Why are cash flows so important for a company?

Hello, I am Umesh Tripathi, and we are learning the concepts of Fundamental Analysis. 
In this video, we are going to learn about the importance of cash flows in analysing a particular company. 
We will also understand what cash flow ratios are, and what free cash flow means. 

In previous videos, we learned what cash flow is. We know that cash is king. Cash is used by companies to pay utility bills, clear dues, and essentially sustain the business. 
Cash flows are real, unlike the profit and loss statement or balance sheet, which may not give a clear picture of actual cash movements. 

Cash flows show where the money is actually going and provide a clearer picture of the company’s financial health than the profit and loss statement alone. 
Always remember: profits are not always equal to cash. A company may report profits but still struggle with liquidity in the background. 
Cash flows reveal the actual inflow and outflow of cash and show the company’s ability to pay dividends, repay debt, and reinvest in the business. 

Cash flow becomes particularly important during periods of economic stress or downturns, as a company’s ability to sustain operations depends heavily on its cash flow data. 
That’s why cash flows are a very important part of the overall fundamental analysis of any company or business. 

Free Cash Flow (FCF) 

Now that we understand cash flows in general, let’s discuss free cash flow. 
Free cash flow shows the true profitability of a company because it removes all capital expenditures from its operating cash flow. 
In other words, it is the actual cash left after spending on capital expenditures needed to expand the business. 
Free cash flow can be used for dividends, buybacks, and debt repayments, and is vital for estimating a company’s or stock’s valuation for example, using the Discounted Cash Flow (DCF) method to derive intrinsic value. We will discuss that in detail in upcoming videos. 

Important Cash Flow Ratios 

To analyse a company’s liquidity, solvency, and efficiency, several key cash flow ratios are used. Let’s go through them: 

1. Operating Cash Flow Ratio

    This is calculated by dividing cash from operations by current liabilities. 
   It measures liquidity i.e., whether short-term liabilities can be covered by cash generated from operations. 
   If the ratio is greater than 1, it means the company’s operating cash flow is sufficient to cover its short-term debts. 

2. Price-to-Cash-Flow (P/CF) Ratio 

   This is calculated by dividing the market price per share by the cash flow per share. 
   It helps determine whether a company is undervalued. 

• If P/CF ≤ 10 → can be treated as undervalued. 

• If P/CF > 20 → may be considered overvalued (though this also depends on the industry). 

3. Cash Flow Coverage Ratio 

   This is calculated as: 

(Operating Cash Flow + Interest Paid + Taxes Paid)/(Interest Paid)  

It measures how easily a company can pay interest on its debt. 
A ratio higher than 1 indicates strong financial ability to service debt. 

4. Cash Flow Margin 

   This is calculated by dividing operating cash flow by net sales. 
   It measures how efficiently a company generates cash from its sales. 
   Higher cash flow margin indicates stronger operational efficiency. 

Example 

Let’s compare two companies, ABC and XYZ: 

• Both have the same net profit: ₹500 crore. 

• Operating cash flow: ABC = ₹600 crore; XYZ = ₹300 crore. 

• Free cash flow: ABC = ₹400 crore; XYZ = ₹100 crore. 

• Price-to-Earnings (P/E) ratio: both are 20x. 

• Price-to-Cash-Flow (P/CF) ratio: ABC = 16.6x; XYZ = 33.3x. 

From this, we can clearly see that ABC is more attractive from a cash flow standpoint. 

Conclusion: 

Cash flow is the real king when analysing a company’s actual performance. It not only helps in evaluating whether a business is sustainable but is also an essential tool for making smart investment decisions. 

That’s all for this video. See you in the next one. 

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