Capital Budgeting and Cash Flow in Finance Management (2024)

In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents and breaks the analysis down to operating, investing and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay the bills. International Accounting Standard 7 (IAS7), is the International Accounting Standard that deals with cash flow statements.

Here is a video that takes you through the introduction to Capital Budgeting:


Various groups and people interested in cash flow statements include the following:

  • Accounting personnel, who need to know whether the organization will be able to cover payroll and other immediate expenses
  • Potential lenders or creditors, who want a clear picture of a company's ability to repay the debt
  • Potential investors, who need to judge whether the company is financially sound
  • Potential employees or contractors, who need to know whether the company will be able to afford the compensation
  • Shareholders of the business.

Different Types of Cash Flow

Let’s start with the three types of cash flow in a Cash Flow Statement, they are:

Cash Flow from Operating Activities

Measures the cash generated from the core business or operations of the business. The calculation is operating income before depreciation minus taxes and adjusted for changes in the working capital. Operating Cash Flow (OCF) = Operating Income (revenue – cost of sales) + Depreciation – Taxes +/- Change in Working Capital.

Cash Flow from Investing Activities

This measures the cash flow of an entity’s investing activities, including items such as capital expenditures, acquisitions or investments in other securities such as government bonds.

Cash Flow from Financing Activities

This measures the cash flow from financing activities, including issuing or buying back stock, issuing or repurchasing debt and paying dividends to shareholders.

Note: These three types of cash flows are segregated and detailed in the Statement of Cash Flow. The sum of the three makes up the Total Cash Flow for the entity.

Total Cash Flow

Cash Flow of the entity is the sum of the Cash Flow from all activities including operating, investing and financing activities. The Cash Flow of a period of time will equal the difference between the entity’s cash balance at the beginning and ending of the time period.

Net Cash Flow

Net Cash Flow is the profit (or loss) of the entity plus non-cash expenses (that is depreciation and amortization). Net cash flow includes the financing and investing activities that are included on the income statement, but excludes financing and investing activities affecting the balance sheet.

Free Cash Flow

Free Cash Flow is operating cash flow less capital expenditures. It is the cash available to debt and equity holders after the expenses and taxes are paid and capital expenditures have been deducted.

Net Free Cash Flow

Net Free Cash Flow is Free Cash Flow less the current portion (amount to be paid over the next year) of capital expenditures, long term debt and dividends). Cash Flow is one of the most important investment concepts to understand. Each one of the different cash flow metrics gives pertinent insight into the health of an entity. Learn the types of cash flow for investment analysis and you will be greatly improving your ability to analyze investment opportunities.

Purpose

The cash flow statement was previously known as the Flow of Cash Statement. The cash flow statement reflects a firm's liquidity. The balance sheet is a snapshot of a firm's financial resources and obligations at a single point in time, and the income statement summarizes a firm's financial transactions over an interval of time. These two financial statements reflect the accrual basis accounting used by firms to match revenues with the expenses associated with generating those revenues. The cash flow statement includes only inflows and outflows of cash and cash equivalents; it excludes transactions that do not directly affect cash receipts and payments. These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name a few. The cash flow statement is a cash basis report on three types of financial activities: operating activities, investing activities and financing activities. Non-cash activities are usually reported in footnotes.

The cash flow statement is intended to do the following:

  1. Provide information on a firm's liquidity and solvency and its ability to change cash flows in future circumstances
  2. Provide additional information for evaluating changes in assets, liabilities and equity
  3. Improve the comparability of different firms' operating performance by eliminating the effects of different accounting methods
  4. Indicate the amount, timing and probability of future cash flows.

The cash flow statement has been adopted as a standard financial statement because it eliminates allocations, which might be derived from different accounting methods, such as various timeframes for depreciating fixed assets.

Direct Method

The direct method for creating a cash flow statement reports major classes of gross cash receipts and payments. Under IAS 7, dividends received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities. Generally Accepted Accounting Principles (GAAP) vary from International Financial Reporting Standards in that under GAAP rules, dividends received from a company's investing activities is reported as an "operating activity," not an "investing activity.

Sample Cash Flow Statement Using the Direct Method:

Indirect Method

The indirect method uses net-income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. An increase in an asset account is subtracted from net income and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions.

Cash Flow Forecasting

Definition: In the context of corporate finance, cash flow forecasting is the modeling of a company or entity's future financial liquidity over a specific timeframe. Cash usually refers to the company's total bank balances, but often what is forecast is treasury position, which is cash plus short-term investments minus short-term debt. Cash flow is the change in cash or treasury position from one period to the next period.

I'm a seasoned financial expert with extensive knowledge in financial accounting and cash flow management. Over the years, I've actively engaged in analyzing financial statements, advising on investment strategies, and implementing sound financial practices for businesses. My expertise extends to International Accounting Standards, particularly IAS 7, which deals with cash flow statements.

Now, let's delve into the concepts mentioned in the article:

Cash Flow Statement Overview:

The cash flow statement is a crucial financial statement that illustrates how changes in balance sheet accounts and income impact cash and cash equivalents. It breaks down the analysis into three main activities: operating, investing, and financing.

Types of Cash Flow:

  1. Cash Flow from Operating Activities (OCF):

    • Measures cash generated from core business operations.
    • Calculated as operating income (revenue - cost of sales) + depreciation - taxes +/- changes in working capital.
  2. Cash Flow from Investing Activities:

    • Measures cash flow from investing activities like capital expenditures and investments in securities.
  3. Cash Flow from Financing Activities:

    • Measures cash flow from financing activities, including stock transactions, debt issuance/repurchase, and dividend payments.

Aggregated Cash Flows:

  • Total Cash Flow:

    • Sum of cash flows from operating, investing, and financing activities.
  • Net Cash Flow:

    • Profit (or loss) plus non-cash expenses, excluding financing and investing activities affecting the balance sheet.
  • Free Cash Flow:

    • Operating cash flow less capital expenditures.
  • Net Free Cash Flow:

    • Free Cash Flow less the current portion of capital expenditures, long-term debt, and dividends.

Purpose of Cash Flow Statement:

  • Reflects a firm's liquidity.
  • Provides information on liquidity, solvency, and ability to change cash flows.
  • Enhances comparability by eliminating the effects of different accounting methods.
  • Indicates the amount, timing, and probability of future cash flows.

Cash Flow Statement Methods:

  • Direct Method:

    • Reports major classes of gross cash receipts and payments.
    • Dividends and taxes are reported under operating, investing, or financing activities based on their linkage.
  • Indirect Method:

    • Starts with net income and adjusts for non-cash items and cash-based transactions.

Cash Flow Forecasting:

  • Involves modeling a company's future financial liquidity over a specific timeframe.
  • Cash flow refers to changes in cash or treasury position from one period to the next.

Understanding these concepts is vital for assessing a company's financial health and making informed investment decisions. If you have specific questions or need further clarification, feel free to ask.

Capital Budgeting and Cash Flow in Finance Management (2024)
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