CASH FLOW
At this point, we are ready to discuss perhaps one of the most important pieces of financial information that can be gleaned from financial statements: cash flow. By cash flow, we simply mean the difference between the number of dollars that came in and the number that went out. For example, if you were the owner of a business, you might be very interested in how much cash you actually took out of your business in a given year.
How to determine this amount is one of the things we discuss next. There is no standard financial statement that presents this information in the way that we wish. We will therefore discuss how to calculate cash flow for U.S. Corporation and point out how the result differs from that of standard financial statement calculations. Important note: there is a standard financial accounting statement called the statement of cash flows, but it is concerned with a somewhat different issue that should not be confused with what is discussed in this section.
From the balance sheet identity, we know that the value of a firm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash flow from the firm’s assets must equal the sum of the cash flow to creditors and the cash flow to stockholders (or owners, if the business is not a corporation):
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
This is the cash flow identity. What it reflects is the fact that a firm generates cash through its various activities, and that cash either is used to pay creditors or else is paid out to the owners of the firm. We discuss the various things that make up these cash flows next.
Cash Flow from Assets
Cash flow from assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Expenses associated with the firm’s financing of its assets are not included since they are not operating expenses.
In the normal course of events, some portion of the firm’s cash flow is reinvested in the firm. Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets). Finally, the change in net working capital is the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase in current assets over current liabilities. The three components of cash flow are examined in more detail below. In all our examples, all amounts are in millions of dollars.
Operating Cash Flow
To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don’t want to include depreciation since it’s not a cash outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes, because taxes are, unfortunately, paid in cash.
If we look at U.S. Corporation’s income statement fro the financial statement page, we see that earnings before interest and taxes (EBIT) are $694. This is almost what we want since it doesn’t include interest paid. We need to make two adjustments. First, recall that depreciation is a noncash expense. To get cash flow, we first add back the $65 in depreciation since it wasn’t a cash deduction. The other adjustment is to subtract the $212 in taxes since these were paid in cash. The result is operating cash flow:
How to determine this amount is one of the things we discuss next. There is no standard financial statement that presents this information in the way that we wish. We will therefore discuss how to calculate cash flow for U.S. Corporation and point out how the result differs from that of standard financial statement calculations. Important note: there is a standard financial accounting statement called the statement of cash flows, but it is concerned with a somewhat different issue that should not be confused with what is discussed in this section.
From the balance sheet identity, we know that the value of a firm’s assets is equal to the value of its liabilities plus the value of its equity. Similarly, the cash flow from the firm’s assets must equal the sum of the cash flow to creditors and the cash flow to stockholders (or owners, if the business is not a corporation):
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
This is the cash flow identity. What it reflects is the fact that a firm generates cash through its various activities, and that cash either is used to pay creditors or else is paid out to the owners of the firm. We discuss the various things that make up these cash flows next.
Cash Flow from Assets
Cash flow from assets involves three components: operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow that results from the firm’s day-to-day activities of producing and selling. Expenses associated with the firm’s financing of its assets are not included since they are not operating expenses.
In the normal course of events, some portion of the firm’s cash flow is reinvested in the firm. Capital spending refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets). Finally, the change in net working capital is the amount spent on net working capital. It is measured as the change in net working capital over the period being examined and represents the net increase in current assets over current liabilities. The three components of cash flow are examined in more detail below. In all our examples, all amounts are in millions of dollars.
Operating Cash Flow
To calculate operating cash flow (OCF), we want to calculate revenues minus costs, but we don’t want to include depreciation since it’s not a cash outflow, and we don’t want to include interest because it’s a financing expense. We do want to include taxes, because taxes are, unfortunately, paid in cash.
If we look at U.S. Corporation’s income statement fro the financial statement page, we see that earnings before interest and taxes (EBIT) are $694. This is almost what we want since it doesn’t include interest paid. We need to make two adjustments. First, recall that depreciation is a noncash expense. To get cash flow, we first add back the $65 in depreciation since it wasn’t a cash deduction. The other adjustment is to subtract the $212 in taxes since these were paid in cash. The result is operating cash flow:
Operating cash flow is an important number because it tells us, on a very basic level, whether or not a firm’s cash inflows from its business operations are sufficient to cover its everyday cash outflows. For this reason, a negative operating cash flow is often a sign of trouble.
There is an unpleasant possibility for confusion when we speak of operating cash flow. IIn accounting practice, operating cash flow is often defined as net income plus depreciation. For U.S. Corporation, this would amount to $412 + 65 = $477. The accounting definition of operating cash flow differs from ours in one important way: Interest is deducted when net income is computed. Notice that the difference between the $547 operating cash flow we calculated and this $477 is $70, the amount of interest paid for the year.
This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same.
To finish our calculation of cash flow from assets for U.S. Corporation, we need to consider how much of the $547 operating cash flow was reinvested in the firm. We consider spending on fixed assets first.
Capital Spending
Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets. At the end of 2005, net fixed assets for U.S. Corporation (Balance Sheet) were $1,644. During the year, we wrote off (depreciated) $65 worth of fixed assets on the income statement. So, if we didn’t purchase any new fixed assets, net fixed assets would have been $1,644 - 65= $1,579 at year’s end. The 2006 balance sheet shows $1,709 in net fixed assets, so we must have spent a total of $1,709 - 1,579 = $130 on fixed assets during the year:
There is an unpleasant possibility for confusion when we speak of operating cash flow. IIn accounting practice, operating cash flow is often defined as net income plus depreciation. For U.S. Corporation, this would amount to $412 + 65 = $477. The accounting definition of operating cash flow differs from ours in one important way: Interest is deducted when net income is computed. Notice that the difference between the $547 operating cash flow we calculated and this $477 is $70, the amount of interest paid for the year.
