Statement of changes in shareholders' equity
Ind AS 1 requires companies to present a statement of changes in shareholders' equity that shows the impact of various types of transactions on each component of equity: share capital, premium, retained earnings, reserves, OCI and non-controlling interest. Bharti Airtel's 2019 annual report is the syllabus's exhibit. It is the bridge between two balance sheets on the equity side: opening equity, plus profit and OCI, minus dividends and buybacks, plus shares issued, equals closing equity.
Why cash is different from profit
Generating cash is critical for long-term survival, yet the P&L and balance sheet do not focus on cash because accounting is on accrual basis: income is recognised when earned rather than when received, expenses when incurred rather than when paid. That creates a difference between profit shown and cash generated.
A business makes cash purchases of Rs 80,000 and cash sales of Rs 1,00,000: profit of Rs 20,000 and the money is in hand. Now make the purchases in cash and the sales on credit. The P&L still shows Rs 20,000 of profit, but there is no money. If the customers never pay, there are no profits, and even the Rs 80,000 of capital is likely lost. Without cash, profits are paper profits, not real profits.
Three categories of cash flow
- 1Operating cash flows: cash from business operations, the P&L items. Incoming cash positive, outgoing negative. Net profit converts to operating cash flow by adding back non-cash expenditure such as depreciation and amortisation and adjusting for changes in receivables and payables.
- 2Investing cash flows: cash on account of assets, balance sheet items. Buying assets is negative, selling assets positive.
- 3Financing cash flows: cash on account of liabilities and equity. Borrowing money or issuing equity is positive; redeeming debt or equity is negative.
The sample question asks which section shows the funds a company borrowed in the preceding year: cash flow from financing activities. There is no such category as cash flow from net operations.
The Kingfisher lesson
A business running negative operating cash flows for several years is an alarming signal of risk. It needs continuous doses of cash stimulus, borrowing or equity expansion, to keep going, and over time it either turns operating cash flow positive or dies when investors and lenders refuse to pump in more.
Net profit before tax: March 2009 negative 2,155.21; March 2010 negative 2,417.92; March 2011 negative 1,520.78; March 2012 negative 3,446.09; March 2013 negative 4,301.12. Net cash from operating activities: negative 645.78, negative 1,665.09, negative 2.23, negative 885.55, negative 1,390.86 for the same years. The airline borrowed money to pay interest because EBIT was much lower than its interest obligations for years; lenders eventually refused further cash, and the business never turned operating cash flow positive even after capital infusion. No business can run on continuous expansion of borrowed money.
An expanding business needs cash. Negative investing cash flows are financed through positive operating cash flows, accumulated past operating cash flows sitting as bank balance, or positive financing cash flows from borrowing and equity. Businesses that depend excessively on borrowed funds for expansion must be viewed with caution: the assets on the balance sheet may realise less than book value, but the liabilities have to be met in total.
Net cash flow alone can be deceptive. Each stream, operating, investing and financing, must be analysed independently. The objective is to focus on sustainable and recurring cash flows. Non-recurring or extraordinary items that affect cash flows must be recognised and adjusted.
- Ind AS 1 requires a statement of changes in shareholders' equity showing how each type of transaction moved each component of equity; Bharti Airtel's 2019 annual report is the syllabus exhibit.
- Accounting is on accrual basis: income is recognised when earned and expenses when incurred, not when cash moves, so profit and cash diverge. Cash purchases of Rs 80,000 and cash sales of Rs 1,00,000 give Rs 20,000 of usable profit; the same sales on credit give the same profit but no money, and if customers never pay even the Rs 80,000 capital is lost. Profits without cash are paper profits.
- Three categories: operating cash flows from P&L items (net profit plus non-cash expenses such as depreciation and amortisation, adjusted for changes in receivables and payables); investing cash flows from asset movements (buying negative, selling positive); financing cash flows from liabilities and equity (borrowing or issuing equity positive, redeeming debt or equity negative).
- Persistent negative operating cash flow is an alarming signal: the business needs continuous cash stimulus through borrowing or equity and either turns positive or dies when funders stop. Kingfisher Airlines borrowed to pay interest for years because EBIT was far below interest. Expansion needs cash from positive operating cash flow, accumulated bank balance or financing; heavy dependence on borrowed funds for expansion deserves caution since assets may realise below book value while liabilities must be met in full. Analyse each stream independently, focus on sustainable recurring flows, and adjust for non-recurring items; net cash flow alone can deceive.