Alternative Method of Defining Cash Flows (used in Ross, Westerfield and Jordan):
Here is another way of defining cashflows that is sometimes used for project valuation. For this purpose, it is necessary to separate cashflows into flows generated by the assets of the business and the cashflows flowing out of the firm to the holders of the firm’s longterm liabilities. Clearly, both quantities must be equal:
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders. We will see below how to obtain such cashflow information from the financial statements.
In order to better understand this, let us look further at a balance sheet:
Assets  Liabilities 
Current Assets  Current Liabilities 
Fixed Assets  Longterm debt 
Common Stock and Paidin Surplus  
Retained Earnings  
Total assets  Total liabilities and shareholders’ equity 
If we take current liabilities to the lefthand side, we can rewrite the balance sheet thus:
Assets  Liabilities 
Working Capital = Current Assets  Current Liabilities  
Fixed Assets  Longterm debt 
Common Stock and Paidin Surplus  
Retained Earnings  
Total assets  Total liabilities and shareholders’ equity 
Now, consider the changes in these quantities.
D Assets  D Liabilities 
D Working Capital  
D Fixed Assets  D Longterm debt 
D Common Stock and Paidin Surplus  
D Retained Earnings  
D Total assets  D Total liabilities and shareholders’ equity 
D Retained Earnings = Additions to Retained Earnings.
From the Income Statement, we know that
Additions to Retained Earnings = Sales  COGS  Depreciation  Interest  Taxes  Dividends.
This can be divided into several categories. Let us define a category called Cash Flows from Operations, which includes only elements that both involve cash flows and are related to operations. Of the terms in the above equation, Depreciation is a noncash item, while Interest and Dividends are financing items. Hence we are left with
Cash Flows from Operations  = Sales  COGS  Taxes 
= EBIT + Depreciation  Taxes. 
We can now write:
Additions to Retained Earnings = Cash Flow from Operations  Depreciation  Interest  Dividends.
Since Interest represents payments to debtholders, we can deduct it from D Longterm debt. We now have a new category Cashflows to Creditors which is defined as Interest less D Longterm debt.
Dividends represent payments to shareholders. Hence we subtract it from D Common Stock and Paidin Surplus. We now have a new category Cashflows to Shareholders which is defined as Dividends less D Common Stock and Paidin Surplus.
Finally, Depreciation is added to D Fixed Assets. This gives us the category Net Capital Expenditures, which only includes the cashflow elements of D Fixed Assets. This can be understood in the following fashion.
The change in Fixed Assets from one year to another is computed as
Ending Fixed Assets  = Beginning Fixed Assets 
 Depreciation  
+ Capital Spending (Purchases less Sales of Fixed Assets) 
Of these Depreciation is the only element that does not have a cashflow component. Therefore, adding Depreciation to D Fixed Assets, gives us Capital Spending, a category which only includes the cashflow elements of the change in fixed assets.
Here is our balance sheet once again, with the different elements of D Retained Earnings distributed as follows (the column headings have been eliminated, since they are no longer entirely appropriate):
 Cashflows to Creditors = D Longterm debt  Interest 

D Working Capital   Cashflows to Stockholders
= D Common Stock and Paidin Surplus  Dividends 
Capital Spending = D Fixed Assets + Depreciation 
Cashflow from Operations 
Note also, that Depreciation has been added to D Fixed Assets, even though it appears in our breakdown of D Retained Earnings with a negative sign, because we have moved it to the lefthand side.
Rearranging, we have
Cashflows to Creditors + Cashflows to Stockholders = Cashflow from Operations  D Working Capital  Capital Spending.
The right hand side of this equation is defined as Cashflow from assets for obvious reasons. We can now recapitulate.
Cash flow from assets has three components.
Cash Flow from Operations refers to the cash generated from operations;
Capital Spending refers to the cash used for purchases of fixed assets; and Additions to Net Working Capital refers to the cash used to increase working capital. Hence:
Cash flow from Assets = Cash Flow from Operations  Capital Spending  Additions to Net Working Capital
A business will run into serious problems if its operating cash flow is negative for a long time, because this means that the firm's operations are not generating enough resources to pay costs. Furthermore, if we wish to evaluate a business's operations, as apart from they way it is financed, we would need to compute its Cashflow from Assets, as described above. Similarly, if a firm wished to evaluate a new project, it would need to generate information about the Cashflow from Assets.
For the example above, we can compute the cash flow numbers:
Cash Flow from Operations  EBIT  1036 
+ Depreciation  + 184  
 Taxes   302  
= 918 
Capital Spending =  Ending Net Fixed Assets  8315 
 Beg. Net Fixed Assets   8106  
+ Depreciation  + 184  
= 393 
Additions to Net Working Capital =  Ending Net Working Capital  3871 
 Beginning Net Working Capital   3358  
= 513 
Total Cash flow from assets = 918  393  513 = 12
Similarly, we can compute the numbers on the liabilities side:
Cash Flow to Creditors =  Interest Paid  148 
 Net New Borrowing   825  
= 677 
Net new borrowing is simply the difference between the firm’s ending longterm debt and its beginning longterm debt.
Cash Flow to Stockholders =  Dividends paid  165 
 Net New Equity Raised  + 524  
= 689 
Net new equity raised is computed as the increase in owner’s equity from yearbeginning to year end, other than retained earnings. This is simply the change in the common stock and paidin surplus account. In our case, this is equal to 524.
Total cash flow to holders of the firm’s liabilities = 677 + 689 = 12, which equals the cash flow from assets, as computed above.
These quantities can be related to our earlier categories as follows:
Net Cash flows provided by Operating Activities = Operating Cashflows  Interest  D Noncash Working Capital (where D Noncash Working Capital º D Working Capital  D Cash)
Net Cash flows provided by Financing Activities =  Cashflows to Stockholders  Cashflows to Creditors + Interest
Net Cash flows used by Investing Activities = Capital Spending
Using this equivalence, we can construct
Net Cash flows provided by Operating Activities =
Operating Cashflows  918  
 Interest   148  
 D Working Capital   513  
D Cash  + 100  
= 357 
Net Cash flows provided by Financing Activities =
 Cashflows to Stockholders   689  
 Cashflows to Creditors   (677)  
+ Interest  + 148  
= 136 
Net Cash flows used by Investing Activities = 393