Essay: Problems and Limitations with Cash Flows

Essay: Problems and Limitations with Cash Flows
April 11, 2011 Comments Off on Essay: Problems and Limitations with Cash Flows Academic Papers on Business Studies,Sample Academic Papers admin

Sample Essay

A major problem exists in the interpretation of cash flows and users of the statement of cash flows may find it hard to evaluate the actual cash receipts and payments as the statement of cash flows is hard to interpret especially if it has been prepared using the indirect method. The users may find it difficult to interpret the information in the statement of cash flows without other statements. If the users of this statement cannot interpret the actual cash inflows and outflows of a particular period it would be quite difficult to forecast future cash flow based on current interpretations of cash which may be miscalculated (Rolfe 2008).

The free cash flow model is an efficient tool to evaluate a firm’s value but it also has some limitations and problems. As the free cash flow model is based on future estimates of earnings, there is a fair chance that the future estimates can be wrong and miscalculated. Madura (2008) suggested that “Even if earnings can be forecasted accurately, the flexibility of accounting rules can cause major errors in estimating free cash flow based on earnings” (p.267). There is a limitation in forecasting the accurate amount of earnings in the future and even if they are estimated accurately then changes in the accounting rules, methodology and standards may affect the validity of these earnings and the cash flows based on these earnings would be misleading.

Another limitation to the free cash flow model is the estimation of future cash flows based on future requirements of working capital, capital expenditures and debt. The estimation is quite simple if the debt ratio of a company remains consistent. The calculation of free cash flows can become complicated in the future if the company plans to change its debt ratio in the future. As the debt ratio will change it would be difficult to calculate the actual amount received from issue of debt and the amount paid to retire previous debt. This complication causes a variation and inconsistency in the estimated free cash flows and any decisions based on them (Damodaran 2008).

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