Cash Flow Vs. Accrual Profit

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Cash Flow vs. Actual Profit

Background

One of the important things that will make or break a company is it’s cash flow. It is widely experienced that many of the companies although running profitably face severe cash crunch, which ultimately lead to liquidation of the company. Many of the investors focus mainly on the profitability of the company in order to assess the worth of their investment. But they seem to be less bothered on the fact that all the earnings of company may not be available for investing in the company’s operations. Cash flow presents a clearer picture of a company’s actual performance, simply because it reflects money received and paid out during a given interval, whereas accrual profit is based on various non-cash incomes and expenditures.

Difference Between Cash Flow and Profit

Cash flow and accrual profit are two entirely different concepts, each with entirely different results. The concept of accrual profit is somewhat narrow, and only looks at income earned and expenses incurred by the company at a certain point in time irrespective of realization or payment of cash. Cash flow, on the other hand, is more dynamic concept. It is concerned with the movement of money in and out of a business. More importantly, it is concerned with the time at which the movement of the money takes place. The concept of cash flow is more in line with reality as it considers the cash in flows and out flows of the company. Accrual accounting policies adopted by the companies creates the difference between the cash profit and the accrual profit. Cash flows cannot be manipulated the way the earnings are manipulated.

Needless to say, there are many other transactions that result in substantial differences between accrual accounting income and cash flow from transactions. For example, depreciation is an expense deducted from business income to reflect the annual cost of assets used in the business. Since the depreciation deduction is purely a paper expense, it requires no cash outflow. Therefore, if a company uses the accrual method of accounting, depreciation must be added back to the accrual net profit to determine the cash flow profit of the company.

Use of the term “Profit”

Most of the investors and the investment analysts consider profit factor while assessing the value of their shares. They use price/earnings multiple as a basis for the valuation of shares. But the ability to generate positive operating cash flow provides evidence of a company’s ability to provide the cash flow that investors seek. Therefore, operating cash flow should serve as a foundation for corporate valuation, the concern of equity investors, and for sustained debt service, the focus of creditors. In fact, less numbers of the analysts use cash-earnings multiples as a basis for the valuation of shares.

Instead of traditional cash operating flow, some investors and investment analysts use earnings before interest, taxes, depreciation and amortization as a preferred measure of cash flow. It is seen as a crude measure, but one that is easy to compute and that provides a generous and liberal definition of cash flow. But investors using this measure must understand that this is not cash flow per se but rather a measure of working capital or funds provided by operations, calculated before interest and taxes.

Use of the term “Cash Flow”

From the business standpoint, cash is the essential fuel that drives business forward and cash flow is omnipresent there is no escape from it, whether one is a businessperson, investor, or lender. Many companies with unexpected cash shortages and even occasional cash surpluses have realized the importance of cash flows.

Management of cash flow of a company is simple in concept but can be complex in execution. If you plan ahead and look for problems as far out as possible, you can avoid many of them and lessen the severity of the ones you can’t avoid. Ways of tackling the cash flow problem could be prevention and cure. The former concept suggests for the management of problem in such a way that problems can be seen and dealt with early. The later concept suggests for dealing with problem after it’s occurrence. Prevention is by far the best option.

The cash flow statement enables the management to track cash as it flows in and out of the operations of the company and helps to find out the causes of cash flow shortfalls and surpluses. The operating activities are the daily occurrences that are essential to any business operation. If these are positive, then it indicates to the owner that the business is self-sufficient in funding its daily operational cash flows internally. If the number is negative, then it indicates that outside funds were needed to sustain the operation of the business.

Investing activities generally use cash because most businesses are more likely to acquire new equipment and machinery than to sell old fixed assets. When a company needs cash to fund investing activities in a given year, it must come either from an internal operating cash flow surplus or from financing activity increases or from cash reserves built up in prior years. Financing activities represent the external sources of funds available to the business. Financing activities typically will be a provider of funds when a company has shortfalls in operating or investing activities. The reverse is often true when operating activities are a source of excess cash flow, as the overflow often is used to reduce debt.

Why “Cash Flow”?

A company running profitably but with inability to generate cash may lead to its failure. This may be because of the fact that the profit of the company does not get quickly converted into cash. This may result negative cash flow. A company with negative cash flow will be unable to meet its obligation towards the creditors. If a company ever runs out of cash, it can’t survive.

When a company faces cash flow problem, it may have some painful choices: borrowing the money, delaying the payment to creditors, delaying the payment of wages and salary, trying to convince the debtors to pay their bill early, etc. A much better option could be to have a close relationship with the banker and raise the funds to finance cash mismatch. The bottom line with cash-flow management is to develop the tools and discipline to manage it constantly, look for problems as far into the future as possible, and set up a good plan for dealing with the unavoidable problems.

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