What is the Cash Flow?

The famous Cash Flow: what everybody says to be the most important thing ever.

Although, few people really know how calculating it or even what is it.

The Cash Flow indicates how much liquidity a business is generating rather than its accounting result.

That gives no clue about how calculating or why is it that important isn’t it?

 

The best way for understanding its importance is by highlighting the difference between the Net profit and the Cash Flow:

Difference between Net Profit and Cash Flow

This is the most common question everybody has.

We have found big companies with incredibly high Net Profits but with very poor Cash Flows.

 

On the other hand, we have seen plenty of “small” companies with discrete Net Profits but very high Cash Flows.

How is it possible?

The accounting Net Profit is based on the revenues you made within a certain period of time and which resources did you use in order to manufacture them. The Cash Flow focuses purely on the company’s cash variation.

That is why there are certain factors that regarded in a complete different way.

The most famous one is the Amortization:

  • In the Net Profit calculation, the Amortizations lower your result, not being a “real” cash-expense. That is why a Cash Flow calculation adds the Amortization to the Net Profit (or takes the EBITDA) as the starting point.

 

However, while the Amortization lowers the Net Profit Calculation, there are other important factors that Net Profit doesn’t take into account that would lower the company’s Cash Flow (like Capital Expenditures or Working Capital variation).

 

Next, we’ll explain how calculating it easily, so you’ll understand it better. But now, lets see an analogy with one example with no numbers at all.

Net Profit and Cash Flow Differences example

Imagine you are planning a Road Trip from New York to Austin (Texas).

Before doing 2.790 km (1.744 miles) you want to check your:

  • Shock absorbers.
  • Air conditioning charge.
  • Oil status.
  • etc.

Everything that must be properly guaranteed in order not to have an accident.

 

If you decided to calculate the cost of your Trip, you could follow the “Net profit” or the “Cash Flow” approaches.

 

What it is sure is that you had to spend 1.000$ on:

  • Two new wheels.
  • 2 Shock absorbers.

Moreover, you had to spend:

  • 500$ in Gasoline.

Your results:

“Net-Profit” cost analysis:

Since the Two wheels and the 2 Shock absorbers will last for 5 years, you apply an Amortization period of 5 years.

You then calculate the cost of your Trip as follow:

  • (1.000/5) + 500 dollars = 700$.

 

“Cash Flow analysis”:

It takes into account the money you had before and after.

Hence, you costs would be:

  • 1.000+ 500 = 1.500 $.

 

The proper calculation in this case would be:

Net profit + Amortization – Capital expenditures = -700 + 200 – 1.000 = -1.500$.

(Since we are talking just about costs, we have negative results).

 

The most important thing is that you understand the concept:

  • We all would probably use the Cash Flow calculation for estimating our road trip costs because it is the real money we would need.

With this example we wanted to show you how sometimes, lots of companies take important decisions just based on their (current or future) Net Profits, while they should have worry about whether they would have enough Cash for it or not.

 

Now, lets learn a basic and easy way of calculating your Cash Flow.

 

* Within the “Business Plan Templates” page, you’ll find an Excel template with these calculations we are about to explain already implemented in a 12 months Business Plan.

How to Calculate Cash Flows

There are different ways of calculating the Cash Flow.

Some people Starts with the EBITDA, some other don’t take into account Tax Shields…

We’ll explain you step by step the easiest way we know.

 

First of all, here is the Cash Flow calculation overall Scheme (Up – Down):

Cash Flow Calculation Scheme

Net Profit

 

– Financial Results * (1- Taxes)

= NOPAT (Net Operating Profits After Taxes)

 

+ Amortization / Depreciation

– Changes in Working Capital (CWC)

= Operating Cash Flow (OCF)

 

– Capital Expenditures (CAPEX)

= Free Operating Cash Flow (FOCF)

 

+ Financial Results * (1- Taxes)

– Financing Debt variation

= Equity Cash Flow (ECF)

 

– Benefits/ Dividend distribution

= Cash Total variation.

Don’t be afraid of all these concepts, they are really simple as we are about to explain.

It is necessary to “subtract” certain results that are added later, in order to know how much Cash was generated strictly by certain means.

 

* For example: the financial results are extracted from the Net profit in order to know strictly how much cash had been made with the operations.

  • If your company made an outstanding amount of money by selling certain financial assets, it should be highlighted on the Equity Cash Flow, not on the Operating one.

 

Now, lets explain in detail all these factors above shown:

1. NOPAT - Net Operating Profits After Taxes

It is nothing but the Net Profit without taking into account the Financial Results multiplied by (1 – Taxes).

Why this (1-T)?

Simply because [Financial results * (T)] is an amount of money you’ll have to pay for sure to the Government.

 

So, the rest of it; [Financial results * (1 – T)] will be “pure” cash that you’ll have to take into account at the right time (on the Equity Cash Flow calculation, not the Operating one).

When to use the NOPAT?

  • When the company’s Financial results are remarkably high, you may have to “not count” them.
    • Else, somebody can think that the operating results were very successful when it was just a one-off good Financial operation.

