Operating, Investing and Financing Cash Flow Compared

A cash flow statement splits every movement of money into three sections according to what caused it. Operating covers the cash thrown off by running the business. Investing covers cash spent on, or received from, assets meant to be kept and used for years. Financing covers cash raised from or handed back to the people who funded the business. The split matters because the same net total can describe opposite businesses.

The reason for the split is simple. Money is the one thing on a set of accounts that carries no memory. A thousand rupees that arrived from a school paying an old invoice and a thousand rupees that arrived because a bank released a loan sit in the same account, in the same column, indistinguishable, and the closing balance can no longer say which is which. The three sections exist to put back the information that the bank account destroyed. The sections are not three kinds of money. The sections are three answers to one question, asked about every single movement: what caused this?

One question decides every classification, and the same question sorts a payment for paper, a payment for a van and a payment to a lender into three different sections without hesitation. Anjani Stationers' mix of plus Rs 36,30,000, minus Rs 34,00,000 and minus Rs 4,30,000 describes one kind of business, and a second business with the identical net movement of minus Rs 2,00,000 could be in real trouble.

Why is the statement split into three sections rather than one?

Because a single figure for the year would answer a question nobody actually has. Anjani Stationers, an invented notebook maker, ended year two with Rs 5,00,000 in the bank against Rs 7,00,000 at the start, so the year's movement was minus Rs 2,00,000. The minus Rs 2,00,000 is true, complete and almost useless. One figure cannot say whether the business is being drained by its customers, whether it spent the money on something it wanted, or whether it borrowed to stay open. Three businesses in three completely different situations can all print minus Rs 2,00,000 at the bottom.

Cash is fungible. One rupee inside a bank account is identical to every other rupee in it, and the three sections are the only mechanism that separates the rupees again after the account has mixed them together. Consider a household current account at the end of a month. Salary went in, a fixed deposit was broken, and a brother-in-law lent forty thousand. By the last day of the month the balance is one figure, and no amount of staring at that figure reveals that the household actually spent more than it earned and covered the gap with borrowed money. Finding out would take going back through the statement line by line and labelling each credit by where it came from. The same labelling exercise, done formally and to a fixed set of rules, is the cash flow statement's three sections.

What belongs in operating, and what is the test?

Operating holds the cash consequences of the transactions that produce profit. Money in from customers, money out to suppliers, wages, rent, the electricity bill, tax actually paid. If a movement is part of the loop the business runs every week in order to earn, it belongs here. Operating is what the business does for a living, expressed in money that actually moved.

The classificationThe act of deciding which of a small number of fixed categories a transaction belongs to, using a stated test rather than judgement about how important it is. test is a question about cause and never a question about size, so the same amount leaving the same account on the same day lands in three different sections depending only on what it was for. One figure carries the point. Rs 12,00,000 leaves Anjani Stationers' account. If it bought paper and card that will be turned into notebooks and sold inside the year, it is operating. Buying the goods the business sells is what a business does for a living. If it bought a delivery van that will run for six years, it is investing. The van is not for sale and its benefit is spread across many years. If it repaid a term loan, it is financing. The money went back to somebody who had funded the business. Same Rs 12,00,000, same bank, same morning, three sections. Nothing about the number decided it.

Two entries in the operating section catch people out, and both are worth naming now. Tax is operating, and the figure that goes in is the tax actually paid across the year rather than the tax charged against profit. Anjani Stationers was charged Rs 8,00,000 of tax in year two and paid Rs 6,20,000, and it is the Rs 6,20,000 that appears. The other is that operating is not the same thing as profit. Anjani Stationers earned Rs 30,00,000 of profit after tax and its operating section came to Rs 36,30,000, and the two figures are computed on different bases from different inputs.

What belongs in investing, and why is it kept separate?

Investing Cash Flow

Investing holds the cash spent on acquiring, and received from disposing of, things the business intends to keep and use rather than sell. Machinery, vehicles, buildings, software, and shareholdings in other businesses. Investing is kept separate for one reason. The spending is discretionary in a way that operating spending is not. Anjani Stationers must buy paper to have anything to sell next week. The business does not have to buy a delivery van this year, and if the year turns difficult it can wait.

