Q: Could you explain quantity and quality of cash flow one more time?
A: We must always look not just at the quantity of, say, Business Cash Income, but at the quality of that number as well.
If Business Cash Income is negative, meaning there is insufficient cash flow to service debt, it is not always a major cause for concern. Let’s say that all income statement profitability ratios are still as steady and strong as in previous years, and all balance sheet turnover ratios are also as good as previous years. If so, then the reason for negative Business Cash Income would be due to sales growth. And financing sustainable sales growth would be a good reason to lend.
However, if Business Cash Income is negative because all profitability ratios are deteriorating and the turnover ratios are increasing, than the primary reason for negative Business Cash Income is poor income statement and balance sheet management in addition to possible sales growth. In that case, we would want to closely analyze the credit to determine the specific reasons for the deterioration in financial performance before approving any new loan.
Course overview: Ratios and Messages about Profitability and Cash Flow