This definition of cash flow thus considers interest paid to be an operating expense. Our definition treats it properly as a financing expense. If there were no interest expense, the two definitions would be the same.
To finish our calculation of cash flow from assets for U.S. Corporation, we need to consider how much of the $547 operating cash flow was reinvested in the firm. We consider spending on fixed assets first.
Capital Spending
Net capital spending is just money spent on fixed assets less money received from the sale of fixed assets. At the end of 2005, net fixed assets for U.S. Corporation (Balance Sheet) were $1,644. During the year, we wrote off (depreciated) $65 worth of fixed assets on the income statement. So, if we didn’t purchase any new fixed assets, net fixed assets would have been $1,644 - 65= $1,579 at year’s end. The 2006 balance sheet shows $1,709 in net fixed assets, so we must have spent a total of $1,709 - 1,579 = $130 on fixed assets during the year:
Could net capital spending be negative? The answer is yes. This would happen if the firm sold off more assets than it purchased. The net here refers to purchases of fixed assets net of any sales of fixed assets.
Change in Net Working Capital
In addition to investing in fixed assets, a firm will also invest in current assets. For example, going back to the balance sheet in previous page, we see that at the end of 2006, U.S. had current assets of $1,403. At the end of 2005, current assets were $1,112, so, during the year, U.S. invested $1,403- 1,112=$291 in current assets.
As the firm changes its investment in current assets, its current liabilities will usually change as well. To determine the change in net working capital, the easiest approach is just to take the difference between the beginning and ending net working capital (NWC) figures. Net working capital at the end of 2006 was $1,403 389 $1,014. Similarly, at the end of 2005, net working capital was $1,112-428=$684. So, given these figures, we have:
Change in Net Working Capital
In addition to investing in fixed assets, a firm will also invest in current assets. For example, going back to the balance sheet in previous page, we see that at the end of 2006, U.S. had current assets of $1,403. At the end of 2005, current assets were $1,112, so, during the year, U.S. invested $1,403- 1,112=$291 in current assets.
As the firm changes its investment in current assets, its current liabilities will usually change as well. To determine the change in net working capital, the easiest approach is just to take the difference between the beginning and ending net working capital (NWC) figures. Net working capital at the end of 2006 was $1,403 389 $1,014. Similarly, at the end of 2005, net working capital was $1,112-428=$684. So, given these figures, we have:
Net working capital thus increased by $330. Put another way, U.S. Corporation had a net investment of $330 in NWC for the year.
Conclusion Given the figures we’ve come up with, we’re ready to calculate cash flow from assets. The total cash flow from assets is given by operating cash flow less the amounts invested in fixed assets and net working capital. So, for U.S., we have:
Conclusion Given the figures we’ve come up with, we’re ready to calculate cash flow from assets. The total cash flow from assets is given by operating cash flow less the amounts invested in fixed assets and net working capital. So, for U.S., we have:
From the cash flow identity above, this $87 cash flow from assets equals the sum of the firm’s cash flow to creditors and its cash flow to stockholders. We consider these next.
It wouldn’t be at all unusual for a growing corporation to have a negative cash flow.As we shall see below, a negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders that year.
A Note on “Free” Cash Flow
Cash flow from assets sometimes goes by a different name, free cash flow. Of course, there is no such thing as “free” cash (we wish!). Instead, the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments. We will stick with “cash flow from assets” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed; different users calculate it in different ways. Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets or something quite similar.
This video shows different calculations of cash flow from assets.
It wouldn’t be at all unusual for a growing corporation to have a negative cash flow.As we shall see below, a negative cash flow means that the firm raised more money by borrowing and selling stock than it paid out to creditors and stockholders that year.
A Note on “Free” Cash Flow
Cash flow from assets sometimes goes by a different name, free cash flow. Of course, there is no such thing as “free” cash (we wish!). Instead, the name refers to cash that the firm is free to distribute to creditors and stockholders because it is not needed for working capital or fixed asset investments. We will stick with “cash flow from assets” as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed; different users calculate it in different ways. Nonetheless, whenever you hear the phrase “free cash flow,” you should understand that what is being discussed is cash flow from assets or something quite similar.
This video shows different calculations of cash flow from assets.
Cash Flow to Creditors and Stockholders
The cash flows to creditors and stockholders represent the net payments to creditors and owners during the year. They are calculated in a similar way. Cash flow to creditors is interest paid less net new borrowing; cash flow to stockholders is dividends paid less net new equity raised.
Cash Flow to Creditors
Looking at the income statement in previous page, we see that U.S. paid $70 in interest to creditors. From the balance sheets in Table 2.1, long-term debt rose by $454-408=$46. So, U.S. Corporation paid out $70 in interest, but it borrowed an additional $46. Net cash flow to creditors is thus:
Cash Flow to Creditors
Looking at the income statement in previous page, we see that U.S. paid $70 in interest to creditors. From the balance sheets in Table 2.1, long-term debt rose by $454-408=$46. So, U.S. Corporation paid out $70 in interest, but it borrowed an additional $46. Net cash flow to creditors is thus:
Cash flow to creditors is sometimes called cash flow to bondholders; we will use these terms interchangeably.
Cash Flow to Stockholders
From the income statement, dividends paid to stockholders amount to $103. To get net new equity raised, we need to look at the common stock and paid in surplus account. This account tells us how much stock the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have:
Cash Flow to Stockholders
From the income statement, dividends paid to stockholders amount to $103. To get net new equity raised, we need to look at the common stock and paid in surplus account. This account tells us how much stock the company has sold. During the year, this account rose by $40, so $40 in net new equity was raised. Given this, we have:
The cash flow to stockholders for 2006 was thus $63.
Below, is a table that contains a summary of the various cash flow calculations.
Below, is a table that contains a summary of the various cash flow calculations.