(190)---COMPONENT OFNET ANNUAL CASH FLOWS

Component of Net Annual Cash Flows

• Net working capital

In reality, the actual cash receipts and cash payments will differ from revenues (sales) and expenses as given in the profit and loss account. This difference is caused by changes in working capital items, which include trade debtors (account receivables), trade creditors (accounts payable) and stock (inventory). Consider the following situations:

• Changes in accounting receivables. The firm’s customers may delay payment of bills which increase receivable. Since revenues (sales) include credit sales, it will overstate cash inflow. Thus, increase (or decrease) in receivable should be subtracted from (or added to) revenues for computing actual cash receipts.
• Changes in inventory. The firm may pay cash for materials and production of unsold output. The unsold output increases inventory. Expenses do not include cash payments for unsold inventory, and therefore, expenses understate actual cash payments. Thus, increase (or decrease) in inventory should be added to (or subtracted from) expenses for computing actual cash payments.
• Change in accounting payable. The firm may delay payments for materials and production of sold output (sales). This will cause accounts payable (suppliers’ credit) to increase. Since accounts payable is included in expenses, they overstate actual cash payments. Thus, increase (or decrease) in accounts payable should be subtracted from (or added to) expenses for computing actual cash payments.

It is, thus, clear that changes in working capital items should be taken into account while computing net cash inflow from the profit and loss account. Instead of adjusting each item of working capital, we can simply adjust the change in net working capital, viz. the difference between change in current assets and change in current liabilities to profit. Increase in net working capital should be subtracted from and decrease added to after-tax operating profit.

Thus, we can calculate net cash flow as below,

NCF = EBIT (1 – T) + DEP – NWC

Where NWC is net working capital