Why Cash Flow?
Companies across industries do nearly everything possible to maximize earnings. Earnings are widely regarded as the gold standard when assessing a company’s performance. Calculated based on the difference between a company’s sales and all costs and expenses, earnings offer insights as to whether the company is performing effectively. The number carries significant weight in assessing everything from shareholder value to dividend paying capacity. There is, however, a line item within the financial statements that is gaining momentum: cash flow.
The earnings number incorporates cash as well as non-cash numbers in its calculation; cash flow looks at pure cash generated by the business. While it is important to understand how much a company earns, it is just as important to understand how much cash a company generates. As the old adage goes: “cash is king.” A company cannot survive without cash and history has revealed this more times than we care to remember. Plenty of companies generate strong earnings but if the underlying cash does not support the earnings number, eventually a company will run into liquidity problems. Consider a company that sells its products on credit and has consistent problems collecting from customers. The company’s earnings appear strong since sales are strong. Over time, however, the company will see its cash flow diminish and may face a serious cash crunch. By contrast a company that appears weaker in terms of total products sold but sells to cash paying customers, may in the end prove more viable. Because of a strong base of cash, the company will avoid the liquidity problems afflicting the company previously mentioned.
The best way to ensure that a company is succeeding in all areas of performance is to track earnings as well as cash flow. Companies that generate positive numbers and strong growth for each will have the best chance of success.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.