From Accounting Earnings to Cashflows

The three factors outlined above can cause accounting earnings to deviate significantly from the cash flows. To get from after-tax operating earnings, which measures the earnings to the firm, to cash flows to all investors in the firm, we have to

• Add back all non-cash charges, such as depreciation and amortization, to the operating earnings

• Subtract out all cash outflows that represent capital expenditures

• Net out the effect of changes in non-cash working capital, i.e. changes in accounts receivable, inventory and accounts payable. If non-cash working capital increased, the cash flows will be reduced by the change, whereas if it decreased, there is a cash inflow.

The first two adjustments adjust operating earnings to account for the distinction drawn by accountants between operating and capital expenditures, whereas the last adjustment converts accrual revenues and expenses into cash revenues and expenses.

Cash Flow to Firm = Earnings before interest and taxes (1-t) + Depreciation & Amortization - Change in Non-cash Working Capital - Capital Expenditures The cash flow to the firm is a pre-debt, after-tax cash flow that measures the cash generated by a project for all claim holders in the firm, after reinvestment needs have been met.

To get from net income, which measures the earnings of equity investors in the firm, to cash flows to equity investors requires the additional step of considering the net cash flow created by repaying old debt and taking on new debt. The difference between new debt issues and debt repayments is called the net debt, and it has to be added back to arrive at cash flows to equity. In addition, other cash flows to non-equity claim holders in the firm, such as preferred dividends, have to be netted from cash flows. Cash Flow to Equity = Net Income + Depreciation & Amortization - Change in Non-cash Working Capital - Capital Expenditures + (New Debt Issues - Debt Repayments) -Preferred Dividends

The cash flow to equity measures the cash flows generated by a project for equity investors in the firm, after taxes, debt payments and reinvestment needs.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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