FOCUS ON   INCREMENTAL   AFTER-TAX   OPERATING   CASH FLOWS

WHY CASH FLOWS RATHER THAN PROFITS?

In finance, cash flows are the focus of the financial analysis and decision making process.  While some might think that accounting profits would be an appropriate focus when making financial decisions, there are a number of serious problems associated with using accounting profits as a basis for decision making. 

First, accounting profits are often manipulated. 

• Management manipulates reported accounting profits for a variety of different reasons.  For example, in countries where businesses are allowed to maintain separate sets of books, one set of financial statements is often prepared for use in calculating income tax liabilities while another set is prepared to provide financial information to shareholders.  The set used for tax calculations are designed to minimize reported profits so as to minimize the income tax liability.  The other set used for shareholders are designed to maximize reported profits.  Since the accounting process provides leeway in the interpretation and recording of different types of financial activities, the process allows, to a certain extent, manipulation of reported profits. 

Second, there are different definitions of accounting profit.

• There are many different types of accounting profit such as profit before (or after) extraordinary items, profit before (or after) taxes, and profit before (or after) foreign exchange gains and losses.  If decisions are made based on some measure of expected profits, the decision process could be affected by the particular definition of profits used in the decision process.

Third, accounting records are on the accrual basis.

• Accounting procedures often attempt to allocate expenses over the periods of time in which the related assets are used to generate revenues and profits.  While this may provide a representation of how assets are consumed over time, it does not properly reflect the cash flows that are related to the purchase of an asset. Typically, many of the cash flows associated with purchasing assets and putting them into place are incurred at the time the asset is purchased while the cash flows occur over time.  In some cases. cash flows continue after the asset has been fully depreciated.

Finally, cash flows, and not profits, are used to meet obligations.

• Maturing financial obligations are met with cash flows; not accounting profits.  Cash flows are used to finance the day-to-day operation of a business and are crucial to the continued operation of the firm. 

WHY INCREMENTAL CASH FLOWS?

In the study of finance, the focus is on cash flows rather than of accounting profits.   Patterns of cash flows and expected cash flows are the basis for many financial decision making processes and for the valuation processes that are often applied to securities, investments, business investment, and companies themselves. 

Often, when making financial decisions, the choice must be made between alternative investment opportunities.  Even if only a single investment opportunity is being considered, there is always an unstated alternative of not investing the money and, instead, leaving the money as an idle cash balance in a non-interest earning account.  Because the making of financial decisions always involves considering alternative courses of action, financial decisions should be made on what is referred to as an incremental cash flow basis.

By focusing on incremental cash flows, the investment decision process focuses attention on the incremental benefits and incremental expenses accruing to the firm from the particular investment being considered.

WHY AFTER TAX CASH FLOWS?

Taxes are a fact of life.  Both individuals and businesses are affected by the tax laws that are relevant to their financial decisions and the returns from their investments.  Furthermore, the tax laws always affect the future cash flows that determine future wealth.  

In many cases, tax laws also effect the cost of entering into an investment.   For example, for businesses, tax implications of replacing existing plant, property, and equipment, allowable depreciation schedules, and tax credits for training or for certain types of capital investment might affect the cost of an investment decision.

For all of these reasons, the affects of taxes need to be taken into account when making financial decisions.

WHY OPERATING CASH FLOWS?

Non-operating cash flows consist of finance related cash flows such as interest payments or dividends.

When making financial decisions within a capital budgeting context, the discounted cash flow decision models (i.e., Net Present Value) uses a discount rate that reflects the weighted average cost of capital and this rate already reflects the cost of debt and equity financing.

If financing cash flows are included in the capital budgeting decision process, the costs of financing are being included in the calculation twice, effectively double counting the costs.

This topic is discussed in greater detail later in the capital budgeting topics.