Cash Flows

Businesses are shaped by a variety of activities and constituent processes, including the capital budgeting process, the organization of human resources by hiring, training, and putting to work of employees, the deployment of technologies by such employees, various production processes, and the process of marketing and selling of products and services. The last of these processes determines the flow of cash into the business. However, cash flows out of the business are often necessary aspects of all of these processes. In order for a business to survive, a sufficient magnitude of positive cash flows must be generated such that the business can meet internal obligations, including wages and benefits to employees, salaries and benefits for internal management, allocations for bookkeeping and internal auditing, and marketing; and external obligations, including taxes due to various governmental agencies, payments to advertising and public relations firms and for lobbying, payments of interest on debt, rent on leased properties, and dividends to equity shareholders. If the business is to be successful, these positive cash flows may need to be significantly greater than the amount required simply for survival. Corporations are legally structured sites and the relationships that occur within such sites, including the creation and ongoing activities of a board of directors responsible for determining the disposition of cash flows. These cash flows are used to meet both internal and external obligations, provide for the acquisition of tangible and intangible assets, and to otherwise pay for services necessary to the reproduction of the corporation. As part of the directors' distribution of cash flows and authority to secure financial contracts, they are responsible for approving internal budgets providing managers within various departments or other divisions with the means to acquire products, pay for services, or otherwise fund corporate activities, including the purchase of production inputs or products for resale. Directors also approve capital budgets and the capital financing plans that provide for cash flows to pay for new projects in the capital budgets. These capital financing plans may include debt obligations, new offerings of equity shares, or other financial arrangements/contracts that establish additional external cash flow obligations that must be met in future by the corporation. Thus, all aspects of corporate life are shaped by cash flows. Cash is the nexus that connects the corporate (or business) structure to the larger society and is a key gauge of corporate (or business) strength.

The economics profession generally ignores the political determinants of business, including the political definition of profits, much less the political, cultural, and environmental determinants of cash flows AND profits (as defined). Instead of recognizing profits as a purely accounting term (politically determined), economists not only talk in terms of generic firms (rather than the politically shaped and heterogenous entities that actually make up the business world, where sole proprietorships, partnerships, and corporations coexist as clearly unequal business structures -- not to mention the heterogeneity that exists within each of those categories), but presume that firms are profit maximizers. This is not a harmless assumption. Firstly, as we've already indicated, cash, not profits, determines corporate survival and success. Profits are not the same as cash flows. You need cash flows to meet cash obligations. Profits, on the other hand, are determined by politically determined rules of accounting (generally accepted accounting principles). It is possible for firms to have negative profits and positive cash flows and vice versa. In order to decipher the success of a firm in generating cash flows, it is necessary to carry out a mathematical translation of accounting data (from financial statements) into cash flows that provide a more accurate indication of the way the operational activities of a firm generate positive cash flows, making it possible to value these operational activities on the basis of projected future cash flows.

What are some of the reasons for the divergence between profits and cash flows? Three accounting principles are particularly important to this divergence: (1) Revenue recognition rules, the matching principle, and depreciation rules. Revenue recognition rules provide for the booking of sales when an agreement for the sale has been consummated, rather than when cash changes hands. Thus, accounts receivable may be created as the bookkeeping entry opposite a sale and cash is only realized when and if the accounts receivable is converted to cash at some future period. (2) The matching principle provides for the booking of costs in connection to sales: expenses associated with the production of products sold are determined on the basis of either first in/ first out or last in/first out. (3) Depreciation rules allow the cost of property, plant, and equipment to be allocated in a politically determined manner. Thus, the reported net income may not on any number of values depending upon the depreciaion rules allowable and applied in specific cases.

It is commonplace for analysts to use earnings before interest, taxes, depreciation, and amortization (EBITDA) as a proxy for cash flow. The answer is, it depends. If we are seeking a measure of cash flow to use in equity valuation, the appropriate cash flow number is one that takes into consideration the political position of shareholders as residual claimants after all other claims to cash flow have been satisfied. This means that the appropriate cash flow in equity valuation must be determined as a residual after deducting the payments for operating expenses, internal management and other administrative expenses (SG&A). external management services (such as payments to outside auditors or consultants), taxes to governments, leases to landlords, and interest to lenders. Since EBITDA includes interest and taxes (does not deduct them from the EBITDA measure) then it is not reflective of the cash flows that are "owned" by the shareholders. EBITDA is, therefore, not an appropriate measure of cash flow for the purpose of valuing equity.


Copyright © 2012, Satya Gabriel, Economics Department, Mount Holyoke College.