Financial Cash FlowsIn finance, the most important item that can be extracted from financial statements is the

actual cash flow of the firm.Since there is no magic in finance, it must be the case that the cash flow received
from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.CF(A)≡ CF(B) + CF(S)

Free Cash Flows There are two types of Cash Flows:

(1) This is the cash flows generated by a company’s operating activities and available to all who provided
capital to the firm (Debt and Equity Holders)𝑂𝐹𝐶𝐹=𝐸𝐵𝐼𝑇−𝑇𝑎𝑥+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛−𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔
𝐶𝑎𝑝𝑖𝑡𝑎𝑙−∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠Current Assets –Current Liabilities

Free Cash Flows(2) “free” cash flows to equity (stock holders), which is derived from after operating free cash
flows have been adjusted for debt payments (interest and principal)𝐹𝐶𝐹=𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒+𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛−𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒+𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 𝐼𝑠𝑠𝑢𝑒−𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝐷𝑒𝑏𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠−∆𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙−∆𝑂𝑡ℎ𝑒𝑟 𝐴𝑠𝑠𝑒𝑡𝑠Current Assets –
Current Liabilities

Limitations of Financial Ratios

Accounting statements:A reasonably good job of categorizing the assets owned by a firmA partial job of
assessing the value of these assetsA poor job of reporting uncertainty about asset valueAccounting
principles:The accounting view of asset value is to a great extent grounded in the notion of historical cost,
which is the original cost of the asset. Historical cost is the best estimate of the value of an asset.Conservative
approach to estimate the value .At the end of 2011, book value of Google is $58.1 billionAt the end of 2011, the
market value of Google is $ billion (stock price= $645)

43 Limitations of Financial Ratios

These values are based on specific datesCapture values of assets and liabilities on a specific dateRatios using
balance sheet may not reflect company’s situation during rest of the yearExample: A company that reports $1
million in cash on last day of fiscal year may have only $100 K two days later after paying salaries and
suppliers

CASH FLOWProvides a summary of cash flows over the period concern, typically the year just ended.Cash
Flow from AssetsCash flow from assets = Cash Flow to Creditor + Cash Flow to StockholdersCash Flow from
Assets involves three components: operating cash flow, capital spending, and change in net working
capital.Operating Cash Flow:It refers to the cash flow that results from the firm’s day-to-day activities of
producing and selling.
18 Capital SpendingIt is just money spend on fixed assets less money from sale of fixed assets.

19 Change in net working capital

20 Cash flow to creditorsA firm’s interest payments to creditors deduct net new borrowingCash flow to
stockholdersDividends paid out by a firm less new equity raised.