Cash Flow Calculation

The Cash Flow indicates how much Liquidity a Business is generating.

• Rather than its Accounting result.

But what is it used for?

Is it so different from Accounting Profits?

Earnings (and / or Profits) use different factors that make the Cash differ from it:

• Many Expenses are paid long after they have been accounted for.
• The Amortization reduces the Profits, but it doesn’t imply a real Cash reduction.
• Many Accounts Receivable are received long after they have been posted.
• etc.

Believe it or not, there are big companies with incredibly high Net Profits but with very poor Cash Flows.

On the other hand, there are small companies with discrete Net Profits but very high Cash Flows.

How is it possible?

The accounting Net Profit is based on the Revenues you made within a certain period of time and the resources needed to manufacture them.

The Cash Flow focuses just on the Company’s Cash Variation.

That is why there are certain factors that regarded in a complete different way.

The most famous one is the Amortization:

• In the Net Profit calculation, the Amortizations lower your result, not being a “real” cash-expense.

Next, we’ll explain how to calculate it in an easy way, but now, let’s see an analogy with one example so you understand the Concept.

Imagine you are planning a Road Trip from New York to Austin (Texas).

Before doing 2.790 km (1.744 miles) you want to check your:

• Shock absorbers.
• Air conditioning charge.
• Oil status.
• etc.

Everything that must be properly guaranteed in order not to have an accident.

If you decided to calculate the cost of your Trip, you could follow two approaches:

• The “Net Profit” or the “Cash Flow” approaches.

What it is sure is that you had to spend $ 1.000 on:

• Two new wheels.
• 2 Shock absorbers.

Moreover, you had to spend:

• $ 500 in Gasoline.

Your results

“Net-Profit” cost analysis:

Since the Two wheels and the 2 Shock absorbers will last for 5 years, you apply an Amortization period of 5 years.

You then calculate the cost of your Trip as follow:

• (1,000 / 5) + 500 dollars = $ 700.

“Cash Flow analysis”:

It takes into account the money you had before and after.

Hence, you costs would be:

• 1,000 + 500 = $ 1,500.

The proper calculation in this case would be:

Net profit + Amortization – Capital expenditures = – 700 + 200 – 1,000 = $ – 1,500.

(Since we are talking just about costs, we have negative results).

The most important thing is that you understand the concept:

• We all would probably use the Cash Flow calculation for estimating our road trip costs because it is the real money we would need.

With this example we wanted to show you how sometimes, lots of companies take important decisions just based on their (current or future) Net Profits, while they should worry about whether they would have enough Cash for it or not.

Now, lets learn a basic and easy way of calculating your Cash Flow.

* In our “Business Plan Templates” page, you’ll find an Excel template with these calculations we are about to explain already implemented in a 12 months Business Plan.

There are different ways of calculating the Cash Flow.

• Some people Start with the EBITDA, other don’t take into account Tax Shields…

We’ll explain you step by step the easiest way we know.

First of all, here is the Cash Flow calculation overall Scheme (Up – Down):

Net Profit

– Financial Results * (1 – Taxes)

= NOPAT (Net Operating Profits After Taxes)

+ Amortization / Depreciation

– Changes in Working Capital (CWC)

= Operating Cash Flow (OCF)

– Capital Expenditures (CAPEX)

= Free Operating Cash Flow (FOCF)

+ Financial Results * (1 – Taxes)

– Financing Debt variation

= Equity Cash Flow (ECF)

– Dividends, Stock Repurchase… (Optional Expenses)

= Cash Total variation.

Don’t be afraid of these concepts, they are not that difficult.

• It is necessary to “subtract” certain results and add them later, in order to know how much Cash was generated in each Stage.

Now, we’ll explain in detail all these factors in an easy way:

It is the Net Profit without taking into account the Financial Results multiplied by (1 – Taxes).

Why should you multiply it by (1 – T)?

Because [Financial results * (T)] is an amount of money you’ll have to pay for sure to the Government.

So, the rest of it [Financial results * (1 – T)] will be “pure” cash that you’ll have to take into account at the right time (in the Equity Cash Flow calculation, not the Operating one).

• When the Company’s Financial Results are remarkably high, it is better to “not count” them.
  • Else, somebody can think that the operating results were very successful when it was just a one-off good Financial operation.

