Question

Fact 2: Anything that doesn't increase cash flows, via improving revenues and returns on capital, doesn't create value.

Question 2: Comprehensively explain, using numerical examples, how, as a corrolary to Fact 1, value is created by companies, for shareholders, when companies generate higher cash flows, not when rearanging investors' claims on those cash flows.

Answer 1

Cash flows are always considered the most important for any company and they are even considered more important than profits because a cash generating company will always be having a higher flexibility in its hands and it will also have a higher liquidity and solvency on its hands so these are preferable by the investor in the long run to invest because they are creating value for themselves.

There are various types of increase in revenues and return on capital which are reported by the company but they are not a resulting into increase in the cash flows as these increase in revenues and increase in return on capital is majorly accredited to to accrual basis of accounting which will be Accounting in for those incomes which will be made by the company in the future but they are not leading to increase in the cash basis of the company in the short run so the company will not be having adequate liquidity in its hands and it will also not have any adequate solvency in its hands but due to the certainty of occurance of the events they are recorded in the books of accounts due to the accrual nature of accounting and hence they will be enhancing the overall revenues and they will also enhance the overall return on capital but they will not mean they are not going to create value for the company in the long run.

The proactive recording of various cash flows due to their probability of occurance like credit sales which has been done by the company on account of 1000000 will be recorded in the books of accounts and if the company is trying to incorporate the overall costs associated with it in the range of 80% than the company will also be trying to estimate the overall rate of return of 20% generated on it but still those amount not received by the company it will mean that these cash flows are not resulting in increased in the overall value of the company so so this will not be resu6lt into a sustainable valuation according to cash basis and these are often not considered for creation of value.