Understanding Cash Flow

Cash flow is an important concept to understand when evaluating a company's overall financial health. It removes the effects of accounting methods, and delivers a clearer picture of the inflows and outflows of money. It's also useful when trying to understand the impact a new investment or project can have on a company's finances.

Cash Flow

The easiest way to think about the concept of cash flow is this: It's the actual inflow and outflow of money from a company.  It removes all of the accounting adjustments that appear on an income statement such as deferred income taxes and depreciation, and allows the analyst to see a company's earning power and operating success in a slightly different way.

It also takes into account some very practical considerations such as inflation.  Perhaps the most important value that understanding cash flow provides to the investor is the ability to know if a company has enough resources to meet its future operating expenses.

Analysis on a Cash Basis

Now that we've explained the concept of cash flow, it's time to discuss the two practical, and important, uses of the concept: evaluating projects and constructing statements of cash flow.  Here is where a distinct split occurs because each of these uses is constructed on a macro (statement of cash flow) or micro (project or investment cash flow) basis.

Evaluating Projects

After a brief introduction to the statement of cash flow, the remainder of this article will be dedicated to the topic of using cash flows to evaluate a project using a business case.  The advantage of this approach, above and beyond the benefits of modeling the movement of cash, is that it allows the analyst to put together a business case without worrying about the financing decisions, which are choices best left to the CFO.

Statement of Cash Flow

A statement of cash flow is one of several financial statements that public companies construct and share with their stakeholders.  In general, this statement will include a formula or calculation that considers:

Cash and Cash Equivalents (Beginning)
+ Cash from Operations
- Cash Flows from Investing Activities
+ Cash Flows from Financing Activities
= Cash and Cash Equivalents (Ending)

We've covered the topic of how to put together a statement of cash flows in another article.

Cash Flow Analysis

The remainder of this article is going to be dedicated to business case analysis, a cash flow 101 course.  Whether or not an analyst is involved with a small or large business, it's important to understand how to analyze a project on a cash flow basis.  Fundamentally, this is the financial tool that most experts talk about when they are discussing a business case.

Here again, we're going to talk about two aspects of these analyses:

  • Building a cash flow analytical model:  the variables that need to be considered when building a model.
  • Analyzing the cash flow results:  including concepts such as Internal Rate of Return (IRR), Net Present Value (NPV), and Payback (PB).

Later on, we're even going to provide links to a cash flow analysis spreadsheet that can be downloaded; demonstrating these concepts and the required calculations.

Cash Flow Analysis Modeling

In order to properly model cash flow for the purposes of building a business case, the financial analyst only has to be concerned with six concepts.  If they understand how and why each of these is used, they can analyze any project correctly:

  • Capital Costs
  • Operating & Maintenance Expenses
  • New Revenue Streams
  • Operating Benefits
  • Depreciation
  • Income Tax

When assessing a project's impact, the convention is to evaluate cash flow on an incremental basis.

Capital Costs

Most projects or business cases involve building or buying something, usually an asset, which provides some kind of future benefit.  It's important to separate these capital costs from operating and maintenance expenses when analyzing a project.  Capital assets can be depreciated, and although depreciation does not produce a cash flow directly, it does provide an income tax benefit or credit, which needs to be included in the business case model.

Operating and Maintenance Expenses

Businesses make new investments in capital assets in the hope of achieving greater operating efficiencies, which is a benefit.  At the same time, the asset may also require additional operating and or maintenance expense to keep it running at peak efficiency.  If a project introduces additional costs, this is a real flow of cash out from the business, and it must be accounted for in the business case model.

New Revenue Streams

Although this doesn't always apply, if the project results in incremental revenues to the company, then this inflow of money needs to be modeled.  It's important to include all of the costs associated with those additional revenues, such as incremental production and sales expense.

Operating Benefits

In the same way a capital project might introduce additional costs, it usually results in lowered operating costs, which is a benefit.  When building a business case to demonstrate the value the asset can bring to the company, a lot of the discussion usually focuses around quantifying the benefits of the project.

Most of the time, a cash benefit is realized through a reduction in one or more costs to the business.  For example, the asset may have lowered the number of people necessary to run a machine, or allows someone to increase the number of widgets they can process each day.  There can also be gains in efficiency, which might result in fewer raw materials consumed per widget produced.

