capture the true sources of cash as they may be selling off assets in the investing activities segment thus compromising future cash generative capability and competitiveness. The business may also be borrowing or raising cash from shareholders in the financing section thus the liquidity is short term as capital providers must be paid a return in future. It should be crystal clear that the best source of cash should be the operations of the business as it is the only viable and long-term source of profitability and wealth.

Having identified the major sources and uses of cash flows, it is imperative to now project future cash needs or inflows so as to place a value on the value of the company. The fundamental concept of fundamental valuation is that the firm value is the present value of future stream of cash flows, so projecting future operating cash flows is fundamental in valuation.

The inter-relationships between operating, investing and financing cash flows should be sequential. Ideally the company should generate cash flows from their operations, that would propel growth through investing in Non current assets that would generate more operating revenues that would be used to pay dividends and interest claims to the firm financiers. A mature company or growing company would have such kind of profile.

A company in its nascent phase would however not project a pattern as above. This is because the cash flows from operating activities are yet to stabilize and might even be negative. This should not be a cause of concern especially if there are reasonable growth prospects and competitive capacity for the future. Such a company should not be written off if the future growth rates are certain.

A company that is declining would be generating cash flows from selling off their assets in the investing activity section rather than operating cash flow generation.  This should be a cause of alarm as future competitiveness is compromised as assets are the cash generative capacity of a business.

The capital structure would determine how the financing section appears. The highly geared company would be expending massive interest payments if classified as a financing cash outflow and where investors require high dividends pay outs, and then also this section would have large outflows. Tax issues would be relevant in determining whether dividend payouts would be more or less as in jurisdictions where there is large capital gains tax the shareholders would prefer dividends.

Finally the statement should self reconcile as the sum of the three sections would give us the net increase or decrease in cash and cash equivalents. The opening balance and closing balance would be explained by the net increase or decrease in cash and cash equivalents.