How to use Cash Flow Approach for Capital Structure Analysis?

One of the most commonly used methods for the valuation of capital structure is the analysis of cash flows from the operations of the business. Cash flows are of the following three types −

  • Operating Cash Flows
  • Non-operating Cash Flows
  • Financial Flows

Operating Cash Flows

These are related to the operations of a firm and can be obtained from the profit and loss statements of the firm. To calculate operating cash flows, net operating volume, sales, and the input/output prices over a given period are used.

Non-operating Cash Flows

It generally includes working capital changes and capital expenditure. For example, in times of recession, the firms may need additional resources for the advertisement of products and services. These expenditures are included in non-operating cash flows.

Certain capital expenditures are unavoidable and they must be included in the cash outflows of the business. Such expenditures should be clearly identified and applied in the cash flow approach.

Financial Flows

Financial flows include rent, interest, dividends, repayment of debt, etc. These are further divided into contractual obligations and policy obligations.

  • Contractual obligations are matters of contract and should not be defaulted. Examples include rentals and principle amounts, etc.

  • Policy obligations are discretions of the top management of the company. An example of policy obligation is dividends.

Utility of Cash Flow Analysis

Following are the utilities of cash flow analysis −

  • It focuses on the solvency and liquidity of the firm for a long period encompassing adverse circumstances. So, it evaluates the firm’s capability of meeting fixed obligations.

  • It goes beyond just the profit and loss analysis covering the balance sheet items.

  • It shows discretionary cash flows so that companies can prepare for an adverse situation.

  • It provides a look at the potential financial flows that can be utilized in the case of a financial emergency.

  • It is a long-term dynamic analysis that provides a holistic view of the cash flows, showing the flexibility of the firm to meet obligations.

Limitations of Cash Flow Analysis

The cash flow analysis is one of the most widely used methods for capital structuring. However, it is not foolproof.

  • The method cannot identify all the possible factors for cash flows.

  • As future cash flows have also to be estimated, the cash flow method is a matter of financial estimation which is uncertain to an extent.

  • The uncertainty arises from the unforeseen business conditions a firm may have to face in the future.

That is why it is not a foolproof way of determining the optimal capital structure of a firm.