Why might it be dangerous to concentrate on cash to exclude Profit when analyzing a set of financial statements?

Cash is a liquid asset in the company. It is also considered a financial analysis metric to access a company’s financial health. Moreover, it is often recommended to be used closely with profits and income statements in general (Stobierski, 2020). The usage of cash may sometimes be misleading in the following scenarios. The first shortcoming of using cash as the financial analysis metric is that cash spending may be delayed. A company may have a lot of cash at its disposal, which translates to good financial health. On the contrary, this may result from the company taking too long to make payments to its creditors hence holding more cash.

Another scenario is when the business stocks more inventory for the future. The underlying implication is that if the inventories are bought today by cash, the business will record a decline in cash flows (Klammer, 2018). A decline in cash flows may be interpreted as the company’s poor financial position. The above may not be the case since the assets have not declined as the inventory has increased, which translates into revenue increment. When revenue increases, the probability of Profit rising is somehow guaranteed.

Moreover, cash may increase due to an increase in sales if the cash is a good metric for analysis; this could mean the company is doing well. On the contrary, that may not be true as sales volume may increase with an increase in operating expenses, thus leaving a small portion for profits or even a deficit (Klammer, 2018). In conclusion, cash may be a good metric for financial analysis, especially when the business in question is cash-based. Any rise in cash flows could also mean high chances for profitability. It is equally important for businesses to consider other metrics before making decisions.

References

Klammer, T. (2018). Statement of Cash Flows: Preparation, Presentation, and Use. John Wiley & Sons.

Stobierski, T. (2020, May 5). 13 financial performance measures managers should monitor | HBS online. Retrieved June 29, 2022, from https://online.hbs.edu/blog/post/financial-performance-measures

 

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