Investment decisions often rely on Cash flows rather than profits.
While profits are the key measure of financial success from an accountant’s
perspective, finance professionals (especially investment analysts) prefer evaluating
investment decisions based on cash flows.
One may wonder that while studying Accounting (which is the
first step in understanding finance) we were first introduced the concept of
Cash Basis of Accounting where all receipts and payments were recorded, then we
were told that the right measure of evaluating business performance was through
Accrual Accounting. However, we’re again talking about Cash Flows – which is a
subset of or is similar to Cash Basis of Accounting. Well, let’s not get into
that right now as Life is hard to understand. But the concept of Cash flows is
not.
Let’s understand how the cash flows and profits are related
First, as we have discussed already, Profits are arrived at
based on Accrual basis of accounting. Revenues are recorded when earned (rather
than when money is received) and expenses are recorded when incurred (rather
than money is paid). Even if you have paid some money for expenses but that relates
to a different period, it would have been excluded from your expenses.
Second, even for the current year’s expenditures, we divide
the expenses into Revenue and Capital Expenditures. While Revenue expenditure
is accounted for in the same year and is charged to Profit & Loss Account
(Income Statement or Statement of Comprehensive Income) leading to a reduced
profit, Capital Expenditures do not affect Profits and are taken straight to
the Balance Sheet as Investments or Fixed Assets (Property, Plant &
Equipment – PP&E). These may come in the Profit & Loss Account in the
form Depreciation over the life of the asset under the Matching Concept of Accounting.
Third, Depreciation is an allocation of capital expenditure
and does not involve any outflow of cash. Accordingly, it is a classic example
of a non-cash expense. While it affects profits but not cash flows.
Now let’s take an
example of an all equity financed company which does all its dealings (income
and expenses) in Cash.
Profit = Revenue – Revenue
Expenses – Depreciation
Profits do not deduct Capital Expenses. Instead, it charges
Depreciation on the Capital Expenses. On the other hand, Cash Flows, ignores
Depreciation but takes into account Capital Expenses (to the extent paid).
Cash Flows would then be equal to
Cash Flows = Revenue –
Revenue Expenses – Capital Expenses
Adjusting the Profit Equation here, we get:
Cash Flows = (Revenue – Revenue Expenses – Depreciation) + Depreciation
– Capital Expenses
Where +/- Depreciation offsets each other
Cash Flows = Profit +
Depreciation – Capital Expenses
Accordingly, Profits may never be equal to Cash Flows. It
overstates cash flows by excluding Capital Expenses and understates Cash Flows
by including Depreciation.
Things become complicated with the introduction of Taxes as Depreciation is Tax deductible
and will further complicate the relationship between Profits and Cash Flows. Let's call this Net Cash Flows which will be "Cash Flows net of Taxes" or After "Tax Cash Flows".
Tax = Tax Rate x Profit
Tax = Tax Rate x (Revenue - Revenue Expenses - Depreciation)
The equation of profit used represents Earnings before Interest and Taxes also known as EBIT. So
Tax = Tax Rate x EBIT
Net Cash Flows will thus be:
Net Cash Flows = Revenue - Revenue Expense - Taxes
Net Cash Flows = Revenue - Revenue Expense - Tax Rate x (Revenue - Revenue Expenses - Depreciation)
Net Cash Flows = Revenue - Revenue Expense - Tax Rate x (Revenue - Revenue Expenses) + (Tax rate x Depreciation)
Net Cash Flows = (Revenue - Revenue Expenses) x (1- Tax rate) + (Tax Rate x Depreciation)
Net Cash Flows = (EBDIT) x (1- Tax Rate) + (Tax Rate x Depreciation)
where EBDIT is Earnings before Depreciation, Interest and Taxes
Note that the expression Tax Rate x Depreciation is known as Depreciation Tax Shield which represents the tax saved on account of Depreciation.
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