346 CHAPTER 9 Financial Statements, Cash Flow, and Taxes
To illustrate depreciation’s effect, suppose a machine with a life of five years and a
zero expected salvage value was purchased in 2001 for $100,000 and placed into ser-
vice in 2002. This $100,000 cost is not expensed in the purchase year; rather, it is
charged against production over the machine’s five-year depreciable life. If the depre-
ciation expense were not taken, profits would be overstated, and taxes would be too
high. So, the annual depreciation charge is deducted from sales revenues, along with
such other costs as labor and raw materials, to determine income. However, because
the $100,000 was actually expended back in 2001, the depreciation charged against in-
come in 2002 and subsequent years is not a cash outlay, as are labor or raw materials
charges. Depreciation is a noncash charge, so it must be added back to net income to obtain the
net cash flow.If we assume that all other noncash items (including amortization) sum to
zero, then net cash flow is simply equal to net income plus depreciation.
Differentiate between net cash flow and accounting profit.
In accounting, the emphasis is on net income. What is emphasized in finance,
and why is that item emphasized?
Assuming that depreciation is its only noncash cost, how can someone calculate
a business’s net cash flow?
Statement of Cash Flows
Even if a company reports a large net income during a year, the amount of cashre-
ported on its year-end balance sheet may be the same or even lower than its beginning
cash. The reason is that its net income can be used in a variety of ways, not just kept as
cash in the bank. For example, the firm may use its net income to pay dividends, to in-
crease inventories, to finance accounts receivable, to invest in fixed assets, to reduce
debt, or to buy back common stock. Indeed, the company’s cash positionas reported on
its balance sheet is affected by a great many factors, including the following:
1.Net income before preferred dividends.Other things held constant, a positive
net income will lead to more cash in the bank. However, as we discuss below, other
things generally are not held constant.
2.Noncash adjustments to net income.To calculate cash flow, it is necessary to
adjust net income to reflect noncash revenues and expenses, such as depreciation
and deferred taxes, as shown above in the calculation of net cash flow.
3.Changes in working capital.Increases in current assets other than cash, such as
inventories and accounts receivable, decrease cash, whereas decreases in these ac-
counts increase cash. For example, if inventories are to increase, the firm must use
some of its cash to acquire the additional inventory. Conversely, if inventories de-
crease, this generally means the firm is selling inventories and not replacing all of
them, hence generating cash. On the other hand, if payables increase, the firm has
received additional credit from its suppliers, which saves cash, but if payables de-
crease, this means it has used cash to pay off its suppliers. Therefore, increases in
current liabilities such as accounts payable increase cash, whereas decreases in cur-
rent liabilities decrease cash.
4.Fixed assets.If a company invests in fixed assets, this will reduce its cash position.
On the other hand, if it sells some fixed assets this will increase cash.
5.Security transactions and dividend payments.If a company issues stock or
bonds during the year, the funds raised will increase its cash position. On the other
hand, if the company uses cash to buy back outstanding stock or to pay off debt, or
if it pays dividends to its shareholders, this will reduce cash.
342 Financial Statements, Cash Flow, and Taxes
