Mr. Warren Buffett often says “Cash is the King”. But why does he give so much importance to cash and cash flow?
Is there something very important which regular Investors often avoid!
Well yes, no matter if a business is small or big, privately owned or publicly owned listed company, startups or a mature established business, offering products or services, cash is the most crucial resource to any business.
Contents
Importance of Cash Flow Statements
In this article, we are going to discuss all aspects of cash and its importance.
What is Cash?
In terms of economics, the most liquid asset is called cash.
Cash is the runway of any business, the more cash a company holds the more time it has to survive in case of a financial crisis and economic slowdown.
Let’s discuss some important points.
Unnecessary debt
Those companies which hold enough cash will never face any problem to fund their regular operational expenses and they will not need to borrow money.
If the companies will not have enough cash then borrowing money will be the only option left which will cost the company another expense of interest and the profitability of the business will be affected.
Low-Cost Raw-material
In the case of a manufacturing company, the company needs raw material to make finished goods. Most companies outsource raw material from another company which ultimately costs some money.
If the cost of raw material is paid in advance or cash then the supplier gives some discount or at the minimum price possible which ultimately increases the profits of the company.
Ease in Interest Payment
Having enough cash helps companies to pay interest on loans and dividends (especially in the case of preference shares) on time.
It further increases the goodwill of business between lenders, investors, and business partners.
Also helps the company to borrow/raise capital very easily whenever needed.
Avoid Bankruptcy
Cash is the runway of any business, the more cash a company holds the more chance it has to turnaround in the case of economic slowdown, financial crisis, business cycles (in case a company operates their business which depends on the macroeconomics cycle).
Many companies often failed not because of loss-making business but due to negative cash-flow. No matter how profitable the business is.
Expansion
An expansion plan helps a company to grow further either by setting up new factories, product lines, internal expansion of the existing factories, etc.
All types of expansion required some investment which paid upfront in cash.
Acquisition
Acquiring small businesses also helps companies to grow their topline as well as the bottom line simultaneously.
Many acquisitions bring fruitful results.
For example,
In the year 2006, Google acquired youtube which was one of the most successful acquisitions in the last decade.
Another successful acquisition was done by Facebook in which Facebook acquired Instagram.
But in the end, acquiring businesses required a lot of cash. Those companies which are loaded with cash could do acquisitions without diluting the stakes of existing shareholders.
What is negative Cash flow?
Negative Cash flow is a situation in which the companies operating business take more cash than it generates.
The operating cash flow of startups always becomes negative that’s why they raise capital by diluting the stakes of founders to fund their operation.
Having negative cash flow of startups is very common. But it is a huge problem for any mature business.
It’s a very negative sign whenever we see negative cash flow in a public listed company.
Reasons for Negative Cash flow?
Basically there could be 3 possible reasons for negative cash flow.
- Loss in business operation- If a business consumes more cash than it generates in business operation then its overall business operation will lose money in net.
Losing money in business operations is very common in startups and most conservative investors avoid these types of business and startups.
- High Debtor Days- If debtors days of any business are increasing overtime it means they are facing issues to get payments from their customers. It may create a situation for negative cash flow.
- Low Inventory Turnover Ratio- A low inventory turnover ratio means the movement of inventory of a business is very slow and it takes a lot of time to manufacture, sell, and ship the finished goods.
A low demand in the market could be another reason for the low inventory turnover. In this case, the inventory started piling up and you can see the inventory details in the balance sheet assets side.
Without any doubt low inventory turnover creates a situation for negative cash flow.
Closing Thoughts
As you can see there are a lot of factors which depend upon the cash. Businesses face a lot of business issues due to lack of cash and at the same time you can see businesses which have a lot of cash have huge advantages for growth strategies.
No need to forget, the purpose of any business activity is to earn cash. Not just profit because profit is worthless for any business if they can’t generate cash. A business invests cash to generate more cash in future.
So what do you think? You will only look for profit or cash flow in analysing any business before investing. Comment Below!
