There are various reasons why you might need to examine another company’s books. You should certainly do so if you’re considering investing in the business, but you may also want to get a better idea of their finances before offering credit.
But what should you be looking for? Turnover? Profit? Or is it better to look at cash flow?
Why Is Cash Flow Important?
Profit and turnover each give only a very partial picture of a company’s financial position. Turnover is a better indication than profit, which is dependent on many factors, but it can still be misleading at best, and even subject to deliberate manipulation.
Cash is either there or not. It gives a completely objective snapshot of precisely how much money is flowing into and out of the company at that moment. While other factors, such as future orders, may be relevant for your decision, that money isn’t in the bank right now — and something may go wrong.
What to Look for in Cash Flow?
- Operating cash flow — This tells you how much income the company generates from its regular business, showing how sustainable its capital is. Consistency is ideal, since a sudden surge in income could come from late payments — a danger sign.
- Changes in debt — Properly managed debt can be a perfectly valid means of raising finance, but constantly rising debt is a red flag. If the company has a negative cash flow, it may be plugging the hole by over-relying on debt.
- Changes in equity capital — Again, there’s nothing at all wrong with either issuing new shares nor buying shares back. However, doing either too frequently may suggest the company could be in financial trouble, and this will need to be investigated.
- Investment — Investing in new equipment, plant or property may cause a big decrease in overall cash flow. As long as it’s undertaken sensibly, though, to promote sustainable growth, this expense can be a positive sign, rather than a negative one.
Sustainable Cash Flow — a Good Sign
Steady and sustainable cash flow is one of the best signs of a financially healthy business. Although other checks are needed before granting credit, a good cash-flow position will suggest a reliable payer.
Of course, nothing is certain in business. A company that’s in a healthy state now might change over time, while someone new in a key position could change their values — such as whether or not they pay promptly.
If, in spite of all your checks, a customer becomes an unreliable payer, give me a call to see how I can help you recover your money.