Question

Imagine that a client has just inherited $100,000 and is considering investing in the company you have analyzed by purchasing common stock. What is your recommendation ? The company has improved cash flow compared to last year. Buy or pass? Buy. Why? Explain in 150 to 200 words.

Answer 1

Analyzing cash flows is a better way to evaluating stocks as the net income (profit) of a company may at times be negative or very less on account of various fixed expenses or non-cash expenditures like depreciation, which may be very high due to various reasons like heavy capital investment (leading to high depreciation) or major borrowings or a major marketing costs incurred.

On the other hand, cash flows show the actual cash generated by the company by way of its activities during the year, hence it provides a more realistic picture of the whether the company is conducting its business in an effective and efficient manner.

Also, positive cash flows of the company suggest that the company can generate adequate cash flows from its operating activities (mainly revenue leading to net income and cash effect of movement in current assets and current liabilities), to provide for fresh capital investments (investing activities) and meet its liabilities like interest, loan repayments and dividends to lenders and owner, i.e., shareholders (namely financing activities).

Therefore, if a company has improved its cash flows compared to last year, a person may consider buying its stocks, as it suggests good liquidity position of the company.