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(^308) Financial Management
payments, that are matters of contract and should not be defaulted Policy obligations
consist of those financial obligations, like dividends, that are at the discretion of the
board of directors. Policy obligations are also called discretionary obligations.
The cash flow analysis may indicate that a decline: in sales, resulting in profit decline or
losses, discretionary obligations. may not necessarily cause cash inadequacy This may
be so because cash may be realised from permanent inventory and receivable Also,
some of the pemranent current liabilities may decline with fall in sales and profits. On
the other hand, when sales and profits are growing, the firm may face cash inadequacy
as large amount of cash is needed to finance growing inventory and receivable. If the
profits decline due to increase in expenses or falling output prices, instead of the decline
in the number of units sold, the firm may face cash inadequacy because its funds in
inventory and receivable will not be released The point to be emphasised is that a firm
should carry out cash flow analysis to get a clear picture of its ability to service debt
obligations even under the adverse conditions, and thus, decide about the proper amount
of debt in the capital structure This can be done by examining the impact of alternative
debt policies on the firm's cash flow ability. The firm should then choose the debt poiicy
which it can service.
Cash Flow Analysis Versus EBIT-EPS Analysis
Is cash flow analysis superior to EBIT-EPS analysis? How does it incorporate the
insights of the finance theory? The cash flow analysis has the following.
l It focuses on the liquidity and solvency of the firm over a long-period of time,
even encomyassing adverse circumstances Thus. it evaluates the firm's ability to
meet fixed obligations.It goes beyond the analysis of profit and loss statement and
also considers changes in the balance sheet items.
l It identifies discretionary cash flows. The firm can thus prepare an action plan to
face adverse situations.
l It provides a list of potential financial flows which can be utilised under emergency.
l It is a long-term dynamic analysis and does not remain confined to a single period
analysis.
The most significant advantage of the cash flow analysis is that it provides a practical
way of incorporating the insights of the finance theory. As per the theory, debt financing
has tax advantage. But it also involves risk of financial distress. Therefore, the optimum
amount of debt depends on the trade-off between tax advantage of debt and risk of
financial distress, financial distress occurs when the firm is not in a position to meet its
cont,actual obligations. The cash flow analysis indicates when the firm will find it difficult
to service its debt. Therefore, it is useful in providing good insights to determine the
debt capacity which helps to maximise the market value of the firm.