If you should improve your net profit in the next quarter with 10-15%, what si going to happen to your cash?

By Christo van Huyssteen, Bizrite Business Advice Services

Scenario

The managing director has just received the latest quarterly financials. During his review he notices that the net profit for the last quarter increased by 15%. Believing his company is doing excellently, he continues with his daily work.

3 months later he gets a very worrying call from the bank telling him that his company has defaulted on loan payments. Two hours later he receives another phone call, this time from a creditor, demanding immediate payment.

In a state the managing director summons his accountant, who informs him that they have exceeded their overdraft and that there is no money to pay their agreements, their creditors and soon their employees.

Cash flow defined

Lot of people think that cash flow can be defined as revenue less expenses paid. Some even believe that increased net profit must result in increased net positive cash flow. Net profit is very important element of financial analysis, but netprofit is based on accounting theory defined for the purposes of creating financial statements for firms and not for measuring cash flow.

Cash flow can be defined as the measurement of a company’s health. Cash flow is calculated on the basis of net cash inflows less cash outflows or, equivalently, operating cash flows (net income plus amortisation and depreciation) minus capital expenditures and dividends.

Measuring cash flow

Typical indicators that are used to evaluate the cash flow trends within a company are:

• Operating cash flow / Sales ratio – provides an indication of cash growth in relation to sales growth
• Free cash/ Operating cash flow – measures the relationship between free cash (operating cash flows minus capital expenditures) and operating cash flow
• Cash flow coverage ratios such as  short-term debt coverage, dividend coverage and capital expenditure coverage

Also, producing cash-flow budgets and controlling it against monthly adjusted cash-flow forecasts should give the basic health checks to ensure cashflows are well managed.

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