There are several relationship between cash flow, profitability and performance. In quantitative terms, if you start from the net income, for determining the income cash flow you should exclude from the net income all the non-monetary income and costs (e.g. amortization, etc.). If you want the global cash flow you should then consider also loan, Investments, etc., i.e. inflow and outflow of cash. This means that you can have an economic loss but a positive cash flow and vice versa.

Profitability emerges from income statement while cash flow is reporting in the cash flow statement.

Does positive cash flow impact on profitability and performance?

Consistency of liquidity is shown by cash flow whether positive or negative. The positive cash flow from operating activities have direct impact on profitability. But in all other activities only cash flow does not lead to profitability.

Indeed, you cannot say, in shore, that cash flows affect positively performance.

Cash flows derive from differences between cash inflows and cash outflows and performance is usually determined with earnings that derive the difference from revenues and expenses.

The positive cash flow from operating activities impact directly on liquidity, but not lead, necessarily, to higher values of performance.

You need the cash inflow in order to be able to perform, though measurement of performance is not necesssrily through Cash Flow. Companies fail because their cash flow is bad. In order to perform you need to be able to operate through sound financials and the cash flow is a primary financial indicator for firms.

Hi Grace,

Let’s start with the quote “cash is a fact, profit is an opinion" (Rappaport 1999, p.15).

Profit is in most measures based on the firms’ earnings, and research has suggested that managers actively are managing the earnings (Rappaport 1999). Firms “manage” their earnings dependent on a number of accounting rules and reservations, for example, the bad debt reservations (revenue recognition), deferred earnings , write-offs, accrued revenues, …etc. There could be multiple reasons for managing the earnings, for example, firms may want to “meet investor expectations” because investors provide the firm with funds and financial incentives. Or there could be environmental uncertainty or risk considerations (timing between cash inflow and the delivery of a product or service) (i.e. magazine subscriptions).

The next issue is WHAT is performance? Firm performance is not a very well defined theoretical construct. The firm performance measure depends on WHAT you want to measure. There are many performance indicators, more than I can list on this medium, and each has its advantages and disadvantages. But in general you can divide them in effectiveness measures and efficiency measures. A firm can for example be very efficient but not effective, or the other way around. And financial/market measures and accounting measures.

Most efficiency related profit measures measure the utilization of the firms’ resources. For example, the firms earnings as a percentage of firm size. In that way they also account for firm size effects. Deflating a profit measure for firm size is important if you want to compare different firms. But with this deflation you introduce also noise or distortions in your measure.

A firm could have a positive profit margin but be at the same time in (financial) distress, and then the question is, do you consider this a good or bad performance. Again this depends on WHAT you want to measure as performance. If the sales revenues of a firm are decreasing, but the firm is able to reduce its expenses/cost at an equal or faster phase, than it still makes profit at a reduced cash flow. You can consider this a good performance considering the circumstances. But the firm has a strategic problem, why are the revenues decreasing? This could be a sign that the firm is losing market share, has outdated products / services / technologies / is loosing its strategic fit (evolutionary fitness (Helfat, 2007)). Think of the Fosters’ S-curve (Foster, 1986). Or maybe other reasons. In this context the performance of the firms could be considered bad and immediate action is required.

When you use the cash flow measure you will see, up to a point, still a positive cash flow. And depending if and whit what measure you deflate the cash flow to account for firm size, it could also be a positive cash flow indicator for performance. You could detect the decreasing performance by looking at the change in cash flow year on year, but if you want to compare firms you have to deflate the annually cash flow difference for firm size. Herewith you could introduce new distortions. In sum, there are no easy answers, it depend on what you want to measure in which context.

Coming back to the main question, What is the relationship between cash flow and performance of an entity? : Cash flow and profitability relationship.

Cash flow is a performance measure that measures the difference between cash inflow (i.e. sales remittance or actual sales), and cash outflow (i.e. purchases) net of the accounting measures (i.e. cost vs expenses) and uncertainty and risk. So, cash flow is the less sensitive (for managerial manipulation) accounting performance measure, but doesn’t account for liabilities, risk and uncertainties. Profit is a performance measure that accounts to a certain extent for uncertainty and risk, but is susceptible to the manipulation of earnings by the firms’ managers. The relationship between cash flow and profitability depends on the used accounting rules and the degree of earnings manipulation of the firm’s managers. If the firm cash flow and profit measure are highly correlated, you can very carefully and tentatively assume that the earrings manipulation of the firm is limited.

I hope that this long answer helps.

Best regards,

Cash flow is the term that describes where cash is coming from and where it is going. These statements only focus on cash, view that (IFRS) example below. Focus on direct and indirect cash flow portions.

Companies need cash to function, for instance: pay salaries, cover operating costs and so forth; cash flow statements determine how efficiently or inefficiently cash is being used. Therefore, a positive cash flow statement is a good sign but it still needs to be monitored to ensure cash is being allocated effectively.

http://media.ifrs.org/ixbrl_example3_2011-03-25.xhtml

It is very simple cash flow directly related to performance. Low cash flow, less work as per target. Less target achievement results in increase completion time. Increase in completion time increase cost of project. Increase cost of project leads to failure of project

@ Marco. There are several relationships between cash flow, profitability and performance. I agree with this standpoint.