Cost Overruns in Infrastructure Projects
The risk involved in an infrastructure project does not remain the same throughout the life of a project. Instead, the risk varies depending upon the stage in which the project is. The construction phase is supposed to be the riskiest phase of an infrastructure project. This is also the phase where investors demand the highest […]
Advantages and Limitations of a Budget
In the previous article, we learned about the three financial statements. We also learned how income statements and balance sheets are backward-looking financial statements. We also understood that the budget is the only forward-looking financial statement in the personal finance domain. It is the only statement that can be used to prevent economic mistakes from […]
How Credit Enhancement Works?
Credit enhancement refers to the artificial restructuring of credit products which results in the improvement of its credit rating. In simple words, if a bond being issued by an entity has credit rating BB+, it can use credit enhancement techniques to increase its credit rating to AA+ or so. There are obvious benefits of using […]
What are Black Friday Sales and What are its Economic Impact on Retailers
The retail industry has been rapidly evolving for many years. The industry has adapted to a wide range of changes varying from the introduction of online retailing to the widespread use of automation. However, there are some aspects of retailing which have not changed for a long time. Retail companies all across the world still […]
Different Asset Classes in which Pension Funds can Invest
Pension funds have a very large amount of money at their disposal. However, that does not mean that the management of these funds can deploy this money as per their will. Pension funds are highly regulated and the asset classes in which they can invest in are limited. Over the years, the limitations have been […]
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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