Interpretation of Cash Flow Analysis in Recession
It can be seen from Table, that interest on element debt is 8 per cent a year, that is, the same in all alternatives. However, dividends, payment of principal and tax payments change as a result of change in the amount of debt or various alternatives.
The conclusions that emerge from the cash flow analysis in Table are
1. Under the current financing plan, with 20 per cent debt, there is a cash deficit in years 1 and 2, assuming there is no cut in divided (Item 3). These deficits are financed by the surplus in the year prior to the onset of recession (1 year). On a cumulative basis (Item 4), the rum could survive the recession without cutting the divided to the shareholders.
2. Under Alternative A, with 35 per cent debt, the cash deficit is somewhat larger in years 1 and 2 (Item 8). The surplus (Rs 1.1 lakh) in year 0 is not sufficient to finance the subsequent deficits. To eliminate cash deficit, dividends are to be cut. It implies that the firm can survive the recession only if it cuts the dividends to the shareholders.
3. Finally, when the debt is increased to 50 per cent (Alternative B), there is cash deficit in an the years of recession (Item 13). Even after eliminating dividends, there is cash deficit in years 1 and 2, even on a cumulative basis (Items 15 and 16). Thus, Alternative B cannot be sustained during a recession even after no dividends are paid.
Given the above facts, it may be concluded that the Hypothetical Ltd. can use 30-35 per cent and avoid financial bankruptcy during recession.
The approach illustrated above to analyse cash flows to determine debt capacity can be refined introducing probabilities. Probability distributions would be required for revenues and other certain cash flows. Probability distributions then could be estimated for the changes in cash nee shown in Table. A complete analysis would yield a probability distribution for each balance figure in each year. Such a procedure is very difficult and complex. We have, fore, excluded this aspect? Thus, cash flow analysis under recession conditions provides nation on the effects of alternative financing plans on the risk of insolvency. This information melt useful in taking capital structure decisions.