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Once upon a time, investors and analysts used to believe in ratios that have been calculated based on the earnings that the company has stated in the Income Statement. Alas! That was once upon a time. Of late, there have been a huge number of frauds and malpractices that have come to the fore. All these malpractices have taught the investors one lesson only.
The lesson is that fact that corporate income statements and balance sheets are susceptible to fraud. This is because the numbers in these statements are based on the policies that management sets. Thus, in the seas of fraud, they have found truth in cash flow ratios. Here is why cash flow ratios are so important and form the backbone of any financial analysis conducted today.
Cash flow is fact, all else is error, or at least susceptible to error. The company cannot fudge how much cash it has in the bank. The auditors are supposed to confirm with the bank the amount of cash that they have in the company’s accounts and verify the same with what the company has stated. How the company received this cash is also made clear by the cash flow statement. Hence, it is the least susceptible to fraud and provides the truest picture of the state of affairs.
The company cannot pay its employees in earnings. Neither can it pay its creditors or suppliers in earnings.
The fact of the matter is that the company needs cash like humans need oxygen to stay alive. A few days without adequate cash and the company may not survive. This is the reason investors want to ensure that they have enough cash on hand to meet forthcoming obligations.
To many investors it seems insane that expenses like interest be compared with earnings since if earnings are not converted to cash, they cannot pay expenses. Therefore cash is what matters!
The company invests cash when it makes capital expenditures. These capital expenditures are what makes the company’s profits and cash flow grow in the future. Therefore, it makes more sense to consider cash flow rather than earnings while trying to gauge the rate at which the company will grow in the future.
There is a slight problem with cash flow ratios though. There has been no consensus on what constitutes cash flow. Hence there are many measures of cash flow instead of one. This leads to there being multiple ratios.
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