Positive cash flow is generally regarded as a strong indicator of a company's future potential. Managers, investors and analysts, however, must consider cash flow in line with other prominent financial reports to avoid misinterpreting a company's situation. You can easily overestimate a company's potential if you look only at its statement of cash flows.
Cash Flow Basics
A cash flow statement shows the net change in cash flows for the company's operating, investing and financing activities during a given period. While each category affects overall cash flow, operating cash flow is especially critical because it shows changes in cash from the company's primary business activities. The culmination of the cash flow statement is the cash flow for the period end date after positive or negative changes have been recorded.
In his October 2010 article "Advance America -- Where High Cash Flow Is Misleading" for GuruFocus.com, Saj Karsan points out an example of a company that predicts and writes off significant bad debt accounts when formulating its net income statement. However, the company's cash flow statement does not account for these bad debts and shows a much higher positive cash flow than the company will ever collect. In essence, it has millions of dollars of expected cash it knows it will never receive.
Sales and profits are two very distinct business concepts. Sales or revenue simply means the company collects cash in exchange for the sale of products or services. However, companies often sell products for less than they actually paid for them. When this is done in desperation to generate cash to pay bills, to avoid bankruptcy, or to drive immediate traffic, although it produces cash flow the company is not profitable and is selling its inventory at a loss.
Another potential problem with interpreting positive cash flow as a good indicator of a company's viability is that cash flow is most beneficial in the short term. Strong cash flow generally means the company can meet its current loan payment obligations. However, a company burdened with overwhelming long-term debt and a high-cost business model still faces ongoing pressure to generate more cash and income. Thus, comparing cash to long-term liabilities is important.
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