Whether you use the paper, plastic or electronic forms of money cash remains one of the most utilized methods for the exchange of goods and services around the world. It forms the basic structure of currency for economies and businesses in all world markets.
For an individual; cash is what you are often paid and spend for everyday activities. You receive cash for the work you do in your career and spend cash to pay bills, consume goods and pay your taxes. On the other side of the coin are corporations; who have bills to pay, money to receive for the sale of their products or services, taxes to pay to governments and at times distributions (from cashflow or earnings) to investors. Regardless of which side of the coin you stand, the importance of cash should be clear to everyone.
The flow of cash in and out of a corporation is often one of the least investigated and acknowledged sources of information for investors evaluating a company. Too often we focus intently on a company’s ability to generate profit and the earnings per share that calculates into various ratios. Investors discuss topics ranging from book value to growth rates, but understanding the important day to day functions of a company can help an investor make better investment decisions about the direction that a company is headed.
Why is cash flow important to a company?
Cash flow is the movement of cash in and out of a business over a period of time. In my Triage Format cash flow is viewed as the blood of a corporation. Without adequate nourishment of vital organs and tissues parts of the human body will slowly begin to die (ischemia). Cash flow provides a business with short-term needs to pay its bills, repay debt, make investments and protect itself against crisis. Cash flow is what the company has at its fingertips to conduct its daily operations. When a company buys raw materials to make products, uses electricity or deposits paycheques into its employees bank accounts the preferred form of currency will always be cash.
Industries such as oil & gas, telecommunication, real estate, manufacturing, technology and healthcare companies all require substantial cash flow in order to stay viable in a competitive environment due to capital intensive activities. If you’re a large growth company, then financing and debt can only get you so far before your balance sheet crumbles under the pressure of debt.
Sustained, controlled and growing cash flow can indicate quality management if the company’s objective is not to seek alternative sources of financing. A company needs to be able to grow internally (organically) over a period of time in order to strengthen its balance sheet for the future by paying off large amounts of debt in order to obtain more. If a company’s objective is to grow through acquisition or expand with additional locations or manufacturing capacity, then cash flow offers a strategic alternative that allows a company to finance a capital expenditure without issuing more shares (share dilution) or taking on unnecessary debt. In the current market environment investors can clearly see the advantage and benefit of strong, excessive cash flow to a business when financing is expensive and credit markets tight.
Cash flow is king largely because companies who generate substantial amounts offer shareholder value through various methods. We already know that cash flow has the ability to pay off debt and avoid taking on excessive debt for growth. But extra cash flow can also be used for purchase of new technology/equipment, increased activities in R&D, share buy backs or an increase in dividends. Predictable cash flows give a company all these opportunities and more to benefit institutions and individuals holding their shares.
When assessing a company for an investment you can want to target companies that never run out of cash. Imagine living off your current income and then suddenly living on exactly half – could you manage? Cash flow is equally as vital for a company to manage and operate (regardless of the business climate) as your own finances. Each company will encounter difficulties throughout a business cycle when good times can lead to bad. What you want to focus on is when a company encounters these difficult times, can management protect or utilize its cash flow advantages to protect or position the company for future successes? The problem of course is when a company has poor management, too much cash flow and doesn’t understand the need for proper discretion in budgeting and providing value to the corporations’ future or shareholders. Beware of these companies because quality management should be directly related to quality cash flow control.
See Also:
Cashflow is King Part II
Click here to see how future posts can be delivered directly to you
