There can be a rather massive difference between our traditional definition of cash flow, i.e., net income plus depreciation, and actual cash flow from business operations, as we all know.  In our one day seminar in Salt Lake City, we came back to that observation repeatedly.  But this is really an unfair comparison, which attempts to match apples and oranges.

Net income plus depreciation largely does what it is intended to do, which is to indicate whether a company generated sufficient profit, absent non-cash charges, to repay debt as scheduled.  After all, a company’s cash flow from business operations cannot exceed its profit.  The profit signals the cash flow.  Consequently, if net income plus depreciation is greater than scheduled debt repayment, then a borrower will indeed be able to properly repay long-term debt as scheduled if and when it converts all accrual profit to cash.

The “if and when” clause is an important caveat.  Nonetheless, in most instances accrual profit is properly converted to cash.  But we still need to refine our definition of “net income” in many instances to include all the compensation flowing from a company to its owners.  Distributions and loans to shareholders provide owners and partners with cash to pay income taxes on company profit for all non Subchapter C corporations.   They also provide compensation that drains resources from the company otherwise available to repay debt.  So our definition of “net income” requires an adjustment or two.  And with these adjustments, we get much closer to a sound measure of debt service capability.

But traditional “cash flow” is still not cash flow from business operations.   The balance sheet impact is missing from traditional “cash flow”, and the balance sheet can either be a major cash drain or a significant cash source – or both in sequential years.  A business runs on cash.  So until we take the time to track the cash flow and understand how management controls and influences company cash flow, we miss a fundamental dimension of business success or failure. 

Or in other words, let’s not ask “cash flow” to do something it was never designed to do.