The investing test asks whether the item is a long-lived assetSomething the business intends to keep and use over several years rather than sell on. A van, a machine, a building or a shareholding in another business. The opposite is trading stock, bought in order to be sold., meaning something bought to be used across years rather than sold within the year, and the size of the payment has nothing to do with it. A street vendor buying a new cart is doing exactly this. The vegetables are the trading stock and their cost is the running of the business. The cart is bought once, lasts five seasons and is not for sale, so it is a different kind of spending, and a lender assessing the vendor would want to know which of the two the money went on. Anjani Stationers' investing section is three payments and nothing else. Rs 12,00,000 of property, plant and equipment bought for cash. Rs 1,00,000 of software. And Rs 21,00,000 for the 70 per cent holding in Chitra Binding Works. A shareholding in another business is an acquisition of a long-lived asset in exactly the same sense as the van. The three payments come to Rs 34,00,000 of cash used in investing.

What belongs in financing, and who is standing on the other side?

Financing Cash Flow

Financing holds money moving between the business and the people who supply its capital. Loans drawn and loans repaid, lease liabilities repaid, shares issued, dividends paid. The useful discipline here is to stop thinking about the instrument and start thinking about the counterparty. For every line in this section there is somebody on the other side who put money into the business and expects it back, or who is being paid for having done so.

The financing test asks who is on the other side of the movement, and the answer is always a funderAnybody who supplied money to the business expecting it back or expecting a return on it. A bank, a lessor, a bondholder or a shareholder. A customer and a supplier are not funders, even when they extend credit in the ordinary course of trade., meaning a bank, a lessor or a shareholder rather than a customer or a supplier. A household feels this distinction instantly. Paying the vegetable seller is running the household. Paying the housing loan instalment is settling with the bank that made the flat possible. Nobody confuses the two, and a business should not either. Anjani Stationers' financing section has three lines and they come to Rs 4,30,000 out. The term loan moved from Rs 4,00,000 to Rs 4,20,000 across the year, and the movement is reported netShown as a single figure for the change rather than as separate lines for the money drawn and the money repaid. Netting is allowed where amounts turn over quickly, and it hides the gross traffic behind the movement. as Rs 20,000 drawn in. Rs 1,00,000 of the lease liability was repaid to the lessorThe party that lets somebody else use an asset for a period in return for payments. The party doing the using is the lessee.. Rs 3,50,000 of interest was paid, and it sits here rather than in operating for a reason taken apart under the classification choice below. Anjani Kulkarni took no dividend in year two, so the shareholders' line is empty.

Where is the classification a genuine choice rather than a rule?

Most classifications are settled. Wages are operating, a van is investing, a loan repayment is financing, and nobody argues. But two lines sit on a genuine boundary rather than inside a rule, and the standards recognise this by permitting more than one placement. Interest paid is the important one. Borrowing is part of how an ordinary trading business runs and the interest is a cost of that year's trading, so interest can be argued into operating. Interest is also the price paid to a funder and belongs beside the loan it relates to, so it can be argued into financing with equal force. Dividends paid sit on a similar boundary.

Where the standard permits more than one placement the business makes an accounting policy choiceA decision the business makes once, from a small set of treatments the rules allow, and then applies the same way every year so that its own statements stay comparable., states it, and then applies it the same way every year. The choice changes what the operating figure looks like without changing the net movement by a single rupee. The effect is visible in the case. Anjani Stationers shows interest paid of Rs 3,50,000 in financing. Operating is Rs 36,30,000 and financing is minus Rs 4,30,000. Move that same Rs 3,50,000 into operating and operating becomes Rs 32,80,000 while financing becomes minus Rs 80,000. Investing does not move. The same rupees are being counted, just in a different row, so the net movement is minus Rs 2,00,000 under both. Comparing two businesses on their operating figure alone is therefore unsafe until the placement of interest in each has been checked.

What does Anjani Stationers' mix say that the total does not?

Here is the whole year at section level. A practised reader takes it in as three sentences rather than three numbers: the business generated strongly from trading, spent nearly all of that on long-lived assets, and gave a little back to its funders.