Sometimes it is just called “Cash Flow”.

Here, there are 2 main factors to take into account:

• The Amortization / Depreciation.
• Changes in Working Capital.

It must be just added to the NOPAT, as we did in the previous “car example”.

• Because it is an accountancy factor that does not mean a real Cash decrease.

But Why don’t we multiply it for (1 – Tax) as we did with the Financial Results?

You have to add it entirely because:

• It reduces the Company’s earnings by that exact amount of money.
• Moreover, it prevents the Company from paying (Amortization * Tax) amount of money.
  • This (Amortization * Tax) is called the Tax Shield.
• On the other hand, the Financial results are an “intended-to-be-a-profit” factor that doesn’t generate this Shield.

You’ll understand it much better in this example:

Imagine you have:

• Net profit before Amortizations: $ 100.
• Amortization: $ 20.
• Financial results: $ 10.
• Taxes: 30%.

In your Net Profit before Taxes you would have:

• $ 100 – $ 20 + $ 10 = $ 90.

The Taxes you have to pay to the Government: 30% of $ 90 = $ 27.

• Net Profit = 90 – 27 = $ 63.

* We are assuming that you generate a huge amount of liquidity so your Earnings are on Cash (Your clients pay you at the moment as well as your Financial results).

You would have a NOPAT of:

• $ 63 – ($ 10 * (1 – 30%)) = $ 56.

Your Operating Cash Flow would be:

• $ 56 + $ 20 (Amortization) = $ 76.

If you calculate it directly, just taking operating factors into account, the result would be the same:

• $ 100 – ($ 100 – $ 80) * 30% = $ 76.

If you now add the Financial Results in order to have the Equity Cash Flow (we’ll explain later):

• $ 76 + ($ 10 * (1 – 30% = 70%)) = $ 83.

Calculating it on the other way, you would have exactly the same result.

• $ 100 + $ 10 – $ 27 (Overall taxes) = $ 83.

As you can see, the Amortization is added entirely and all the results fit perfectly.

• No matter how you calculate it. That is why.

* If your Financial Results are negative, you may have some tax-discounts.

• Depending on your country.

The Change in working Capital is the variation experienced in Operating Assets and Liabilities.

Working Capital = [Operating Assets – Operating Liabilities].

• CWC = [Working Capital of Year 2 – Working Capital of Year 1].

Since this is a bit confusing factor, lets see an example:

Imagine that you buy T-shirts, paint them and then sell them online.

Your Operating Assets would be:

• The amount of T-Shirts you have in stock.
• The painting you have.

Your Operating Liabilities would be:

• How much you owe to your suppliers.

Now, imagine you had a Net profit of:

• Year 1: $ 100.
• Year 2: $ 105.

Your Net profit is increasing a 5% yearly but, what happens to your Cash Flow?

You have no Amortizations nor Financial results, but in order to supply all your Clients, you had to increase your Stock of T-shirts and paint.

Moreover, your suppliers are not allowing you to pay 2 month later anymore but just 1 month later.

On year 1, you have a Cash Flow of $ 100 (remember, no amortizations, no Financial Results… Just pure cash).

• Operating Assets (Stock): $ 50.
• Operating Liabilities (accounts payable to your suppliers): $ 40.

Working Capital: $ 50 – $ 40 = $ 10.

On year 2, your Changes in Working Capital are:

• Operating Assets: Increase from $ 50 to $ 70 since you need more T-Shirts and Paint in Stock.
• Operating Liabilities: Reduce from $ 40 to $ 20.

Working Capital: $ 70 – $ 20 = $ 50.

• Change in Working Capital in 2 year, with respect to year 1 = $ 50 – $ 10 = $ 40.

This means that you need $ 40 more of Cash this year.

*Remember that Operating Liabilities and Assets are considered to be “almost” Cash.

• They are nor long-term assets nor Loans.

Operating Cash Flow = NOPAT – CWC (We have not Amortizations) = $ 65.

Hence, your Business would be Increasing a 5% yearly in Net Profit.

• However, your Cash Flow has Changed from $ 100 to 65$ ($ 105 – $ 40).

The more Working Capital you need, the for the Cash Flow.

This example shows how important is not forgiving about Working Capital Changes.

• Because you may think that everything is running perfectly and suddenly you realize that you have no Cash left.

You should always study the Operating Cash Flow.

