Cash flow as an indicator of financial resources

Cash flow indicates whether a company has the financial means to support itself. It is calculated by totaling pre-tax earnings and amortization/depreciation.

Cash flow is the ideal index/ratio for evaluating the financial resources and earning capacity of a company. It shows whether the company's own means are sufficient to ensure its existence in the long term. In the day-to-day running of the company, it is calculated from profit or loss for the fiscal year before tax, adding back amortization and depreciation. Changes in reserves, provisions, non-operating revenues and expenses, inventories and private withdrawals must be calculated exactly and included.

At a minimum, cash flow must cover expenses, as this is the only way that a company’s capital can be maintained. Without profit, the company is not in a position to repay debt capital or to invest to expand the company. Cash flow over three years should be sufficient to repay the total of all debt capital (debt factor 3).

Banks are especially interested in knowing the debt capacity of a company. The starting point is the sustainable, realizable free cash flow, i.e. the net cash flow after tax, adjusted for investments actually carried out and changes in current assets. In other words, this is the freely disposable cash flow that can either be paid out as profit or invested as a reserve to grow the company. Free cash flow should be sufficient for servicing and repaying (in theory) operating liabilities over 5 to 8 years.

It is essential that free cash flow is regularly achieved. If it is not as high as a result of exceptional investments, this is not a problem. It is a different issue, however, if the returns drop because there is a price war in the sector in question or production costs have increased dramatically. In this case, the company will need to explain to the bank exactly what measures have been taken to increase free cash flow.

Liquidity, debtor and inventory management, profitability and capital structure are key performance indicators that help to evaluate the position of a company.

Tip: new entrepreneurs tend, naturally, towards an overly positive evaluation of their company and its outlook. They often lack experience. In addition, they are highly enthusiastic and have great confidence in the future, which is a positive point.

It is therefore well worth envisioning several scenarios and putting all the variations down on paper. As a precaution, the purportedly realistic budget should be considered to be an optimistic scenario, and a conservative budget and a worst case budget should also be prepared. Unfortunately, in many cases, we find that the reality is closer to the worst case scenario than the optimistic one. It is therefore better to prepare in advance for this eventuality.

Sample calculation: Financing potential

Free cash flow (before interest)   CHF 100'000
Interest rate for imputed debt capital costs 6.0 %  
Consideration of tax effect -1.5 %  
Capitalization rate 4.5 %  
Theoretical repayment period 7 year  
Present value factor (4.5% over 7 years) 5.89  
Debt capacity (5.89 x 100,000)   CHF 589'000

Result: a company with regular free cash flow of CHF 100,000 has a debt capacity of CHF 589,000. It is therefore feasible to obtain loans of up to CHF 600,000 at favorable rates.


Last modification 04.05.2021

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