Cash Flows and Profit
The use of net present value (NPV) rule in investment decisions requires information about cash flows. It is the inflow and outflows of cash, which matters in practice. It is cash, which a firm can invest, or pay to creditors to discharge its obligations, or distribute to shareholders as dividends. Cash flow is a simple and objectively defined concept. It is simply difference between rupees received and rupees paid out.
Cash flow should not be confused with profit. Changes in profits do not necessarily mean changes in cash flows. It is not difficult to find examples of firms in practice that experience cash shortages in spite of increasing profits. Cash flows are not the same thing as profits, at least, for two reasons.
- Profit, as measured by an accountant, is based on accrual concept revenue (sales) is recognized when it is earned, rather than when cash is received, and expense is recognized when it is incurred rather than when cash is paid. In other words, profit includes cash revenues as well as receivable and excludes cash expenses as well as payable.
- For computing profit, expenditures are arbitrarily divided into revenue and capital expenditures. Revenue expenditures are entirely charged to profits while capital expenditures are not. Capital expenditures are capitalized as assets (investments), and depreciated over their economic life. Only annual depreciation is charge to profit. Depreciation (DEP) is an accounting entry and does not involve any cash flow.
Thus, the measurement of profit excludes some cash flows such as capital expenditures and includes some non-cash items such as depreciation.
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