You might have heard about this phrase ‘Cash is king’. It is sometimes used in business analysis or investment portfolio, to emphasise on the importance of cash flow in indicating the overall health of a company.
As lenders, we must back our decisions and credit analyses with cash flow.
You may ask: Why not other aspects like profit, revenue growth, etc? Aren’t these important factors as well?
While these are important factors for consideration, they do not tell the full story. It is a common misconception is to mistake profits as cash. A company could have fantastic revenue growth, and be profitable, but it does not translate into its ability to create value (i.e. generate cash flow).
Hence, the Golden Rule in any credit analysis is always the cash flow movement – how is the cash flow generated? Where has it gone to?
Examples of areas that generate cash flow:
- The company’s operations or Ultimate Economic Activity (UEA)
- Interactions with its stakeholders (e.g. suppliers, customers)
- Contributions by promoter (e.g. as equity)
Examples of areas that uses cash flow:
- Financing the company’s day-to-day operating costs and overheads
- Repaying capital owners – interest payments, dividends, debt repayment
- Capital expenditure on physical and/or financial assets