Cash Flow Definitions
WHAT IS CASH FLOW?
In
the most general sense, Cash Flow is simply the flow of cash through the
business over time. Cash flows are
necessary for the firm to survive and prosper.
Cash is paid out in return for the inputs that are used in the
manufacturing process (materials, labor, professional expertise, etc.) and after
goods or services are created and sold, the revenues received are used to
finance further production and sales. Cash
flows that are not reinvested in the production and sales process may be paid
out to owners.
Cash
flows are also the fundamental source of economic value for the firm in that
investments provide future cash flows that contribute to the firm’s economic
value. An understanding of how future cash flows are generated and what factors
impact those flows is an integral part of making financial decisions that
increase a firm’s economic value.
DEFINITIONS OF CASH FLOW
In
additional to the general definition of cash flow provided earlier, there are
additional, more specific, accounting and financial definitions of cash flow.
Some of these definitions include: net cash flow, operating cash flow,
free cash flow, and discounted cash flow.
Net Cash Flow
This
accounting definition of cash flow reflects what is sometimes referred to as
“cash earnings”. It is
calculated as Net Income plus any non-cash items appearing on the income
statement. Non-cash expense items generate cash flows above and beyond the net
income of the firm. Non-cash items
typically include depreciation, depletion, and amortization.
The cash flow calculation ignores the impact of changes in short term
asset and liability accounts over the accounting period.
Net Operating Cash
Flow
This
accounting definition of cash flow is calculated as Net Income, plus any
non-cash expense items appearing on the income statement, and adjustments for
any changes in current asset and liability accounts. Changes in current asset
and liability accounts also impact the cash position of the firm.
Decreases in current asset accounts generate positive cash flows and
increases result in negative cash flows. The
opposite is true for current liabilities; increases in current liabilities
generate cash flows and decreases result in negative cash flows.
This
measure of cash flow is the beginning point for identifying Incremental
Operating Cash Flows.
Incremental Net
Operating Cash Flows
This
represents the incremental benefits or changes in net operating cash flows
associated with a particular investment opportunity that is being evaluated with
Discounted Cash Flow (DCF) methods. For
any business investment opportunity, management has two choices: do not invest
or undertake the investment. The
decision to do nothing has an associated set of cash flows that reflect a
continuation of the current state of affairs.
The decision to invest has another set of cash flows associated with
taking the investment. The difference between the two sets of cash flows are the
incremental cash flows that will be generated by the investment.
Estimation
of these incremental cash flows, adjusted for taxes, are one of the three
foundations of value maximizing decision making. See the Capital Budgeting modules for instruction on
the calculation of incremental operating cash flows.
Discounted Cash Flow
(DCF)
The
present value of a stream of future cash flows that has been obtained by
discounting the incremental after-tax cash flows with the appropriate required
rate of return. The diagram below shows
the future cash flows being discounted in order to arrive at the NPV.
Free Cash Flow
Cash
flow available for use in repaying creditors of the firm or for distribution to
owners after all positive Net Present Value (NPV) investments have been
accepted. This cash flow concept is
often used by investment analyst who analyze firms as investment vehicles.