Cash Flow Statements Analysing Operations, Investments, and Financing Activities

Cash flow statement

– Indirect cash flow

At this pivotal point in our journey of financial modelling, we will produce the cash flow statement and insert it into the balance sheet. Any luck, this should result in a balance being struck. I used ‘produce the cash flow statement’, but what did I intend by that? It is necessary to take a step back and contemplate the aim of the cash flow statement.

A cash flow statement of a company presents its liquidity situation, which is determined by analysing all the inflows and outflows of cash, resulting from operations, investments, and financing activities. These activities either bring in or drain funds.

Reflecting on the High-level overview of cash flow, the CFO and their team must craft the statement. This includes incorporating voucher entries, bills, invoices, receipts, and bank reconciled statements – an effort known as the ‘Direct Cash Flow Method.’

Financial modellers have two choices for constructing a cash flow statement in their model.

Gain access to company bills and vouchers to construct the cash flow, just as the finance team does.

Increase the hardcoded historical statement as we did for the P&L and Balance sheet, then project out future estimations.

Clearly option one is not viable. Option two could be a possibility, yet if we take the hardcoded course, the element of “validation of the model” will be lost. I’ll elaborate further in a moment.

The indirect method of cash flow statement preparation requires the inputs from P&L and Balance sheet data. By processing the input with a number of logical steps, we can arrive at the net cash flow generated by the company. Favourable results are validated when this number is equal to that reported in the balance sheet. However, if a discrepancy arises, it serves as an alert for us to review and amend our model accordingly. With this understanding, the indirect method is selected for further analysis.

When it comes to validating this model, you may argue that due to the assumptions made, it could have inaccuracies. I understand this and am not overly concerned.

Consider this: the first order of business is to construct a house with a sturdy foundation. Upon doing so, we can rearrange the insides however many times it takes to obtain what we want. Similarly, our aim is initially to build the model with appropriate associations. When everything’s set up and unified, we can go over each presupposition to assess if it works and alter the details accordingly.

You may have some queries about this process, but if you take the time to read the rest of this chapter (and module) carefully, your questions will be answered. Let’s focus now on the indirect method for creating cash flow statements.

– Cash flow activities

A company can be viewed through its operations. Generally, these activities include –

Operating activities

Investing activities

Financing activities

Examining Bajaj Auto, what is the company’s role? They manufacture two and three-wheeler vehicles, sell them, and provide servicing. To proceed with these activities they need to invest in capital such as plants, equipment, and machinery. Depending on need, external funds may be obtained. When borrowing from external sources there are repayment obligations and dividends are then distributed from the profits.

Can you think of any other task that the company performs? You can broaden this framework to encompass any organization and see that all their activities would fit into these three categories.

These categories can all affect the amount of cash in a business. For instance, think about a firm’s inventory. It is tied to the company’s activities and if there is more of it this year than last, that means money has gone into creating products. So, inventory as an operational activity has used up cash. Conversely, if there is less stock this year than last, that means money has been brought in or retained.

Let us consider one more instance. Suppose that a business has taken out a loan from the bank to finance operations. This is a financial activity, and by obtaining financing, the cash is deposited into the firm’s bank account, therefore regarded as generated cash.

When it comes to distributing dividends, it is a cash consuming activity as money is transferred out of the company’s account.

Imagine being able to view line items from the balance sheet in their entirety.

Classify transactions as either operating, financing, or investing actions.

Determine whether it is creating or using up money.

By adding together cash flow from different activities, you can create the company’s cash flow statement and discover their current financial position.

Let’s proceed with this for our model.