For a business, the cash flow statement is a key financial document. It records the cash earned and spent in a specified period. A cash flow statement can be an insightful tool for investors and businesses as they engage in fundamental and technical analysis. They provide information regarding the actual financial health of a company and its revenues. One of the major components of the cash flow statement is cash flow from investing activities. It contains accounting for the expenditure and the returns generated from investments to grow a business.
In this article, we will examine and focus on one specific cash flow, the cash flow from investing activities, to learn about its significance and calculation. Let us start by discussing the different types of cash flows.
Cash flow types
Firstly, it is essential to know the different types of cash flows. These are cash flows from operations, investments, and financing. All of these have their significance in the cash management of a business.
Also read: Cash flow vs fund flow
Cash flow from investing
The cash flow pertaining to a business’s investment earnings is crucial for accounting. A company’s investments are typically well-planned and strategised over a long tenure. Discrepancies in the expected and actual returns may be a cause of concern and must be closely tracked. Investments are also major contributors to the sustainability and scaling up of business operations. Thus, any changes in returns must be studied closely and optimised as much as possible.
A net positive cash flow from investing activities is an indicator of good health for the company. It is also instrumental in indicating its continued and sustained growth over time. It supports expansion and ambition as big companies heavily rely on this data. While a positive cash flow is always desired, companies could have a negative cash flow. However, it is important to understand that this is not always a bad sign.
For example, a company’s cash flow records may simply have a negative cash flow from investing activities if they have recently purchased costly equipment and machinery to help the business in the long run. Such purchases temporarily make the cash flow negative but have a positive impact in the long term. Instead of machinery, a company’s cash flow from investing activities may also be negatively impacted owing to a focus on R&D (research and development) activities that pay off in the long haul.
Also read: Discounted Cash Flow
Where do companies invest?
Companies typically can have investment incomes from one or more of the sources mentioned below:
- Sale of movable and immovable assets
- Sale of securities
- Sale of intellectual property
- Investments in securities
- Physical asset purchase
- Mergers and acquisitions
Do note that a company’s sources of investment income go beyond those listed above. Usually, any cash proceeds that a company receives involving their assets, equipment, or investments fall under the umbrella of cash flow from investing activities.
What is not included in investment activities?
After knowing what is included in cash flow from investing activities, it is also crucial to know what is not considered an investment activity. These include:
- Dividends and interest income
- Financing, in any form
- Depreciation in capital assets
- Revenue and expenses arising from everyday core business operations
Positive and negative cash flows
Cash flow from investing activities can be negative or positive. Here are a few examples:
- Purchase of fixed capital assets - Negative
- Purchase of bonds, stocks, securities, etc. - Negative
- Sale of capital assets - Positive
- Acquisitions - Negative
- Money lending - Negative
Also read: Free cash flow
Calculating cash flow from investing activities
While cash flow from investing activities is a crucial metric, there is no standard formula for calculating the cash flow. What assumes the highest importance here is identifying positive and negative cash flows to gain better insights. In addition, cash flow reports must be studied in conjunction with the company’s income statement and balance sheet to get the complete picture of a company’s financial health.
Let us take an example of a company ‘ABC’, which manufactures footwear. The information we have about the financials is as follows:
- A new factory was set up in the previous fiscal quarter, worth Rs. 5 crore
- Additionally, in the new factory, Rs. 1 crore was utilised for construction
- An old factory was sold at Rs. 2 crore
- The company received Rs. 1 crore as dividend
In this example, the first two entries represent cash outflows and are thus negative cash flows. The total cash outflow comes out to be Rs. 6 crore. On the other hand, the third and fourth entries represent cash inflows and represent positive cash flow. The cumulative positive cash flow stands at Rs. 3 crore, and the total cash flow from investing activities is thus negative. However, as mentioned above, it may not be a sign of bad financial health as the majority of the outflow results from acquiring a capital asset.
Conclusion
Cash flow from investing activities holds significant importance in assessing a company's financial health. While a positive cash flow from investing activities is generally desirable, negative cash flows are not always indicative of poor financial health. By understanding the context behind these cash flows, investors can make informed decisions about the company's performance and financial future.
