How to Judge the Company’s Cash Position

The objective of a business is not simply to earn a profit, but to generate cash inflows as quickly as possible. The faster a company collects cash, the less cash it needs to raise from investors or creditors for business operations.

Cash flow from operations is the most important source of cash inflow to a business. By operations, accountants mean day-to-day business activities — making and selling product, paying workers, and so on. A business can sell off some assets to generate cash, and it can borrow money or get shareholders to invest more funds, but cash flow from operations is essential in keeping the business afloat.

A business needs this cash flow to pay dividends to shareholders, purchase inventory, and make payroll.

Comparing net income to cash flow

Net income and cash flow are reported in two different financial statements. The income statement’s bottom line is net income. The net change in cash is reported in the statement of cash flows. The net change in cash may be higher or lower than the net income number in the income statement.

Growth may penalize cash flow — or, more accurately, growth may suck up cash from sales because the business has to expand its assets to support the higher level of sales. The key is to increase cash collections at a faster rate than the growth in spending.

Considering solvency

A company’s primary source of cash should be generated from operating activities. Operating activities represent the day-to-day business events (making a product, collecting on sales, paying workers) that occur continually.

If the majority of cash is generated from investing or financing activities, managers should question the company’s solvency. Solvency means the ability of a firm to generate positive cash flow and profits over the long term.

A business thrives over the long term by making and selling a product or service. As a result, those activities should generate most of the cash flow. Generating cash through other means — by selling assets or issuing more stock — isn’t sustainable over the long term.

Here are some other considerations for solvency:

  • Paying vendors: A company must pay vendors on time to maintain good relationships. This is particularly true of suppliers of raw materials or inventory. Pay too slowly, and a vendor is likely to consider ending the business relationship.

    Then you have to find another supplier, which may increase costs. Word gets around — a company that doesn’t pay its bills may have trouble finding any vendors willing do business with it.

  • Short-term versus long-term: Solvency differs from liquidity. Solvency refers to the ability to generate sufficient cash flows over the long term (generally more than a year). Liquidity, on the other hand, addresses the ability to meet cash needs over the short term (usually less than a year). A company may have liquidity problems that are resolved over the long term. In that instance, the firm is still solvent.

  • Debt load and cash flow: A company that generates reliable earnings and cash flow may be able to carry a large debt load. By debt load, accountants mean the ability to raise a large portion of capital by issuing debt rather than stock.

    A good example is a utility company. Because everyone uses electricity, the company has fairly stable earnings and cash flow. As a result, a utility is in a better position to make principal and interest payments on debt.

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