Corporate bodies all across the world maintain three critical financial statements, namely, the balance sheet, income statement, and cash flow. These statements objectively reflect aspects like financial performance, managerial competency, growth prospects and are, therefore, paramount to analysts and investors.
Of these, the cash flow statement presents a substantial understanding of a company’s financial health. It comprises three sections – CFO or cash flow from operations, CFI or cash flow from investing activities, and CFF or cash flow from financing activities.
This section of the cash flow statement demonstrates the cash inflows and outflows from a company’s financing activities. In other words, it enumerates the flow of cash to and from an organisation’s capital and the means through which a company raises funds for its operations.
Financing activities examples include the issuance of shares and bonds, borrowing a loan, servicing debt, buying back shares, etc. Since these activities directly affect a company’s capital structure, analysts and investors use this as a critical indicator of a company’s financial health.
It is the last section in the cash flow statement preceded by CFO and CFI. Regardless, concerning entities can also find information about a company’s financing activities from its balance sheet’s equity and long-term debt sections, alongside footnotes.
Financing activities refer to the transactions involved in raising and retiring funds. The former is associated with cash inflow, and the latter denotes cash outflows.
The items in cash inflow from financing activities usually include the following:
Cash outflow from financing activities consist of the following transactions:
In order to calculate cash flow financing, one needs first to identify the changes appearing in a company’s balance sheet and differentiate cash outflows from cash inflows. If equity capital increases over a period, it indicates additional issuance of shares, which denotes cash inflow. On the other hand, if equity capital decreases over a period, it implies share repurchase, which is a cash outflow.
Similarly, if debt capital, like short-term and long-term borrowings, decreases over a period it suggests that the company has repaid its debts, which is a cash outflow. Conversely, if there’s an increase in the amount of debt – short-term or long-term – it indicates that such a company has availed additional debt resulting in cash inflow.
Here, one should note that CFF calculation does not account for changes in retained earnings since it does not correlate to financing activities.
Nevertheless, apart from changes in a company’s capital structure, accountants shall also note payments made for dividends and interest. One can find these transactions in the company’s Income statement on the debit side.
Once these items have been identified and recognised, one can go by the following steps for calculation of CFF:
It can be expressed in the following manner:
CFF = Cash flows from issuance of equities and debts – (Dividends + Interest + Stock repurchase + repayment of debt + repayment of lease obligations + dividend distribution tax)
The following is an excerpt from the Hindustan Unilever Limited cash flow statement highlighting the CFF portion for the Financial Year 2017 – 18.
|Cash flow from financing activities||Amount (in crores)|
|Proceeds from share allotment under employee stock options||0|
|Dividend distribution tax||(Rs.913)|
|Net cash flow from financing activities||(Rs.5,462)|
Maxwell Limited decides to issue 30,000 stocks of Rs.10 each to finance a new expansion project in the Financial Year 2019 – 20. The company also borrows a sum of Rs.200,000 from the bank for 1 year for that purpose. It paid a total dividend of Rs.50,000 in that year and had to incur interest of Rs.45000. It also spent Rs.3 lakh toward repaying an existing loan.
|Repayment of existing loan||(Rs.300,000)|
|Cash flow from financing activities||Rs.105,000|
As mentioned earlier, analysts and investors look at a company’s CFF to determine its financial standing and capital structure construction. Let’s break it down into different components for better understanding.
One might need to vet the frequency of cash inflow from financing activities across several periods to determine a company’s operational efficiency. For instance, if a company frequently issues new stocks and borrows additional debts, it implies that such an organisation is unable to yield sufficient earnings to finance its operations. In that case, positive cash flow is not a promising indicator but a sign of warning.
One shall also note which option a company frequently chooses for financing. If a company overtly relies on stocks for raising capital, it implies value dilution for investors, which results in a share price fall.
On the other hand, if a company turns toward debt options predominantly, it means that such a company is saddled with fixed obligations. Such obligations might be compounded if there’s an increase in interest rates. An ideal capital structure would demonstrate a balance that minimizes the cost of capital.
It is critical to consider this component’s inference within the context of a company’s net income. If a company is yielding sizeable net income consistently, then share repurchase is good news for investors. This is because a share’s value appreciates due to less number of stocks. Similarly, dividend distribution is also an agreeable cash outflow when earnings are performing well.
Conversely, if a company’s earning is suffering a downside or underperforming, then buyback or dividend distribution is a serious red flag. That’s because it demonstrates that such a company is trying to prop up its share price to cover for low income.
Nevertheless, it shall be noted that the analysis of CFF shall be in conjunction with other financial statements and critical ratios for a more comprehensive understanding of a company’s performance.