Understanding Cash Flow from Operations (CFO)

Modified on October 30, 2018

The current article in this series provides responses related to:

  • Step-by-step calculation of cash flow from operations (CFO) from net profits (PAT) of a company.
  • Can companies arbitrarily add depreciation in CFO calculation to inflate CFO?
  • Can Dividend & Interest Income be a part of cash flow from operations (CFO) instead of cash flow from investing (CFI)?
  • Can inventory losses (write-down) lead to inflated cash flow from operations (CFO)?
  • Why is the amount of dividend declared in a financial year in the director’s report section of the annual report different than the amount of dividend payment shown as outflow in the cash flow statement?
  • Can we find the amount of capital work in progress (CWIP) and the amount of capitalized interest from cash flow statement?

 

Step-by-Step Calculation of Cash Flow from Operations (CFO) from PAT

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.Further Reading: Capitalization of Interest, Fixed Asset Turnover

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 cashflow from operations (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 cashflow from operations (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 cashflow from operations (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 cashflow from operations (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

 

Can companies arbitrarily add depreciation in CFO calculation to inflate CFO?

Hi Sir,

I have a general query.

In cash flow from operations (CFO), we know that we have to add back the depreciation to know the cash flow. However, I saw cases where some companies arbitrarily add a huge amount of depreciation, which misleads the actual net cash flow from operations.

Sir, how can we assess the actual depreciation and at which level?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

An investor may get further details about the amount of depreciation by reading:

  • The detailed schedule to financial statements contains details of fixed assets in the annual report.
  • Moreover, the companies also disclose the assumption of life of different assets in the “key accounting policies” section in the annual report.

An investor may get little bit more insights about the depreciation from combining the learning from the above two sections of annual report. However, if still investor has doubts about the amount of depreciation, then she may contact the company directly for clarifications.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

 

Can Dividend & Interest Income be a part of cash flow from operations (CFO) instead of cash flow from investing (CFI)?

Hello Sir,

Recently I am reading a book, Creative Cash Flow Reporting by Charles W Mulford. On page: 15, it states that

“Any income generated by those investments, such as cash revenue less cash expenses on investments in property, plant, and equipment, interest income on investments in debt securities, or dividend income on investments in equity securities, is included in the calculation of operating cash flow”

We have learnt so far that any dividend income on investment is considered in Cash flow from investing (CFI), but this book contradicts here.

Kindly suggest.

Author’s Response:

Hi,

Thanks for writing to us!

As rightly mentioned by you, our understanding is the same that dividend income, interest income etc. are non-operating income and therefore, excluded while calculating cash flow from operations (CFO). Such income is included in cash flow from investing (CFI).

The only situation where such income (dividend and income) are included in CFO is for the companies whose main business is making investments like investment funds/NBFCs etc. This is because dividend and interest income is the operating revenue for them.

We do not have any views on why the said book has mentioned that dividend and interest income are included in CFO. You may read more about this topic in the said book. Probably reading more will provide you the context in which the author has made this statement.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Can inventory losses (write-down) lead to inflated cash flow from operations (CFO)?

Hello sir,

I understand that while calculating cash flow from operations (CFO), we adjust for the working capital (WC) changes to arrive at CFO.

While analysing the CFO calculation of a commodity type business, I saw that the changes in the inventory led to addition of a large amount of inflow in CFO and thus heavily inflated the CFO.

The company in question uses commodity as raw material (RM). The raw material/inventory was valued at very high prices last financial year inventory closing as the commodity was at its cyclical peak. However, in the recent year commodity prices has corrected to very lows (recent year inventory values). Therefore, the value of inventory at the end of the year has come down significantly. I understand that while adjusting for the working capital in CFO calculation, the reduction in the value of inventory on the balance sheet during a year is shown as cash inflow.

Therefore, I feel that the losses in the inventory held by the company due to decline in the price of the commodity have the potential of inflating the CFO.

