Question

Why cashflows rather than profits are most desirable in financial management?

Answer 1

Cash flow: Cash flow is the net amount of cash & cash equivalents (bank, marketable securities etc..) being transferred into and out of business. Cash flow may be positive or negative. At most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows.

The most important thing to have positive cash flow is to meet its day to day activities. For example if a infrastructure company is doing a big project. So it have to deploy daily labour for its construction work. If the company not having proper cash to settle daily labour in regular intervals, they (labour) won't come for work, due to that projest will going to be delay. A delay in project will cost the company in many ways. It may lead to higher costs. Sometimes non financial disadvantages also will be there. So having positive cash flow is very important to run the business in a smooth way.

Positive cash flow allowing the company to reinvest, pay out money to shareholders, or settle future debt payments. If a company with negative cash flows unable to meet its obligations, then it have to face some leagal regulatory issues also, which may altimately effect going concern of the company.

Generally cash flows are three types

1.Operating cash flow: Cash generated by a company's main business activities.

2.Investing cash flow: All purchases of capital assets and investments in other business ventures.

3.Financing cash flow: All proceeds from issuing debt and equity as well as payments made by the company to debt & equity holders in the form of interest and dividend. It includes repayment of debt also.

Positive cash flows are the key to continue main business activities, key to improve the efficiency and effectiveness of the company through investing in assets, key to expansion of business.

Even profitable companies can fail if their operating activities do not generate enough cash to stay liquid. This can happen if profits are tied up in outstanding accounts receivable and overstocked inventory, or if a company spends too much on capital expenditures. Most of the infrastructure companies are facing this problem.

To understand the true profitability of the business, we have to look at free cash flow. It is a really useful measure of financial performance – that tells a better story than net income — because it shows what money the company has left over to expand the business or return to shareholders, after paying dividends, buying back stock, or paying off debt.

Free Cash Flow = Operating Cash Flow - Capital Expenditures

Profit: Profit is the surplus after all expenses are deducted from revenue.There are two major types of profit that analysts analyze: gross profit or operating profit, and net profit. Each type of profit gives the analyst more information about the company's performance, especially when compared against other time periods and industry competitors

When determining whether profit is more important or cash flow is more important, it depends on business and circumstances. But a company can survive without profit for some time, it can't survive without having positive cash flows. For example a company like Uber is surviving without profits for many years, but it is expanding its business due to its positive cash flows. These cash flows may come from operating or investing or financing activities.

So companies having growth in future can concentrate more on cash flows (positive) rather than profits. A good cash flow management may automatically lead to profit.