(181)---ILLUSTRATING THE DIFFERENCES BETWEEN CASH FLOW AND PROFIT

Illustrating the Differences between Cash Flow and Profit

Assume that a firm is entirely equity-financed, and it receives its revenues (REV) in cash pays and its expenses (EXP) and capital expenditures (CAPEX) in cash. Also, assume that taxes do not exist. Under these circumstances, profit is equal to:

Profit = Revenues – Expenses – Depreciation

Profit = REV – EXP – DEP

And cash flow is equal to:

Cash flow = Revenues – Expenses - Capital expenditure

Cash flow = REV – EXP – CAPEX

It may be noticed from equation one and two that profit does not deduct capital expenditures as investment outlays are made. Instead, depreciation is charged on the capitalized value of investments. Cash flow, on the other hand, ignores depreciation since it is a non-cash item and includes cash paid for capital expenditures. In the accountant’s book, the net book value of capital expenditures will be equal to their capitalized value minus depreciation.

We can obtain the following definition of cash flows if we adjust equation two for relationship for relationships given equation one:

CF = (REV – EXP – DEP) + DEP –CAPEX

CF = Profit + DEP – CAPEX

Equation three makes it clear that even if revenues and expenses are expressed in terms of cash flow, still profit will not be equal to cash flows. It overstates cash inflows by excluding capital expenditures and understates them by including depreciation. Thus, profits do not focus on cash flows. Financial managers will be making incorrect decisions if they put emphasis on profits or earnings per share. The objective of a firm is not to maximize profits or earnings per share, rather it is to maximize of shareholder’s wealth, which depends on the present value of cash flows available to them. In the absence of taxes and debt, equation three provides the definition of profits available for distribution as cash dividends to shareholders. Profits fail to provide meaningful guidance for making financial decisions. Profits can be changed by affecting changes in the firm’s accounting policy without any effect on cash flows.

For example, a change in the method of inventory valuation will change the accounting profit without a corresponding change in cash flows.