Depreciation

Oftentimes, depreciation is referred to as a non-cash expense, and that's true when it comes to cash flow.  Depreciation is an accounting allocation that allows a company to expense an asset over its useful life.  The value this brings to a company is usually in terms of their net income.  Instead of expensing the cost when purchased, depreciation spreads out this expense, thereby mitigating a short-term impact on profits.

Depreciation expense is also tax deductible, which is a real benefit.  The reduction in income taxes is cash the company no longer has to pay.  The business model needs to account for this benefit.  This is done by calculating the depreciation expense, and using those values to lower income taxes.

Income Taxes

The final concept we're going to discuss is income taxes.  The convention among financial experts is to state cash flows on an after-tax basis.  That's because taxes are a very real expense, and a change in operating expenses and capital expenditures (through depreciation) can change a company's total income tax bill.

Discounted Cash Flows

When analyzing the after-tax cash flow of a business case model, the convention is to discount the flows.  The discount rate used would typically be a company's after tax weighted average cost of capital, which is a proxy for the company's cost of money.  Perhaps the most common measure that uses discounted cash flows, or DCF, is the calculation of net present value.

Net Present Value of Cash Flows

The concept of net present value can be stated in this manner:  The best way to evaluate a business case is to recognize the fact money received in the future is not as valuable as money received today.  Most investors would prefer to receive $100 today than get paid $100 five years from now because they can take that $100 today and invest it in an asset that provides a return.  This concept is often referred to as the time value of money.

This concept also helps to explain why discounting cash flows at a company's after tax weighted average cost of capital (WACC) is the appropriate rate.  The WACC calculation is the percentage capitalization of stock, preferred stock, and debt, times the cost of each component.  For example:

WACC Example Calculation

  Capitalization (%) Cost (%) Weight (%)
Debt 50% 6.0% 3.00%
Preferred Stock 2% 4.9% 0.10%
Common Stock 48% 12.2% 5.86%
WACC 100%   8.95%

In the above example, 8.95% is a proxy for the company's cost of money, which is the same as its opportunity cost.  When evaluating a project, managers usually look for a positive NPV of cash flows, which would indicate whether or not the project provides benefits in excess of the company's cost of capital.

Internal Rates of Return

The internal rate of return, or IRR, is simply the discount rate (in terms of percentage) where the net present value of cash flow is equal to zero.  The value provides executives / decision-makers with a better feel for how "good" the investment is that's being modeled.

Some companies set hurdle rates for new investments, and these hurdle rates are usually expressed in terms of IRR.  For example, a company might decide that a new computer system requires an IRR of 15% or more for the project to be approved.

Calculating Payback

Payback is a measure that allows the decision maker to see how quickly the initial investment is returned to the company.  To demonstrate this point, consider the following cash flow example:

Payback Cash Flow Example

Year Y0 Y1 Y2 Y3
Cash Flow -1,000 500 500 500

In this example, the payback on this project would be 2.0 years.  The $1,000 investment is returned after only two years.  Sometimes companies wish to calculate payback on a discounted cash flow basis.  So in this next example, the cash flows are discounted by 8.95%:

Discounted Payback Example

Year Y0 Y1 Y2 Y3
Cash Flow -1,000 500 500 500
DCF -1,000 459 421 387

In this example, the discounted payback on this project would be 2.3 years.

Profitability Index

The profitability index, which is also known as the benefit-cost ratio, is the present value of cash flows divided by the initial investment.  This measure tells the decision maker to accept all projects with a profitability index that is greater than one, because when that occurs, the benefits are higher than costs.

Cash Flow Example

As promised, we're going to finish up with an example of a business case based on the cash flow concepts explained earlier.  In this particular example, the analysis includes:

  • An $8,000,000 investment in new equipment
  • Additional operating costs of $1,000,000 per year
  • Additional revenues of $250,000 per year
  • Additional benefits of $2,250,000 per year

This example can be downloaded by clicking on the following link:  Cash Flow Business Case Example.

The results of that business case appear in the table below.  We've taken the inputs and provided live calculations for nearly all of the important measures mentioned earlier.

Business Case Results:  
NPV of Cash Flow $1,367,525
IRR 12.1%
Profitability Index 1.17
Simple Payback 6 Years
Discounted Payback 8 Years

The next article in this series is going to continue with this example and take a closer look at evaluating cash flow results.  That article discusses the pros and cons of using each of the above measures (IRR, NPV of Cash Flows, Profitability Index and Payback) in evaluating projects.


About the Author - Understanding Cash Flow (Last Reviewed on October 14, 2016)