Financial Statements and Firm Value 127cash coming from? How is it being used? What are the levels of and trends in cash flows from the three types
of activities?
Cash flow from operations
+ Cash flow from investment activities
+ Cash flow from financing activities
+ Net effect of exchange rate changes on cash
= Net increase (decrease) in cash.Operating activities are related to the firm’s ongoing ability to generate cash from operations. This in-
cludes information on cash receipts from customers for sales and service, cash payments related to vendors,
employees, taxes and interest. The net of all these, gives the cash flow from operations.
Investment activities relate to change in non-current assets. This includes information on capital expend-
iture to acquire fixed assets and proceeds from sale of non-current assets. Only cash transactions get reflected.
Financing activities relate to changes in borrowings and owners’ equity. This includes information on cash
proceeds from issuing equity and short-term and long-term debt, and cash outflow due to repurchase of
shares. Dividend payment is also a financing activity. Exhibit 5.5 shows a pro forma cash flow statement.
Cash flow from operating activities shows the result of cash inflows and outflows due to the fundamen-
tal operations of the company like cash receipts from sale of goods and services, payment of rent and taxes,
purchase of inventory, etc. Note that cash from operating activities is arrived at in the ‘indirect format’—in
the sense that, it starts with the net income figure and adjustments are made. The direct format for prepar-
ation of cash flow from operations is prepared by deducting cash outflows from cash inflows to arrive at net
cash flows. Cash flows from investing activities are cash flows associated with purchases and sales of non-
current assets such as building and equipment, etc. The section also contains purchase and sale of short-term
investments. Cash flows from financing activities include issuance and repayment of debt, issuance of com-
mon stock, the payment of dividends. Interest on debt, however, is clubbed under cash from operating
activities. The cash flow statements of three companies are given in Exhibit 5.6; look at them, before reading
further, and rank them on a 5 point scale—with 1 being the worst position, and 5 being the best. Cash flow
from operating activities provides cash necessary for replacement of assets and payment of dividends. The
cash flow pattern depends on the nature of business and the life-cycle of the company. Start up companies
in high growth industries will have negative cash flow because of high capital expenditure in relation to the
level of earnings. The gap is to be met by selling debt or equity. Established growth companies can meet
their investment requirements from internally generated funds. Mature companies will have modest capital
expenditure requirements.
Exhibit 5.5 Statement of cash flows
Cash flow from operating activities
Net income xxxxx
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Changes in other accounts affecting operations
(Increase)/decrease in accounts receivable
(Increase)/decrease in inventories
(Increase)/decrease in prepaid expenses
Exhibit 5.5 contd.