Corporate decision makers and governments have subscribed to the view that cashflow is a reliable indicator of a firm’s health.usually, cash flows are pragmatic yardsticks. One need not look into other sources of information, but in the level of cash coming in versus the amount of cash being spent, to determine the feasibility of a business.
However, Gentry says that cashflows, particularly operating cash flows are not as reliable as they seem to be. Taking off from a study done by Casey and Bartzack, it has been found that operating cashflows do not provide significant information on the potential of a company to become bankrupt (Casey et al, 1984).
The examination made by Gentry et al included 33 financially sound companies versus 33 failed ones. The failed companies were culled from the 1981 Standard and Poor’s Annual Industrial Research File. After the failed ones were identified, none failed counterparts were chosen, companies with similar size in terms of sale and assets (Gentry, 1985)
One observation made in the study was that healthy companies tend to invest in receivables. In contrast, the companies that filed for bankruptcies reduced the amount of receivables. The latter preferred cash, thus showing a marked increase in their inflow. Such decision was afforded by the healthier firms for they had enough cash to cover net working capital (Gentry, 1985). However, those which did not turned to compelling the clients or counter parties to pay cash, instead of extending them credit. In turn, the unhealthier companies may possibly lose clients due to such preference.
It was found however that the reliability of the amount of receivables and investments a company makes increases as the period measured is close to bankruptcy. Three years prior to bankruptcy, such indicators show no difference. But, a year prior to the event, such shall be dependable financial signals (Gentry, 1985).
Some companies which may prove to have little operating cash flow may not be necessarily poor performers. It may also indicate that the company had a sizeable outflow towards investments, that may prove to be profitable in the long term. For example, retail firms are expected to have very high cash inflows. However, with the delayed payments they give to their suppliers, they will have also a bulk of outflows (Bauwerauts, 2016).
Dividends meanwhile, continue to be a reliable measure of a company’s financial health. It has been found that companies which were performing well tend to pay higher dividends, whereas those who do not forego the payment of cash dividends (Gentry,1985). This finding is not surprising at all as the inflow from the operating activities are lower, the company will opt to tighten its outflows.
The question remains, however, if cashflow is not what is seems to be, then how can financial distress be signalled, so as to aid companies or to alert investors perhaps. As the study has mentioned, financial ratios, along with cash flows provide better pictures of a company’s financial state(Gentry,1985).
Liquidity ratios for instance, which are currently widely used to determine the possible performance of a company during a financial crisis are one of the many ratios that may provide foresight. Current assets are those which can be easily sold off and converted to cash. It indicates the level of coverage a company has when the market is unable to provide them with cash inflow(Investopedia, 2016).
Reliance on cash flows alone do not predict the propensity of a firm to go bankrupt. Using such, growth companies will instantly be considered distressed(Gentry,1985). Start-ups for example, which may have sizeable cash but likewise plenty of investments to make, will register negative flows.
Thus the statement that cash is king is not what it really seemed to be. Truly, cash of course remains unmatched, especially during a crisis or a recession when properties and other assets lose their value. However, the valuation of a company based on its funds flows alone shall prove to be a miscalculation. The funds flow should be read along with other indicators such as ratios to be able to arrive at a complete financial analysis of a firm.
References
Casey, C., & Bartczak, N. (1984). Cash Flow-It's Not the Bottom Line. Retrieved March 24, 2016, from https://hbr.org/1984/07/cash-flow-its-not-the-bottom-line
Gentry, J. A., Newbold, P., & Whitford, D. T.. (1985). Predicting Bankruptcy: If Cash Flow's Not the Bottom Line, What Is?. Financial Analysts Journal, 41(5), 47–56. Retrieved from http://www.jstor.org/stable/4478871
Bauweraerts, J. (2016). Predicting Bankruptcy in Private Firms: Towards a Stepwise Regression Procedure. International Journal of Financial Research, 7(2).
Liquidity Ratios Definition | Investopedia. (2006). Retrieved March 24, 2016, from http://www.investopedia.com/terms/l/liquidityratios.asp
