Cash Flow
Following your financial analysis and the calculation of performance ratios, it is also important that you assess the firm’s cash flow. Cash flow is critical to a firm’s survival. Cash-on-hand is necessary to ensure that creditors, employees, and others are paid on time.
In essence, a firm’s cash flow position = cash received – cash distributed. Net cash flow can be taken from a company’s statement of cash flows.
Cash flow is important because it discloses a company’s financing needs. A strong positive cash flow enables a company to fund future investments from its operations rather than from external borrowing (money from bankers or investors); hence, it enables the firm to generate more cash and profits. As Martha Stewart says, “This is a good thing” because the company avoids paying interest or dividends. Conversely, a weak or negative cash flow means that a company has to use external sources to fund future investments. The company and industry lifecycle are also determinants. Firms in strong-growth industries often find themselves in poor cash flow positions due to substantial investment requirements; successful companies in mature industries, on the other hand, generally find themselves in a strong cash flow position. Cash flow is seen by most financial analysts as an indication of a company’s financial strength.
A company’s internally generated cash flow is calculated by adding back its depreciation provision to profits after interest, taxes, and dividend payments. If this amount is insufficient to cover proposed new investment expenditures, the company has two options: borrow funds to make up the shortfall, or curtail investments. The company can use a surplus to build up its liquidity (e.g. investments in financial assets), buy back company shares, or repay existing loans ahead of schedule. Firms must utilize surplus cash effectively. Funds cannot sit dormant.
