8.1 – Overview
Is this information not revealed in the P&L statement you may think? Well, the answer is both a yes and a no.
Assume a simple coffee shop selling coffee and short eats. All the shop’s sales are mostly on a cash basis, meaning if a customer wants to have a cup of coffee and a snack, he needs to have enough money to buy what he wants. On a particular day, assume the shop manages to sell Rs.2,500/- worth of coffee and Rs.3,000/- worth of snacks. The shop’s income is Rs.5,500/- for that day. Rs.5,500/- is reported as revenues in P&L, and there is no ambiguity with this.
Now think about another business that sells laptops. For the sake of simplicity, let us assume that the shop sells only 1 type of laptop at a standard fixed rate of Rs.25,000/- per laptop. Assume on a certain day; the shop manages to sell 20 such laptops. Clearly the revenue for the shop would be Rs.25,000 x 20 = Rs.500,000/-. But what if 5 of the 20 laptops were sold on credit? A credit sale is when the customer takes the product today but pays the cash at a later point in time. In this situation here is how the numbers would look:
If this shop were to show its total revenue in its P&L statement, you would see revenue of Rs.500,000/- which may seem good on the face of it. However, how much of this Rs.500,000/- is actually present in the company’s bank account is not clear. What if this company had a loan of Rs.400,000/- that had to be repaid urgently? Even though the company has a sale of Rs.500,000, it has only Rs.375,000/- in its account. This means the company has a cash crunch, as it cannot meet its debt obligations.
The cash flow statement captures this information. A statement of cash flows should be presented as an integral part of an entity’s financial statements. Hence in this context evaluation of the cash flow statement is highly critical as it reveals, amongst other things, the true cash position of the company.
To sum up, every company’s financial performance is not so much dependent on the profits earned during a period, but more realistically on liquidity or cash flows.
8.2 – Activities of a company
Before we understand the cash flow statement, it is important to understand ‘the activities’ of a company. If you think about a company and the various business activities, you will realize that the company’s activities can be classified under one of the three standard baskets. We will understand this in terms of an example.
Imagine a business, maybe a very well established fitness centre (Talwalkars, Gold’s Gym etc.) with a sound corporate structure. What are the typical business activities you think a fitness centre would have? Let me go ahead and list a few business activities:
- Display advertisements to attract new customers
- Hire fitness instructors to help clients in their fitness workout
- Buy new fitness types of equipment to replace worn-out equipment.
- Seek short term loan from bankers
- Issue a certificate of deposit for raising funds
- Issue new shares to a few known friends to raise fresh capital for expansion (also called preferential allotment)
- Invest in a startup company working towards innovative fitness regimes
- Park Lafollette Tennesseepayday loan excess money (if any) in fixed deposits
- Invest in a building coming up in the neighbourhood, for opening a new fitness centre sometime in the future