Accounting Article

Cash Flow Analysis
Reading Borrower’s Health

An experienced banker was once asked about secret of his decision making.  He replied that before taking any lending decision he wanted the prospective borrower to satisfy him on two basic points: firstly how he is going to pay back the money and secondly what should he (banker) do to know that his plans on which repayment depends are really materialising. Obviously there should be a system for the banker to know about the health of his borrower’s business.  Cash flow is one of the tools to have this information and more precisely borrower’s ability to meet his obligations as and when they mature.  Unfortunately the system has not been given due importance in credit appraisal in Indian context.

Liquidity and Solvency

Liquidity refers to borrower’s ability to meet his current obligations i.e. how fast the current assets are converted into cash to pay for current liability.  Solvency on the other refers borrower’s ability to service the debt i.e. ability to meet interest cost and repayment of term loan.  A borrower may have enough assets but may not have enough cash to meet his obligation (for the reasons which we shall analyse afterwards).  Thus, there is a need to look into liquidity in depth.

Liquidity and Profitability

Generally speaking the health of a borrower is gauged by his ability to earn.  But sometime a borrower though showing profits may not be in a position to meet his obligations because profits always does not mean liquidity.  Profitable companies can be cash broke and unprofitable companies may have rich cash lodes.  A borrower in distress may resort to window dressing to hide his real state of affairs by resorting to certain accounting conventions, change in valuation of inventory (LIFO TO FIFO or vice-versa), under provision of liability, revaluation of assets etc. are usually adopted practices to inflate/manipulate profits.  Hence there is a need to know what cash is exactly generated by the borrower from operations to see his ability to service the debt and meet current obligations.

Cash Generation – What does it represent ?

Refer cash generation most probable reply would be “profit add back depreciation”.  Let us analyse the statement with the help of a simple example:
  Sales             100
  Cost of sales  (80)  excluding depreciation

  Depreciation  (10)
  Profit              10

So profit plus depreciation means that cash generated is 20.  Is it represent the cash generated?  In fact is not so because :-

(a) Sales include sales on credit which very often are not realised in all.
(b) Cost includes expenses which very often not paid in all.
(c) Profit includes tax and other items though provided but not paid.

Hence there is a need to look beyond what we normally conceive as cash generated.

Cash Flow Statement – Source of Vital Information

Cash flow statement provides information regarding sources (where got) and uses (where gone) of cash.  In other words it provides information of movement of cash between two balance sheets dates.  A reference to “Cash Flow – Flow Chart” will provide information to the readers that how Profit & Loss and Balance Sheet can be used to recast cash flow statement.  The ability to understand Profit & Loss statement as it relates to Balance Sheet and Balance Sheet as it relates to cash flow can provide under noted valuable information to the banker :

(a) Whether operating cycle is generating enough cash to meet out cost of operation.  (ability to meet current obligations)?
(b) Surplus available after operating cycle is enough to meet out interest and dividend obligation.  In other words whether company borrow money to meet this obligation?
(c) What surplus is left to meet out term liability due (solvency)?
(d) Is there any surplus left for meeting  cost of expansion?  (Investment in fixed assets for expansion, inventory built up etc.)?
(e) At what time cash flow turns negative and how it is financed (short term loan or long term loan)?
(f) Overall cash management shows management efficiency i.e. how cash is managed?  (Excess, adequate, inadequate).

With study of 3-4 years of cash flow statement a banker can find out cash management position and can see whether cash position is improving or deteriorating.  Pertinent here is that cash flow cannot be manipulated by accounting conventions and there is no way to hide significant flows from a banker.  It should be taken for granted that a company not generating cash will eventually fail because external source (bank loan, equity of long term loan) are like fair weather friends whose help is available only when borrower is in a position to service them.  No investor would like to risk his money if he finds that borrower will not be able to repay it. It should, however, be noted that cash consuming operating cycle does not always mean ‘sickness’.  It is true for growing organisations also because both need outside finance for their survival.  The difference is that while former need to make up money eaten up during operation later needs it to meet growing needs i.e. increased inventory, receivable etc.  Here banker’s perception is crucial to differentiate between growing and weak organisations and to decide whether he would like to put more money.