Anjani Stationers' mix says that operations produced Rs 36,30,000 and the business chose to spend Rs 34,00,000 of it on equipment and a subsidiary. The mix is the signature of a growing business funding its own expansion out of its own trading. Much of the reading comes from the relationship between the sections rather than from any one of them. Operating covered investing almost exactly, with Rs 2,30,000 to spare. Financing barely moved. No outside money was needed to make the expansion happen. The cash balance fell only Rs 2,00,000, from Rs 7,00,000 to Rs 5,00,000, the residue of all that activity rather than the story of it. The three sections together give what happened. The last line on its own gives almost nothing.

Now put a second business beside it. Imagine one where customers are paying late and stock is piling up, so the operating section is minus Rs 18,00,000. It sold nothing, bought a modest Rs 6,00,000 of equipment, and drew Rs 22,00,000 of fresh borrowing to keep the lights on. Add those three up and the net movement is minus Rs 2,00,000, the same figure Anjani Stationers reported. Two businesses, the identical bottom line, and the difference between them is not a matter of degree. One is spending money it made; the other is borrowing money to replace money it lost.

Each of the four mixes describes a different kind of business. Anjani Stationers at plus Rs 36,30,000, minus Rs 34,00,000 and minus Rs 4,30,000 is a business paying for its own growth. A mix of minus Rs 18,00,000, minus Rs 6,00,000 and plus Rs 22,00,000 is a business whose trading consumes cash and whose lender is filling the hole. A mix of plus Rs 2,00,000, plus Rs 14,00,000 and minus Rs 18,00,000 is a business selling long-lived assets to pay down its funders. Selling assets to repay debt is a real strategy when a business is shrinking deliberately and a warning sign when it is not. A mix of plus Rs 40,00,000, minus Rs 8,00,000 and minus Rs 34,00,000 is a mature business generating strongly, reinvesting modestly and handing most of the surplus back, and all four of these report a net movement of minus Rs 2,00,000.

How does a lender or an analyst actually use the mix?

Step out of the classroom. The mix is not an idea people admire but a thing people use in rooms where credit is being priced. Three readers open Anjani Stationers' statement and each goes to a different pair of sections first, and none of the three starts at the bottom line.

A lender divides the operating section by what has to be serviced, an equity analyst subtracts investing from operating to see what the business could have handed over if it had chosen to, and Anjani Kulkarni reads all three together to find out how much of next year's expansion she can pay for without asking anybody. Take the lender first. Operating produced Rs 36,30,000 and the whole financing section cost Rs 4,30,000. The cover is comfortable, and the lender's next question is what happens to that comfort if the receivables that grew Rs 17,00,000 this year grow again next year. Take the analyst second. Operating of Rs 36,30,000 less investing of Rs 34,00,000 leaves Rs 2,30,000, and the analyst wants to know how much of that Rs 34,00,000 was expansion the business chose and how much was replacement it could not avoid. The two have very different implications for what next year looks like. Take Anjani Kulkarni third. She reads the same three numbers as an answer to a household question: the business made Rs 36,30,000 of real money, it is committed to Rs 4,30,000 of servicing, and everything above that is hers to allocate.

There is one thing all three of them do before any of that, and it is worth copying. All three check what is not in any section at all. Anjani Stationers recognised a right-of-use assetThe value of being allowed to use somebody else's asset for an agreed period, recorded as an asset in its own right alongside the obligation to make the payments. of Rs 7,00,000 in year two with a matching lease liability of Rs 7,00,000, and because no cash moved on recognition, that Rs 7,00,000 appears nowhere in the three sections. The lease is disclosed as a non-cash transactionSomething that changes what a business holds or owes without any money changing hands. A statement built on movements of cash has nowhere to record it, so it is disclosed separately. instead. A reader who compares the Rs 12,00,000 of equipment bought for cash against the Rs 8,00,000 that property, plant and equipment actually rose by, and does not know about that Rs 7,00,000, will conclude something is missing. Nothing is missing. The statement is doing exactly what it should.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.