If you are familiar with the balance sheet, you would know that the value of any firm’s assets is equal to the sum of its liabilities and its shareholders’ equity.
Assets = Liability + Equity, then
Cash Flow from Assets SHOULD BE = Cash Flow to Stockholders + Cash flow to Creditors
However, cash flow to stockholders would be replaced by cash flow to the owner in case it is a private business.
The second equation is what we will refer to as the “Cash Flow Identity”. It communicates the fact that any cash earned by the firm is used for paying off debts and the remaining amount either goes into the owner’s pocket (to be spent on oneself or to be reinvested in the business), or is paid to shareholders as dividends.
Now that you have understood this concept, let’s move on to discuss the components that make up each of these cash flows.
Cash Flow from Assets
Cash flow from assets comprises of the following:
- Operating Cash Flow
- Capital Spending
- Change in Net Working Capital
Operating Cash Flow
The flow of cash that is maneuvered by routine business activities such as production and sale of goods is referred to as Operating Cash Flow (OCF). However, costs incurred in financing the assets are excluded because they do not fall under the category of operational expense.
While calculating OCF, costs are subtracted from revenue, however, only those costs are subtracted that are incurred in cash. Depreciation is excluded because it does not result in a cash outflow. Similarly, interest is also not included in operational costs as it falls under the head of financing expenses.
Since tax payments are made in cash, they are subtracted from the revenue when calculating Operating Cash Flow.
To calculate OCF for any business, we will need to extract the value of Earnings before Interest and Taxes (EBIT) from its income statement. We use this value because interest payments are not deducted from it. However, depreciation usually is, but we can make up for it by adding back that value. Since EBIT does not exclude tax payments, we will need to subtract that amount as well.
Let’s assume that a firm’s EBIT as per its income statement is $600, the depreciation of its assets is equivalent to $60, whereas the tax payment it has made amounts to $200.
This is how its Operating Cash Flow will be calculated:
|Earnings before Interest and Taxes||600|
|Operating Cash Flow||$460|
This value holds particular significance because it reflects whether the cash generated via a firm’s operations is sufficient to meet its day-to-day cash expenses. Therefore, a negative value for OCF would be alarming for a business.
It must be noted that the definition of Operating Cash Flow that exists in accounting is different from what we have discussed concerning Cash Flow Identity and therefore the two must not be confused with each other.
In case you are wondering what is the difference between the two, be informed that the accounting definition calculates operating cash flow by adding the depreciation amount to net income rather than EBIT. Net income is the one that remains with you after the deduction of interest.
Thus, according to the accounting definition interest is classified as an operating expense in contrast to this concept where it is considered a financing expense.
Now that we have understood the Operating Cash Flow, let’s move on to discuss other components of Cash Flow from Assets.
To keep the business running, a certain percentage of the cash flow generated by a firm is invested back into it. The net amount spent on fixed assets is referred to as “Capital Spending”. It is calculated by subtracting the dollar value of fixed asset sales from that of fixed asset purchases.
Let’s say that at year-end, net fixed assets for a firm were $1600, and the following year these assets depreciated by $60, our net fixed assets for that year would then be:
1600 – 60 = 1540
If the net fixed assets for the succeeding year were reported as $1700, it would have meant that the firm has spent $60 (1700-1540) on purchases of new assets, thus the net capital spending being $60.
If this value is negative, it means that a firm sold more fixed assets than it bought.
Change in Net Working Capital
Change in Net Working Capital (NWC) is observed via calculating the difference between its current assets and current liabilities.
This is understandable because any business needs to spend on current assets along with fixed assets.
If current assets at the end of one year are $1100, and at the end of next year they are $1400, it means that during that one year the firm spent 1400-1100 = $ 300 on current assets.
It is no surprise that a change in current assets will be accompanied by a change in current liabilities. Therefore, the best approach to track a change in networking capital would be to note the difference between NWC values at the start and end of the year.
Let’s assume that current liabilities for the preceding year were $400 whereas those for the next year were $300.
|Net Working Capital- Year 1||Net Working Capital – Year 2|
Thus, the change (increase) in Net Working Capital would be 1100-700 = $400.
Now that we have all the required values, we can easily determine what Cash Flow from Assets would be. The formula to calculate it is:
Operating Cash Flow – (investment in fixed assets + investment in net working capital)
|Operating Cash Flow||460|
|Net Capital Spending||(60)|
|Change in Net Working Capital||(300)|
|Cash Flow from Assets||$ 100|
Cash Flow from Assets is also known as Free Cash Flow. This is because the business has the freedom to distribute this amount amongst its stockholders or to use it for paying its debts rather than hoarding it for investments in fixed assets or for meeting its working capital requirements.
As per the rule of Cash Flow Identity, the sum of the cash flow to stockholders and cash flow to creditors must equal $100, i.e., the value for Free Cash Flow.
However, a business may have a negative value for cash flow during its growth phase. Reason being that it would be taking more loans and trying to raise funds via the sale of its stock rather than paying back the creditors or giving out dividends.
Cash Flow to Creditors
Cash Flow to Creditors is also known as Cash Flow to Bondholders. It is calculated by subtracting Net New Borrowing from the interest payments.
Cash Flow to Creditors = Interest Expense – Net New Borrowing from Creditors whereas
Net New Borrowing = Ending Long-term Liabilities – Beginning Long-term Liabilities
Let’s assume that the hypothetical organization we have been considering to understand these calculations made interest payments equivalent to $100, but simultaneously borrowed $60 more.
The value for Net Cash Flow to Bondholders will be 100-60= $40.
Cash Flow to Stockholders
Cash Flow to Stockholders is calculated by subtracting net new equity raised via the sale of additional stocks from the cash amount paid as dividends to shareholders.
One thing that must be noted is that if dividend payments are made via other modes besides cash, for example, in the form of assets or stocks, then they will not be included in the cash flow.
The value for dividend payments can be retrieved from the Income Statement. To determine the figure for net new equity, common stock and paid-in surplus accounts need to be looked into. From here we can find out the monetary value of the stock sold. If the account shows an increase of $90, it means that this is the value of net new equity raised.
Assuming that the firm paid dividends equal to $150, Cash Flow to Stockholders would be
You must have noticed that the sum of cash flow to creditors and stockholders (40 and 60) equals the value of Cash Flow from Assets, i.e., 100.
We hope you would have understood the Cash Flow Identity concept in detail by now.