2. Operating Cash Flow - OCF

Sometimes it is just called “Cash Flow”.

Here we have 2 main factors for taking into account:

  • The Amortization/Depreciation.
  • The Change in Working Capital.

2.1. Amortization

It must be just added to the NOPAT, as we did in the previous car example since it is an accountancy factor that does not mean a real expenditure, just a decrease in the Assets’ value.

 

Now, you’ll be surely asking to yourself: Why don’t we multiply it for (1-Tax) as we did with the financial results?

You have to add it entirely since:

  • It reduces the company’s earnings by that exact amount of money.
  • Moreover, it prevents the company from paying: (Amortization * Tax) amount of money.
    • This (Amortization * Tax) is called the Tax Shield.
  • On the other hand, the financial results are an “intended-to-be-a-profit” factor that doesn’t generate this Shield.

 

Imagine for a second that Financial results had the same “Tax-benefits” as Amortizations do. Suddenly everybody would speculate all the company money:

  • If the results were good; there would be benefits, and if they were bad, at least they would decrease the Taxes payable.
    • While Amortizations encourage the companies to keep investing on machinery and new equipment.

And mathematically speaking, it is calculated in this way since it is the real Cash you will or won’t have to pay.

 

In this example you’ll see how everything fits perfectly:

Cash Flow - Amortization Tax shield example

Imagine you have:

  • Net profit before Amortizations: 100$.
  • Amortization: 20$.
  • Financial results: 10$.
  • Taxes: 30%.

 

In your Net Profit before Taxes you would have:

  • 100$ – 20$ + 10$ = 90$.

 

The Taxes you have to pay to the Government: 30% of 90$ = 27$.

  • Net Profit = 90 – 27 = 63$.

 

* We are assuming that you generate a huge amount of liquidity so your Earnings are on Cash (Your clients pay you at the moment as well as your Financial results).

 

You would have a NOPAT of:

  • 63$ – (10$ * (1 – 30%)) = 56$.

 

Your Operating Cash Flow would be:

  • 56$ + 20$ (Amortization) = 76$.

 

If you calculate it directly, just taking operating factors into account, the result would be the same:

  • 100$ -(100$-80$)*30% = 76$.

If you now add the financial results in order to have the Equity Cash Flow (we’ll explain later):

  • 76$ + (10$ * (1 – 30% = 70%)) = 83$.

 

Calculating it on the other way, you would have exactly the same result.

  • 100$ + 10$ – 27$ (Overall taxes) = 83$.

As you can see, the Amortization is added entirely due to the Tax Shield it represents and all the results fit perfectly no matter how you calculate it. That is why.

 

* If your financial results are negative, depending on your country you may have some tax-discounts.

2.2. Changes in Working Capital

The Change in working Capital is the variation experienced in operating assets and liabilities.

 

Since it is a bit confusing factor to explain just-theoretically, lets see an example:

Changes in Working Capital - Cash Flow example

Imagine you buy T-shirts, paint them and then sell them.

 

Your Operating Assets would be:

  • The amount of T-Shirts you have in stock.
  • The painting you have.

 

Your Operating Liabilities would be:

  • How much do you owe your suppliers (if you are a company, sometimes you may pay them after they send you the T-Shirts).

 

Now, imagine you had a Net profit of:

  • Year 1: 100$.
  • Year 2: 105$.

 

Your Net profit is increasing a 5% yearly but what happens to your Cash Flow?

You have no amortizations nor Financial results, but in order to supply all your worldwide clients, you had to increase your Stock of T-shirts and paint.

Moreover, your suppliers are not allowing you to pay 2 month later anymore but just 1 month later.

 

On year 1, the base year you have a Cash Flow of 100$ (remember, no amortizations, no Financial results… pure cash).

  • Operating Assets (Stock): 50$.
  • Operating Liabilities (accounts payable to your suppliers): 40$.

Working Capital: 50$ – 40$ = 10$.

 

On year 2, your Changes in Working Capital are:

  • Operating Assets: Increase from 50$ to 70$ since you need more T-Shirts and Painting in stock.
  • Operating Liabilities: Reduce from 40$ to 20$.

Working Capital: 70$ – 20$ = 50$.

 

  • Change in Working Capital in 2 year, with respect to year 1 = 50$ – 10$ = 40$.

 

This means that you need 40$ more of Cash every year.

 

*Remember that Operating Liabilities and Assets are considered to be “almost” Cash: they are nor long-term assets nor Loans.

 

Operating Cash Flow = NOPATCWC (We have not Amortizations) = 65$.

Hence, your Business would be Increasing a 5% yearly in Net Profit while your Cash Flow has Changed from 100$ to (105$ – 40$) = 65$.

  • The more Working Capital you need, the worse regarding Cash Flow.

 

* In future sections we’ll explain everything about Working Capital in more detail; it is not an easy concept to understand.

