Tuesday, June 15, 2010


Important Points about Cash Flow Calculation

The estimation of cash flows, through difficult, is the most crucial step in investment analysis. Here are some important points about cash flow calculation.
  • Profits vs. cash flows

Cash flows are different from profits. Profit is not necessarily a cash flow; it is the difference between revenue earned and expenses incurred rather than cash received and cash paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure is made.

  • Incremental cash flows

Cash flows should be estimated on Incremental basis. Incremental cash flows are found out by comparing alternative investment projects. The comparison may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist.

  • Components of cash flows

Three components of cash flows can be identified: (1) initial investment (2) annual cash flows, and (3) terminal cash flows.

  • Initial investment

Initial investment will comprise the original cost (including freight and installation charges) of the project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset should also be adjusted to compute the initial investment.

  • Net cash flow

Annual net cash flow is the difference between cash inflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting deprecation while computing net cash flows.

  • Depreciation

Depreciation is a non-cash flow through tax shield. The following formula can be used to calculate change in net cash flows from operations

  • Working capital and capital expenditure

In practice, changes in Working capital items – debtors (receivable), creditors (payable) and stock (inventory) – affect cash flows. Also, the firm may be required to incur capital expenditure, during the operation of the investment project.

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