Cash Flow Analysis
Cash Flow Analysis is the process
where the debt capacity of a firm is assessed which is acceptable by the
management by default. It helps to establishes the debt capacity of the firm.
Steps To Calculate Cash Flow Analysis
To assess the debt capacity by cash flow
approach it includes following steps
§ Specify the tolerance limit on the probability of default
§ Estimation of probability distribution of cash flows considering
the forecasted performance of firm.
§ Calculation of fixed charges with respect to interest and repayment
of principal amount at various level of debt.
§ Estimation of debt at highest level that is acceptable by
management by default with respect to the tolerance limit, probability
distribution and fixed charges defined above.
Limitations
of Cash Flow Analysis:
Though Cash Flow analysis is simple
and intuitively appealing it has many limitations. Let us see the difficulties
and limitations of Cash Flow Analysis below
§ It is highly difficult to assess the operating cash inflows
especially with respect to firms in industries that are continuously changing
and are volatile.
§ This approaches appears conservative and assumes that the firm will
depend only on the cash balance and cash inflows and will not raise the
financing from external sources.
§ The tolerance limits reflects the management interest and not the
shareholders interest because management
wishes to have negligible probability by default which may not be the interest
of shareholders.
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