This example shows how important is not forgiving about Working Capital Changes since you may think that your business is running perfectly when suddenly you realize that there is not enough cash for purchasing your stock (you would never imagine how many times we’ve seen that).

When to use the Operating Cash Flow?

The Operating Cash Flow should be employed… always.

  • In businesses with no remarkable Capital expenditures (consultancy, advisory, internet-based businesses, etc) this would be the common Cash Flow to be calculated rather than the Free Operating Cash Flow we are about to explain.

 

Lets move now to the next step:

3. Free Operating Cash Flow

Practically everybody calls this Cash Flow simply Free Cash Flow, but it is not exactly the same; by now, we are strictly speaking about operating results.

Compared to the Operating Cash Flow, it takes into account the Capital Expenditures (or CAPEX) necessary for the core business to keep its activity.

 

But… What is exactly the “core business”?

Basically:

  • Machinery directly related with the business’s activity.
  • Civil Works done.
  • Stock warehouses, etc.

You may understand its importance better with a brief example:

Free Operating Cash Flow example

Imagine you have 2 exact companies.

However, one of them decides to install a machine in order to improve its manufacturing capacity.

 

On year 1:

  • Their Operating Cash Flow = Free Operating Cash Flow is the same: 100$.

 

On year 2:

  • Company 1, without purchasing any machinery (nor CAPEX) has an Operating Cash Flow = Free Operating Cash Flow of 105$.
  • Company 2, improved its Operating Cash Flow to 120$.
    • However, since it spent 50$ on a new machinery, its Free Operating Cash Flow is just: 120$ – 50$ = 70$.

 

On year 3:

  • Company 1, without having done any Capital Expenditure, has an Operating Cash Flow = Free Operating Cash Flow of 110$ (takes into account the Changes in Working Capital).
  • Company 2, spent no money on an additional machine, so they have this year an Operating Cash Flow = Free Operating Cash Flow = 120$ thanks to last year’s investment.

This example shows how important is not just analyzing the Operating Cash Flow but also the Free Operating Cash Flow.

Sometimes one year of CAPEX decreases your Cash availability but would boost your results on the next year.

 

*Some people include the Changes in Working Capital in the Free Operating Cash flow rather than on the Operating Cash Flow, so remember: If it is properly calculated, there is no problem at all, but you must know what are you looking at and explain what are you showing.

When to use the Free Operating Cash Flow?

It is interesting for comparing the Free Operating Cash Flow evolution together with the Operating Cash Flow.

  • Hence, you’ll be able to check whether the Investments done, have increased the Cash Flow generation as much as expected or not.

Usually, from here on, practically everybody says:

  • “With this, you pay the rest of the things, and there you have, the Free Cash Flow”.

Yes… but no…

 

Now is time to talk about the Equity Cash Flow:

4. Equity Cash Flow

Here you must include all the Financial Results (we subtracted previously in order to calculate the NOPAT) Financial Debts Payments…

  • Everything that is not “strictly” Operative but must be paid.

Why is Equity Cash Flow important?

Because it shows how much cash is left for paying dividends and benefits.

Technically, you should not pay dividends or benefits unless your Equity Cash allowed you to do so.

 

However, not even half of the Dow Jones companies have had continuous positive Equity Cash flow.

  • If your company is on the Stock Market, there are other external pressures that you should contain even if it implies getting into debt for paying Dividends.

 

And last but not least:

5. Cash Variation

It takes into account all the remaining non-vital expenses:

  • The Benefits sharing.
  • The Dividends.
  • Stock purchase operations.
  • Currency exchange variations.

At this point, there is “nothing left” to be included.

Why everybody says just "Free Cash Flow"?

That is why saying just Free Cash Flow is “so controversial”:

What does FREE mean?

  • If you had not considered yet the Debt, is it Free Cash Flow really? (as tons of people and Websites claim).
  • If you have not included the Dividends… is it Free the Cash Flow?
    • Even if the Company had paid Dividends for the last 10 years?

Call it just Free Cash Flow whenever you want:

  • To the Free Operative Cash Flow,
  • To the Equity Cash Flow…

But before anything, explain perfectly what did you take into account.

Summarizing

You must remember 2 things:

1. The Overall scheme:

Net Profit

– Financial Results * (1- Taxes)

= NOPAT (Net Operating Profits After Taxes)

+ Amortization / Depreciation

– Changes in Working Capital (CWC)

= Operating Cash Flow (OCF)

– Capital Expenditures (CAPEX)

= Free Operating Cash Flow (FOCF)

+ Financial Results * (1- Taxes)

– Financing Debt variation

= Equity Cash Flow (ECF)

– Benefits/ Dividend distribution

= Cash Total variation.

2. And one important thing:

There are almost infinite ways of calculating the Cash Flow and Infinite ways of calling it as well; Free Cash Flow, Free Operational Cash Flow, Equity Cash Flow…

  • Moreover, some people include one thing or another depending on what they have learnt.

 

Then, the first thing you must always do is:

  • Explaining how did you calculate it.
    • And the factors you took into account.

It is better to understand the concept than getting lost into the formalities.

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