Liquidity is the key
Cash flow is often considered more crucial than profitability for several reasons. Liquidity, or the availability of cash, plays a critical role in a company's ability to operate smoothly and meet its obligations. For instance, a company like Amazon, despite reporting losses, is highly valued not because of its lack of profit but due to its strong cash flow and extensive customer base. This solid cash flow and loyal customer base contribute to the company's goodwill and potential for future growth. Therefore, focusing solely on profitability while neglecting liquidity can prevent a business from realizing its true value and potential.
In capital budgeting decisions, cash flow is prioritized over profitability when deciding whether to purchase equipment or undertake a project. Accountants abuse income statements by dumping non-cash and non-operating items into income statements to adhere to global accounting frameworks, which can obscure the company's true financial health. The key consideration is whether the company has enough cash to cover its operational expenses and installment payments. Even if accounting statements show a project as unprofitable, it may still receive approval if it promises sufficient liquidity. Thus, liquidity is crucial in these decisions, ensuring the company can sustain its operations and fulfill its financial commitments.
By CA L.Muralidharan and CPA L.Mukundan
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