As a follow-up to my popular post ‘How to read any P&L statement’, I decided to write ‘How to read any cash flow statement’. Cash flow is an easy to understand concept. But the way of calculating it is not so simple.
Please note: I am a financial controller myself. I know this is a very simplified view of a piece of information that is intrinsically difficult. I simplified it for the benefit of the reader and to increase her understanding. My in this blog is to ‘give people an extra edge’ and aims at managers, business men, economics students, MBA aspirants and anything in between. Please also have a look at the schedule included below.
The basis of the cash flow statement is the P&L. But also the Balance Sheet, notably the fluctuations in it, play a big role as well. The start is the bottom line of a P&L, the EBIT. On itself, it is NOT a good reflection of the cash generation or consumption. We need to amend this with a few corrections. We need to determine, especially for the costs, what are cash costs and what aren’t.
The EBIT has been impacted by a number of costs, such as OPEX, COGS etc. But when the company’s CFO looks at the company’s bank account, he does not see the same fluctuations. Some costs have no direct cash impact. We call this non-cash costs, and the expenses with a direct cash repercussion are cash costs.
Example: when booking the salary costs of 100K, we are also paying salaries of 100K, the bank account will drop with 100K. This is a cash cost. However, when booking depreciation on an asset of 100K, the bank account does not move. Why? When the investment has been done years ago, the cash was spent in one shot at that time. Depreciation is only an accounting ‘trick’ to smear out this cost over the economic life of the asset, but do not have any yearly cash impact. What happens is that certain costs, typically depreciation, are added back to the EBIT line, thereby creating the EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization).
Next in line are investments. If we look at the asset investment example from above, a company may have invested in a machine, which is depreciated over the next five years. The depreciation is added back in our cashflow statement, but all investments (and of course divestments) need to be taken into account in the period they are done.
The final item is the fluctuation in working capital need (current assets minus current liabilities). As certain balance sheet items grow or shrink over a period of time, this may have a cash impact which is not necessarily reflected in the P&L. Example: if inventory has been building up over the last year, this means the company has consumed cash, in the form of goods stocked. The bill of acquiring the goods may have been booked earlier or later, so might not have been reflected correctly in P&L. Second example: if a company bills a sale, it is booked in the P&L as revenue. But if, over the given period, that invoice has not been paid it adds to the current assets in the shape of Accounts Receivable. So it adds to the working capital. And a rise in working capital means a cash drain, a negative impact in cash over and above the EBITDA line. The other way around, an increase in Accounts Payable means a drop in working capital. If you want to know more on how to read a balance sheet, click here.
Schematically, this is how a typical cash flow statement looks like:
When you take these effects into account, you can easily how a profitable company can still have cash flow (liquidity) problems by not timing investments well, or by failing in the collection of A/R.
I hope it got a bit clearer for you, looking forward to your comments!
By the way, if you’re interested, please click here to download my P&L and cashflow schemes.