Why Cash Flow Analysis is Important - Pt. 1

It is not uncommon to see the entrepreneur look at his numbers and draw the relevant conclusions considering only the economic aspect , or even worse, focusing exclusively on the last line of the Profit and Loss Statement, that is, the profit or loss of the financial year (or in any case of the period being observed), and from there take a specific decision or, more generally, redefine his strategy .

This approach is the legacy of a certain popular culture that is still quite widespread, a culture that we have been carrying around for decades and according to which when a worker has a salary of 1,000 (income: economic aspect), he knows that at the end of the month he will be credited with 1,000 (liquid assets: financial aspect).

So we are often naturally and unconsciously led to believe that the economic aspect (profit) and the financial aspect (receipt) coincide!

Today, unfortunately, the complexity of business processes and the environment in which the company finds itself having to operate, means that the economic dynamics often differ significantly from the financial one, even though both always represent two sides of the same coin .

In fact, every purchase and sale operation has two sides: an economic one and a financial one, and for the entrepreneur, understanding the difference well is not a useless theoretical exercise!

So for example, imagine two companies, A and B, that sell stationery supplies:

• Company A sells a box of pens for 100 euros to a strategic consulting firm, and cashes in immediately;
• Company B sells the same box for 100 euros to a small local public body, and it is likely that several months will pass before the money is collected.

A's operation has an economic aspect (revenue) equal to 100, and a financial aspect ( immediate cash inflow) equal to 100.

B's transaction has an economic aspect (revenue), also equal to 100, and a financial aspect (cash inflow), which this time however will occur at a future date , giving rise to a credit equal to 100.

Both companies can claim to have made a turnover of 100, but while A can immediately spend that 100 to purchase new goods or new services, B could be short of liquidity and therefore forced to turn to third-party financiers, with the further consequence that it would see its future economic results worsen due to the passive interests that it would have to pay on the financing thus received.

Therefore, with regard to the difference between profit and cash flow and the links between these two quantities, it can be concluded that:

• the existence of the first is a necessary (but not sufficient) condition for the existence of the second : as can be easily understood, if there is no profit - that is, if the company is unable to achieve revenues higher than costs - then any other consideration on the creation of cash is perfectly useless!
• the existence of the first does not guarantee the existence of the second (this is why it is said that it is only a necessary condition and not also a sufficient one!): it is possible to achieve revenues that are much higher than costs, but if the sales remain credits and are not transformed (or do so with difficulty) into cash , then the company may encounter liquidity tensions even if it is formally in profit!
• the lack of the second could compromise the first : a company with financial tensions may be forced to resort to bank debt , with an increase – sometimes even significant – in terms of passive interest , which only further worsens the situation, with the risk that a vicious circle is triggered which is rather difficult to stop.

In the second part of this article we will try to understand how to effectively analyze corporate financial dynamics, to always be able to consciously face market situations that are sometimes particularly adverse , as we have unfortunately had the opportunity to experience in recent years due to the extraordinary events that have occurred.