So while analysing the fund flow analysis from the balance sheet or cash flow analysis, how should we consider such changes, which may not be real?

Author’s Response:

Hi,

Thanks for writing to us!

We believe that in such cases of inventory write-down only a case to case based awareness is sufficient for investors and no change to the general method of CFO calculation is needed.

Let us see the impacts on both the balance sheet fund flow analysis as well as the cash flow from operations (CFO) calculation in the case of inventory write-down.

1) Calculation of cash flow from operations (CFO):

The positive entry of change in inventory in the CFO calculation under working capital changes nullifies the impact of loss recognised in the P&L due to inventory write down. This positive entry in CFO does not inflate CFO but cancels out the impact of reduction from loss due to inventory write down in the profits.

If we do not add the positive change due to reduction of inventory in CFO, then the CFO will be unduly reduced from inventory write-down losses (which is a non-cash item).

2) Fund flow analysis from the balance sheet:

The decline in inventory will be factored in profit & loss statement as a loss/expense, which will reduce the profits and in turn will reduce the retained earnings (shareholders equity).

If we ignore all other transactions, then in the fund flow analysis, the fund inflow due to decline in asset (inventory) will be matched with fund outflow due to decline in shareholders’ equity (reduction in retained earnings due to loss in P&L because of inventory write down).

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

 

Why is the amount of dividend declared in a financial year shown in the director’s report section different than the amount of dividend payment shown as outflow in the cash flow statement?

Hi Dr Vijay,

Trust you are doing great.

I have a doubt regarding a company that I am analysing.

In a particular year (FY2005), this company’s director’s report mentioned that they declared a dividend of ₹1/share on 30 lac shares It means an outflow of ₹34 lacs including dividend distribution tax (DDT). However, the same year’s cash flow statement shows only an outflow for dividend plus DDT of ₹17 lac in the cash flow from financing activities.

How did this difference arise?

In addition, in the next year (FY2006) they declared the same dividend amount and correctly showed an outflow in CFF as ₹34 lacs.

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

The cash flow statement contains the amount of dividend paid in cash during the year. If out of total dividend of ₹ 1, ₹ 0.50 is paid as interim dividend within the financial year (e.g. FY2005). Moreover, the balance ₹0.50 is declared as final dividend, which will be paid out in next year i.e. FY2006 after approval in AGM, then the cash flow statement for FY2005 will have cash outflow only for the interim dividend and not for final dividend.

In the next year i.e. FY2006, the cash flow statement in the cash flow from financing section will contain the outflow for the final dividend of FY2005, which is paid after AGM in FY2006 and the outflow for any interim dividend for FY2006, which is declared and paid within FY2006.

Hope it will help.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

 

Can we find the amount of capital work in progress (CWIP) and the amount of capitalized interest from cash flow statement?

Dear Sir,

I have two queries:

  1. While analysing the cash flow statement, how can we find what is the total amount of capital work in progress (CWIP) and where is it adjusted? This is because the capital work in progress might be in form of inventory, plants, etc.
  2. In addition, if any company is capitalising interest cost, can we find it in the cash flow statement?

Author’s Response:

Hi,

Thanks for writing to us!

Capital work in progress (CWIP) is a part of fixed assets. It constitutes those fixed assets, which are still under construction. Inventory is not classified under CWIP. Please note that the inventory, which is under process is classified under current assets >> inventory >> WIP.

The money spent on CWIP along with fixed assets is shown as an outflow in the cash flow from investing (CFI) under headings similar to: “Purchase of Fixed Assets”.

We have experienced that it is difficult to find out the exact amount of capitalization of interest from the cash flow statement. This is because companies show a lot of capitalized interest as part of outflow under “Purchase of fixed assets” under CFI instead showing it as a part of outflow in “Interest outflow” under cash flow from financing (CFF).

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above except Vinati Organics, in my portfolio.

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