What is a Cash Flow?

∗
Utkarsh Majmudar

Typically cash flow is defined as (where τ is the tax rate):

Cash Flow = EBIT × (1 − τ ) + Depreciation ± Change in Net Working Capital

− Capital Expenditure

Alternatively, it can be represented as:

Cash Flow = EAT + Interest × (1 − τ ) + Depreciation ± Change in Net Working Capital

− Capital Expenditure

Yet the logic behind this formulation evades most students. In this short note I attempt to lift the veil
over this simple but easily misunderstood concept.

We know that Earnings or Profit are computed as:

Tab. 1: Earnings Statement

Revenue ...
Less: Expenses ...
Earnings before Depreciation Interest and Taxes (EBDIT) ...
Less: Depreciation ...
Earnings before Interest and Taxes (EBIT) ...
Less: Interest ...
Earnings before Tax (EBT) ...
Less: Tax ...
Earnings after Tax (EAT) ...

We use the above table as a basis for arriving at cash flows.

Some notations for future use:
R= Revenue
E= Expense
CR=Cash revenue
CE=Cash Expense
D=Depreciation
T= Taxes
CT= Cash Taxes
τ = tax rate

∗ Visiting Faculty, Indian Institute of Management Bangalore. Prepared as a basis for class discussion rather than to illustrate

either effective or ineffective handling of an administrative situation.

1
1 Starting Point 2

1 Starting Point

We start by assuming:

1. All purchases are converted into goods and sold within the year i.e. no opening and closing inventories.
2. Everything is paid for and received in cash. No credit purchases or sales. [R=CR; E=CE]
3. No depreciation or taxes. [D=0, T=0, τ =0]

4. The firm is debt free. No interest is to be paid.

Now the cash flow is in terms of:

Cash inflow: Cash Revenue
Cash outflow: Cash Expense

∴ Cash Flow = R − E = CR − CE = EBDIT = EBIT

2 Taxes are here!

Now we drop the assumption about no taxes. Absence of tax is an illusory scenario. The government has
to and does charge tax on earnings. What is the impact of taxes on profits and cash flows? It is the same!
Both profits and cash flows decrease by the amount of taxes paid. (Remember there can be no outstanding
or or accrued taxes – we live in a credit-less world (another illusion!)) Now our cash flow is:
Cash Flow = CR − CE − CT = EBDIT − CT = EBIT − CT
or ,
Cash Flow = [CR − CE] × (1 − τ ) = EBDIT × (1 − τ ) = EBIT × (1 − τ )

3 Welcome depreciation !!

We, further, drop the assumption regarding absence of depreciation. With depreciation (and still living in a
cash economy and debt-free world) our taxes would reduce. This is because for tax-purposes depreciation is
a deductible expense but we must also bear in mind that depreciation is just a book entry.
Now, EBIT = [EBDIT − Depreciation] × (1 − τ )
and,

Cash Flow = EBDIT − CT

= EBDIT − [(EBDIT-D) × τ ]
= EBDIT − (EBDIT)τ + Dτ
= EBDIT(1 − τ ) + Dτ

The presence of depreciation has a positive impact on cash flows. The term Dτ is referred to as the
depreciation tax shield.
4 Goodbye, Cash Economy! 3

Now to put the cash flow in terms of EBIT we simply subtract and add D to the above equation.

Cash Flow = EBDIT(1 − τ ) + Dτ − D + D

= EBDIT(1 − τ ) + D(τ − 1) + D
= EBDIT(1 − τ ) − D(1 − τ ) + D
= (EBDIT-D)(1 − τ ) + D
= (EBIT)(1 − τ ) + D

Recognize that this represents the first two terms of our cash flow equation.

4 Goodbye, Cash Economy!

Let us now drop the most unrealistic of our assumptions. We live in a credit economy, where transactions
can take place on credit too. Goods and services need not necessarily be bought and sold for cash. Credit is
available and given. Let us see what happens when a firm sells goods for cash as well as credit. The revenue
for a year is:
Revenue = Cash Sales + Credit Sales
However we are interested in the cash recovered from debtors (for credit sales in the past and present) which
is fairly simple:

Cash recovered from Debtors = Opening Balance of Debtors + Credit Sales − Closing Balance of Debtors
Cash recovered from Debtors = Credit sales + ∆ Debtors

Hence,

Cash Revenue = Cash Sales + Credit Sales + ∆ Debtors

= Revenue + ∆ Debtors

Note, if:

Closing Balance > Opening Balance then Reduction in Cash Balance

Closing Balance < Opening Balance then Increase in Cash Balance

Thus if only receivables (or debtors) are the only element in the change in net working capital, then an
increase in net working capital is a reduction in cash flow and an increase in net working capital is a increase
in cash flow (recall our sources and uses of funds!).
Similarly one can work out the impact of increase/decrease in the levels of creditors.
What about inventories? How do they impact the cash flow? How about finding it out for yourself! We
have now also taken care of the third term in our cash flow equation (Change in Net Working Capital).

5 Capital Expenditure, Here goes my money . . .

Any capital expenditure is a cash outflow. For instance, plant and machinery may be acquired by paying
cash or writing out a cheque to the supplier.

6 Interest, Where art thou?

We’ve completely overlooked interest. This is because our discount rate takes care of interest. Reducing
interest from cash flows will amount to double counting. Can you find out how?