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 long-term 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 Long-term debt
  Common Stock and Paid-in Surplus
  Retained Earnings
Total assets Total liabilities and shareholders’ equity

If we take current liabilities to the left-hand side, we can rewrite the balance sheet thus:

Assets Liabilities
Working Capital = Current Assets - Current Liabilities  
Fixed Assets Long-term debt
  Common Stock and Paid-in 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 Long-term debt
  D Common Stock and Paid-in 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 non-cash 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 debt-holders, we can deduct it from D Long-term debt. We now have a new category Cashflows to Creditors which is defined as Interest less D Long-term debt.

Dividends represent payments to shareholders. Hence we subtract it from D Common Stock and Paid-in Surplus. We now have a new category Cashflows to Shareholders which is defined as Dividends less D Common Stock and Paid-in 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 Long-term debt - Interest
D Working Capital - Cashflows to Stockholders =
D Common Stock and Paid-in 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 left-hand 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 long-term debt and its beginning long-term 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 year-beginning to year end, other than retained earnings. This is simply the change in the common stock and paid-in 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 Non-cash Working Capital (where D Non-cash Working Capital 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