Learn the Importance of Cash Flows

Information about cash flows can influence decision makers in important ways. For instance, we look more favorably at a company that is financing its expenditures with cash from operations than one that does it by selling its assets. Information about cash flows helps users decide whether a company has enough cash to pay its existing debts as they mature. It is also relied upon to evaluate a company’s ability to meet unexpected obligations and pursue unexpected opportunities. External information users especially want to assess a company’s ability to take advantage of new business opportunities. Internal users such as managers use cash flow information to plan day-to-day operating activities and make long-term investment decisions.

Macy’s striking turnaround is an example of how analysis and management of cash flows can lead to improved financial stability. Several years ago Macy’s obtained temporary protection from bankruptcy, at which time it desperately needed to improve its cash flows. It did so by engaging in aggressive cost-cutting measures. As a result, Macy’s annual cash flow rose to $210 million, up from a negative cash flow of $38.9 million in the prior year. Macy’s eventually met its financial obligations and then successfully merged with Federated Department Stores.

The case of W.T. Grant Co. is a classic example of the importance of cash flow information in predicting a company’s future performance and financial strength. Grant reported net income of more than $40 million per year for three consecutive years. At that same time, it was experiencing an alarming decrease in cash provided by operations. For instance, net cash outflow was more than $90 million by the end of that three-year period. Grant soon went bankrupt. Users who relied solely on Grant’s income numbers were unpleasantly surprised. This reminds us that cash flows as well as income statement and balance sheet information are crucial in making business decisions.

Decision Insight Cash Savvy  “A lender must have a complete understanding of a borrower’s cash flows to assess both the borrowing needs and repayment sources. This requires information about the major types of cash inflows and outflows. I have seen many companies, whose financial statements indicate good profitability, experience severe financial problems because the owners or managers lacked a good understanding of cash flows.”—Mary E. Garza, Bank of America ▪