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:

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

Now, consider the changes in these quantities.

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

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

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):

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:

Total Cash flow from assets = 918 - 393 - 513 = 12

Similarly, we can compute the numbers on the liabilities side:

Net new borrowing is simply the difference between the firm’s ending long-term debt and its beginning long-term debt.

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 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 =

Net Cash flows provided by Financing Activities =

Net Cash flows used by Investing Activities = 393