Company’s ability to generate positive cash flow is more important than profitability, because cash is needed to pay suppliers, employees and to take care of other expenses to continue as a going concern.
A company that generates positive cash flow from its operating activities is at a better position than a company without positive cash flow. The company with positive cash flow will have more flexibility in funding new business opportunities in order to generate more cash.
Therefore, analysts always give priority to those companies who have better future cash flow generating power. Does it mean profit should not be considered as important as cash flow.
Before getting into why cash flow is more important than a company’s net earnings or profit, let us understand why net profit is not equal to cash profit of a company. We will explain it by using a simple example.
Why company’s net profit and cash flow are not equivalent
Net Profit of a company represents the excess of the prices at which goods or services are sold over all the costs of providing those goods and services, regardless of when cash is received or paid.
Net profit margin is the profitability ratio used to know how much company is able to earn from its revenue in percentage terms.
Let’s understand this concept through one example. XYZ Limited sells imported goods to its customers on a retail basis. During the financial year XYZ limited sold goods for cash of Rs 2,50,000.
Supplier of the goods has granted 2 months credit terms to XYZ limited. Therefore XYZ limited has paid only 1,00,000 rupees during the year out of the total purchase value of Rs 2,00,000.
Assuming no other costs are incurred by XYZ limited, the company’s profit for the year is Rs. 50,000, which is the excess of the sales price (Rs 2,50,000) over the cost of the goods that were sold (Rs. 2,00,000). You will get Rs 50,000 in the company’s income statement as net profit.
However, the company has not paid its supplier, therefore the cash flow for the year will differ from the company’s net profit.
For the year XYZ limited’s cash flow is Rs 1,50,000, which is Rs 2,50,000 (cash sales) minus Rs 1,00,000 (paid to supplier).
Therefore, even though the company has made Rs 50,000 profit for the year, the company must be having a cash balance of Rs 1,50,000 instead of Rs 50,000. Out of Rs 1,50,000 cash balance, the company is required to pay Rs 1,00,000 to its supplier, which is to be shown as liability in its balance sheet.
In this example, cash flow is not the important factor for decision making as the company has future liability of Rs 1,00,000.
Company’s net profit tells you the ability of its business to deliver goods and services at a price in excess of the costs it incurs for delivering those goods and services.
Therefore, many analysts based on past performance prefer to forecast future profitability of the company.
Financial analysts while evaluating a company pays attention to both net profits and cash flow. Net profit or earnings are used when they value shares of a company on the basis of certain ratios such as price-to-earnings ratio, PEG, Earnings Per Share (EPS), etc.
Cash flow analysis is important when analysts pay attention to understand the current financial position of a company. Balance sheet of the company depicts the current financial position of a company by comparing the resources controlled by the company in relation to the claims against those resources.
Cash is used in order to pay the obligation to the supplier or claims against the company.
Two important criteria come for evaluation when you analyse a company on the basis of future viability. They are liquidity and solvency.
Liquidity means you are evaluating a company’s ability to meet its short-term obligations.
The ability to meet a company’s long-term obligations is generally referred to as solvency.
Both the long term and short term obligations can be settled only if the company has cash or liquid assets which can be easily converted to cash.
Manufacturing companies use huge assets to generate revenue. Depreciation due to wear and tear of the assets for the period is charged to the income statement in order to get net earnings.
Due to depreciation in income statements, a company’s net profit goes down but cash generated from operating activities remains intact. In order to get the cash profit of a company, you need to add back depreciation to net earnings or profit.