• In businesses with no remarkable Capital expenditures (Consultancy, Advisory, online businesses, etc) this would be the Cash Flow to study.
  • Rather than the Free Operating Cash Flow that we are about to explain.

Lets move now to the next step:

Practically all the Analysts calls this Cash Flow simply Free Cash Flow.

But, strictly speaking, this is no the real Free Cash Flow, but the Free Cash Flow resulting from Operations.

• We’ll explain you later, in the Equity Cash Flow.

What is its difference with the Operating Cash Flow?

• The Free Operating Cash Flow takes into account the Capital Expenditures (CAPEX) necessary for the core Business to keep its Activity.

But… What are these Capital Expenditures?

• Machinery necessary to Manufacture the Product that is being sold.
• Civil Works necessary for the Manufacturing Process.
• Stock Warehouses, etc.

You’ll better understand its importance with a brief example:

Imagine you have 2 exact companies.

However, one of them decides to install a machine in order to improve its manufacturing capacity.

Year 1:

Both Companies: Operating Cash Flow = Free Operating Cash Flow is the same: $ 100.

Year 2:

Company 1: not purchasing any machinery  OCF = FOCF = $ 100.

Company 2: improved its Operating Cash Flow to $ 120.

• • However, its Free Operating Cash Flow is: $ 120 – $ 50 (CAPEX) = $ 70.

Year 3:

Company 1: with no CAPEX OCF = FOCF = $ 100$ (CWC are included).

Company 2: spent no money on an additional machine OCF = FOCF = $ 120.

• Thanks to last year’s investment.

* We’ve assumed that Sales and Costs have remained constant.

This example shows how important is not just analyzing the Operating Cash Flow but also the Free Operating Cash Flow.

• Sometimes Investments decrease your Cash in the current year but boost it in the next year.

*Some people include the CWC in the Free Operating Cash flow rather than in the Operating Cash Flow.

• If it is properly calculated and you explain what are you showing, there is no problem.

It is interesting to compare the Free Operating Cash Flow with the Operating Cash Flow.

• In this way, you’ll be able to check whether the Investments done have increased the Cash Flow as much as expected or not.

Usually, from here on, practically everybody considers that there is nothing left to calculate.

• And, hence, This is the total Free Cash Flow.

But… This is not True at all.

Now is time to talk about the Equity Cash Flow:

Here you must include all the Financial Results, Debts Payments… etc.

• What we subtracted previously in order to calculate the NOPAT.

Everything that is not “strictly” Operative but must be paid.

Because it shows how much Cash is left for paying Dividends.

Technically, you should not pay dividends or benefits unless your Equity Cash allowed you to do so.

However, few Companies (even in the Dow Jones) have positive Equity Cash flows.

• Many times, Companies pay Dividends due to Market pressures.

And last but not least:

It takes into account all the remaining non-vital expenses:

• The Dividends.
• Stock purchase operations.
• Currency exchange variations.
• …

At this point, there is “nothing left” to be included.

That is why saying just Free Cash Flow is a bit controversial:

What does FREE mean?

• If you have not considered the Debt… Is it really the Free Cash Flow?
• If you have not included the Dividends… Is it really the Free the Cash Flow?
  • Even if the Company have paid Dividends in the last 10 years?

You Call it just “Free Cash Flow”, if you want, to:

• The Free Operative Cash Flow,
• The Equity Cash Flow…

But before anything, explain perfectly what you took into account.

You must remember 2 things:

1. The Overall scheme:

Net Profit

– Financial Results * (1 – Taxes)

= NOPAT (Net Operating Profits After Taxes)

+ Amortization / Depreciation

– Changes in Working Capital (CWC)

= Operating Cash Flow (OCF)

– Capital Expenditures (CAPEX)

= Free Operating Cash Flow (FOCF)

+ Financial Results * (1 – Taxes)

– Financing Debt variation

= Equity Cash Flow (ECF)

– Dividend distribution, Stock Repurchase… (Optional Expenses)

= Cash Total variation.

2. Important:

There are many ways to calculate the Cash Flow and an also many ways of conceiving it.

• Free Cash Flow, Free Operational Cash Flow, Equity Cash Flow…

What you must Remember is:

• Explain how you calculated it and which factors you took into account.

It is better to understand the concept than getting lost into the formalities.