The title seems obvious, yet many businesses and even financial institutions focus more on income than on cash flow when assessing the strength of a business. Income is one component of financial strength, but understanding and assessing operating cash flow is the key to determining a company’s ability to meet payment obligations.
There are several key considerations to assessing operating cash flow:
- Quantify the amount of internally generated cash (defined as EBITDA–Earnings Before Interest, Taxes, Depreciation and Amortization–adjusted for one-off items).
- Subtract primary payments (i.e., interest, taxes and scheduled debt payments) to get cash from operations.
- Analyze the effect of changes to Adjusted Working Capital for information regarding cash management efficiency and reliance on debt.
- For example, is the business turning accounts receivable and inventory in line with industry standards? If not, why not? The slower the turns, the less cash flow the company generates.
- Are payables paid in a timely manner? If not, why not?
- Evaluate spending for capital expenditures versus requirements.
- Evaluate truly discretionary spending, such as shareholder dividends, to determine if these were appropriately funded (i.e., through internally generated cash or using borrowed money?).
Working capital changes, capital expenditures and owner’s withdrawals do not impact the income statement, but all can significantly impact the business’ cash flow and its ability to repay debt. Once the business’ cash flow is understood, a business owner can better plan for future needs and manage his or her business. This understanding also allows the lender to structure credit facilities that best serve the needs of the business.
-Jeanne Zeske is vice president of commercial banking at Brown Deer-based Bank Mutual.
