Monday, October 6

Relationship between Profits and Cash Flows

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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