A business can be profitable but it may still not have enough cash flows. Sounds paradoxical right? Don’t be surprised but this is a real problem with many companies across the world; not only in India. That is because your profits represent your book profits. They are not necessarily reflective of your cash flows. That is why the cash flow statement or the cash from operations becomes such an important consideration. Let us understand why is cash flow more important than profit? In the cash flow vs net profit debate let us also understand the relationship between profit and cash flow.
Why can a company's profits not be reflective of cash flows..
Most of tend to equate profits with cash flows. But that is not the case. There are 3 reasons why there is a difference between cash flows and profits..
Your income statement contains non-cash charges like depreciation and amortization which really do not involve cash outflow. These items reduce the profits but do not reduce the cash flow. Similarly, when you issue zero coupon bonds, the accrued interest is booked in your income statement each year but there is no cash outflow.
The accounting system is basically an accrual base accounting system. That is why expenses are recorded on accrual and not on actual spending.
The company may have sold goods but the receivables may be locked in receivables in the balance sheet as current assets. This increases your profits but not your cash flows. Similarly sales are recorded when the inventory is transferred to dealers but the funds are locked up in inventories in the current assets till the time the dealer actually sells the products.
Why cash flows matter more than income statements..
There are 3 reasons why focusing on cash flows is more important than focusing too much on the profit statements..
Cash can highlight operational issues better than income statements. You may have a sharp increase in client base but you may be offering longer credit periods. This could be positive for profits but negative for cash flows. These operational issues are immediately highlighted by the cash flow statement.
Cash flow statements are a better barometer of sustainable growth. Any good business thrives on sustainable not by growing at any cost. Cash flow statement strikes that balance between client expansion and cash flows. It shows whether your business is cash flow accretive or not.
Cash flow statements are a good barometer of whether your debt levels are sustainable and whether your cost of debt is manageable or not based on your sustainable operating cash flows. Remember, you need real cash to pay your debts and book profits are not sufficient.
How cash flow statements forces you to change tack and strategy..
The cash flow statement gives you a pick picture of whether your business is operating cash flow generating or cash flow depleting. More than identifying the problem, it is the correct action which it triggers that really matters. Here are a few correction actions that cash flow statements can trigger..
It will force you to relook at your current credit terms and also your payment follow-up mechanism. Most clients tend to treat creditors as the best source of cheap financing and hence payments will get delayed. This analysis will force you to put proper checks and balances in place to ensure that your payments are received on time.
The analysis of cash flows will also force you to look at your price points and the discounts offered. You can consider offer 5-10% discounts if payments are made on time to ease your cash flow situation. After all, in business an ounce of cash is worth a pound in commitments.
Take a relook at your invoice process. Can you shift from a post invoicing system to a pre-invoicing system. Can you ensure that all invoices are sent out within 48 hours of the completion of the task. More often than not, delays from the vendor’s side leads to bad cash flow management. This analysis forces you to take a look at these inefficiencies and plug the same.
The cash flow analysis will force you to look at how to finance your long term assets. If your operating cash flows are insufficient to finance your long term purchases then you can use long term financing. You can also simulate the impact of the cost of long term finance on your cash flow statements.
When you focus on your profitability you have the tendency to lock up funds in inventories and receivables. This system forces you to think cash all the time and becomes the core of your business. That is the big shift that cash flow brings about!