Once upon a time, investors and analysts used to believe in ratios
that have been calculated based on the earnings that the company has
stated in the Income Statement. Alas! That was once upon a time. Of
late, there have been a huge number of frauds and malpractices that have
come to the fore. All these malpractices have taught the investors one
lesson only. The lesson is that fact that corporate income statements
and balance sheets are susceptible to fraud. This is because the numbers
in these statements are based on the policies that management sets.
Thus, in the seas of fraud, they have found truth in cash flow ratios.
Here is why cash flow ratios are so important and form the backbone of
any financial analysis conducted today.
Cash Flow is Fact
Cash flow is fact, all else is error, or at least susceptible to
error. The company cannot fudge how much cash it has in the bank. The
auditors are supposed to confirm with the bank the amount of cash that
they have in the company’s accounts and verify the same with what the
company has stated. How the company received this cash is also made
clear by the cash flow statement. Hence, it is the least susceptible to
fraud and provides the truest picture of the state of affairs.
Company Expenses Cash
The company cannot pay its employees in earnings. Neither can it pay
its creditors or suppliers in earnings. The fact of the matter is that
the company needs cash like humans need oxygen to stay alive. A few days
without adequate cash and the company may not survive. This is the
reason investors want to ensure that they have enough cash on hand to
meet forthcoming obligations. To many investors it seems insane that
expenses like interest be compared with earnings since if earnings are
not converted to cash, they cannot pay expenses. Therefore cash is what
matters!
Company Invests Cash
The company invests cash when it makes capital expenditures. These
capital expenditures are what makes the company’s profits and cash flow
grow in the future. Therefore, it makes more sense to consider cash flow
rather than earnings while trying to gauge the rate at which the
company will grow in the future.
There is no Consensus on Definition of Cash Flow
There is a slight problem with cash flow ratios though. There has
been no consensus on what constitutes cash flow. Hence there are many
measures of cash flow instead of one. This leads to there being multiple
ratios.
