Corporate Finance

126
Corporate Finance

period. In short, non-cash transactions do not enter the cash flow statement. The net cash flow is simply
the net of all inflows and outflows during the period. The cash flow statement is helpful in a number of
situations where cash flows are important. These include:

• Analysis of credit proposals.


• Firm’s need for external financing and the use of its long-term debt.


• Firm’s ability to meet current and long-term cash obligations.


• Ability of the firm’s operations to generate cash.

Thus,

Cash balance at the beginning of the year + Net cash flow during the year
= Cash balance at the end of the year.

There are two ways of arriving at the net operating cash flow: direct and indirect methods. Under the
direct method all cash inflows are recorded during the period and all outflows are deducted to arrive at
the net cash flow. The net cash flow could be either positive or negative depending on whether the com-
pany has generated or consumed cash. Consider a hypothetical company that starts with Rs 1,000 in hand.
During the period, the company pays its suppliers, workers, etc., amounting to Rs 600. Customers pay Rs 700
during the period.

Net cash flow = –600 + 700 = Rs 100

Cash balance at the end = Rs 1,100

The cash flow statement is usually prepared for the year although any other duration may be chosen. Net
profit is not the same as cash flow. The financial statements are prepared on the accrual basis of accounting.
For instance, sales are recorded when products are sold even if customers do not pay cash immediately
or salaries are recorded as expense even when in reality the actual cash outflow is in the next period (say, the
beginning of next month). The cash flow statement is designed to analyze the underlying cash flow position.
Cash flow might be higher or lower than the net profit figure. The direct method illustrated above is simple
and straightforward but time consuming. Managers of the company who have intricate details of the trans-
actions can use it. The indirect method arrives at the same result in a circuitous way. Starting with the net
income figure, a series of adjustments are made to transform the net income into cash flow from operations.
To arrive at the cash flow (from operation) from net income:

• Add back expenses that do not involve cash outflow.
  For example, depreciation, amortization.


• Subtract cash outflows not treated as expenses.
  For example, capital expenditure (machines, land, etc.).
  Increase in inventory involves outflow but not recorded as expense.


• Subtract revenues that do not involve cash inflow.
  For example, sales on credit, i.e., increase in a/c rec.
  Increase in accrued interest earned.

It is useful to classify cash flows on the basis of activities. The standard practice for preparing the cash
flow statement is to classify activities—into operating, investing, and financing activities—and record cash
flow under each heading. A manager or an analyst can make useful interpretations like: Where is the