May 17, 2017

Understanding Cash Flow from Operations (CFO)

www.drvijaymalik.com has a section dedicated to answering queries of readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. I have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to:
  • calculation of cash flow from operations (CFO) from net profits (PAT) of a company.


Cash flow from operations, CFO, operating activities, investing activities, financing activities, CFI, CFF, calculation of CFO




Query


Hi Dr Vijay,

I am reading the annual reports and mostly, I get confused in the cash flow from operations. In the reading material of Vinati Organics Limited, I have some doubts which I am unable to link. This may be about very basic accounting terms.

I tried to understand the cash flow statement on google. However, I could not get any clarity. Cash flow gives a lot of insights into a company’s financial position, therefore, expecting your dedicated article on cash flow in future.

Annual report of Vinati Organics Limited for FY2015-16, Page 80

A. Cash flow from operating activities
  1. Depreciation of ₹18.43 cr is added along with amortisation: Why?  It creates a cash inflow in the statement, though practically it has no impact on cash generation.
  2. Interest paid is ₹3.25 cr.: It is added as cash inflow for CFO, whereas it is actually a cash outflow from the company.
  3. Provision for the expense is also added in CFO: actually, it is a cash outflow from the company.
  4. Interest income is deducted: actually, it is a cash inflow to the company.
  5. Dividend received ₹4.40 cr is deducted: It is actually a cash inflow to the company.
  6. Export incentive are deducted to arrive at CFO: whereas it may be a cash inflow
  7. Trade and other receivables of ₹10.98 cr are deducted in FY15. How can it be negative? If it outflow then it should be payables.
  8. Inventory is deducted in FY2015: It is not understood

B. Cash flow from investing activities

9) Dividend received of ₹4.40 cr is added, which is exactly the same that of the above (which was deducted from CFO). Net increase/decrease in cash and cash equivalents (A + B + C): if we add (+) and (-) dividend income and interest paid ₹3.25 cr then the net impact will be 0.


Thanks.

Krimal Patel

Author’s Response


Hi Krimal,

Thanks for writing to us! We appreciate that you are putting time & effort and doing the hard work required from an equity investor to do the stock analysis.

Please find below our inputs to your queries:

Cash flow from operations, CFO, operating activities, investing activities, financing activities, CFI, CFF, calculation of CFO


1) Depreciation of ₹18.43 cr is added along with amortisation: Why?  It creates a cash inflow in the statement, though practically it has no impact on cash generation.

Depreciation expense like amortisation as rightly pointed out by you, is a non-cash expense. It is the adjustment of cash outflows, which happened in the past while creating fixed assets (plants, machinery etc.). At the time of creation of plants, the cash outflow took place but the same was not deducted from the P&L as it was directly put on the balance sheet under fixed assets. The depreciation expense is the deduction of those past cash outflows from the P&L now. It is effectively to match the expense deduction of the cost of plants with the revenue being generated by them now.

As mentioned above, in the case of depreciation, the cash outflow has already happened in the past and now there is no cash outflow. However, the PAT of the company has been arrived at after deduction of depreciation (no cash outflow). Therefore, to derive at the actual cash position of the company from PAT/PBT, we add back the depreciation. Otherwise, the CFO calculation will be erroneously lower whereas we will find that the company has excess cash, which is not accounted for.

2) Interest paid is ₹3.25 cr.: It is added as cash inflow for CFO, whereas it is actually a cash outflow from the company.

Interest paid/expense is added back in PBT as it is a financing item and therefore it should not reduce the CFO. We add the interest paid in PBT to arrive at CFO and the same interest paid is deducted as a cash outflow from financing in CFF. This is a mere reclassification of interest expense from CFO to CFF

3) Provision for the expense is also added in CFO: actually, it is a cash outflow from the company.

Provision are a non-cash expense, where a company believes that it might have to pay something in future and therefore it recognises those expenses in P&L today itself. The cash outflow might not have happened in the current year.

Therefore, just like in the case of depreciation, provisions, which are non-cash expenses, are added back to derive CFO from PBT or PAT.

4) Interest income is deducted: actually, it is a cash inflow to the company.
5) Dividend received ₹4.40 cr is deducted: It is actually a cash inflow to the company.

Interest income and dividend income are deducted from PAT/PBT to derive CFO as these are income from financial investments. Therefore, they are removed from CFO calculation and are put under cash inflow from investing (CFI).

6) Export incentive are deducted to arrive at CFO: whereas it may be a cash inflow

Export incentives: The export incentives, which are deducted are "Unrealized export incentives". It indicates that the company is eligible to receive these incentives and therefore, they are included in the profits of the current year. But as they are still unrealized meaning that the cash is yet to be received, therefore, they are deducted while deriving CFO.

This transaction of deduction of unrealized export incentives is the exact opposite of depreciation. In depreciation, a non-cash expense is added back to calculate CFO. In unrealized export incentives, a non-cash profit/income is deducted to calculate CFO.

7) Trade and other receivables of ₹10.98 cr are deducted in FY15. How can it be negative? If it outflows then it should be payables.

The increase in trade receivables is deducted to calculate the CFO for FY2015. Conceptually, Increase in receivables means that if hypothetically in FY2014 the amount to be collected from customers was e.g. Rs. 100cr. and in FY2015, the amount to be collected has increased to e.g. Rs. 150 cr., this effectively means that cash of Rs. 50 cr. (150-100) has gone out of the company to its customers, which it needs to collect.

As it is equivalent to cash outflow, therefore, it is deducted from profits to arrive at CFO

8) Inventory is deducted in FY2015: It is not understood

The increase in inventory in FY2015 is deducted to calculate CFO. The concept of inventory adjustment is similar to receivables adjustment. Hypothetically, if in FY2014 the inventory with the company was e.g. Rs. 100cr. and in FY2015, the inventory has increased to e.g. Rs. 150 cr., this effectively means that cash of Rs. 50 cr. (150-100) has gone out of the company to vendors (inventory suppliers), which is deducted to arrive at CFO

9) Dividend received of ₹4.40 cr is added, which is exactly the same that of the above (which was deducted from CFO). Net increase/decrease in cash and cash equivalents (A + B + C): if we add (+) and (-) dividend income and interest paid ₹3.25 cr then the net impact will be 0.

Dividend received is added in cash flow from investing as per the concept explained above while answering 4 & 5.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

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DISCLAIMER


Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:


Currently, I own stocks of Vinati Organics Limited in my portfolio.