Question

Why does finance managers prefer cash flow to profit a business makes?

Answer 1

Many relate the success of a company to its profits but finance managers prefer cash flow to profits. Profits do not exactly represent the financial standing of the firm. It may be possible for a company to show profits and go out of business or may not be able to secure financing or attract investors. There are a number of reasons for having such a scenario:

• Profits can be easily manipulated because they include non-cash items like depreciation and goodwill write-offs whereas, cash flow analysis provides a more straight forward report of the cash.
• Cash is necessary to keep na business alive. For example: If a company fails to purchase new inventory, it will gradually become unable to generate sales.
• Profits are reported based on sales. When sales are on credit, the profit recorded is greater than the cash received. So, in case the credit period is in months, the business may not have enough cash to meet its operating expenditure.
• To generate growth in sales and expand the capacity, cash outlays are necessary in early stages for additional personnel, equipment, inventory etc. More sales and profit are great as long as they do not result in depletion of cash.
• Businesses may even resort to commercial financing in case of scarcity of cash for expansion and growth purposes, but then also they require cash as lenders expect regular repayments on the financing they provide to businesses.

These instances are just a few examples of why cash is preferred by managers instead of profit figures. In real life scenarios, more such reasons may be seen on day to day basis.