Question

You are working as a loan officer at a local bank. Earlier today, a former high-school classmate came in to see you about a loan for the family’s retail business. After looking over the store’s financial statements, you notice that the store is posting a strong net income growth. However, these statements also reveal that the store has had a negative cash flow for the last two years and that account receivables have almost doubled over the same time span. Should this concern you? Why?

Answer 1

Yes, this should concern me. A business no matter how beneficial it is or in a huge profit, it might be running can't function without cash. If the cash flow is negative that means the business has no cash in hand to fulfill its current liabilities. This will force the business to borrow and the repayment amount with interest will increase the operating cost and reduce profit.

Moreover, the amount which the company is going to receive from the sources in the future can turn into bad debts and this will further eat into the profit. A company needs cash for buying raw material, paying wages and almost everything in the business. If the cash is low the company will soon run into huge debts to carry on these day to day functions and will not be profitable anymore.

While giving a loan to the company the bank has to look for the liquidity the company has in hand to fulfill its current liabilities as well as assets and future prospects for servicing long-term debts.