The Cash Flow Concept
The concept of cash flow is one of the central elements of financial analysis, planning, and resource allocation decisions. Cash flows are important because the financial health of a firm depends on its ability to generate sufficient amounts of cash to pay its creditors, employees, suppliers, and owners.
Only cash can be spent.
Sometimes firms are expected to have an excellent year but unexpectedly cash shortages arise. Shortages of cash may arise for several reasons.
First, not all sales are expected to be for cash or to be credit sales (accounts receivable) collected during the year.
Firms may have debt repayment obligations. Payment of taxes, interest and a cash dividend may further reduce the firm's cash position.
The firm's managers have to arrange to meet this cash shortfall through actions such as borrowing, the sale of new common equity, a reduction in dividend payments, sale of accounts receivable, or increases in accounts payable.
Preparation of a cash budget is useful in helping a firm plan for its cash needs over some future period of time.
Financial managers know that generally accepted accounting principles (GAAP) provide considerable latitude in the determination of the net income of a firm. As a consequence, GAAP concepts of net income do not provide a clear indication of the economic performance of a firm. Cash flow concepts provide a clear measure of the performance of a firm.
To evaluate the cash flows generated from the firm's activities managers use the net present value concept.
Net present value represents the difference between the present value of future cash flows associated with a project and the present value of the initial investments to acquire that project. It is the most commonly used technique to evaluate capital budgeting proposals.