Cash Flow Identity (re: Chapter 2)
An Illustrative Example
Basic Premise:
A company generates cash from the assets it owns and uses cash to acquire assets. This cash generated or used flows entirely from/to either or both of bondholders (creditors) or shareholders (owners).
Similarly and alternatively, from the point of view of the company, with brackets indicating the direction of the cash in or (out):
Cash generated from or (used for) Assets
= Cash (given to) or sourced from Bondholders
+/- Cash (given to) or sourced from Shareholders.
The Cash Flow Identity or relationship’s three components are outlined below.
1. Cash from/to Assets is comprised of three elements:
Operating Cash Flow - Capital Expenditures +/- Changes in Working Capital
Each of these three elements can be determined as follows:
Operating Cash Flow = Net Income + Depreciation (a non-cash expense or a non-use of cash)
+ Interest Expense (i.e. part of cash paid to Bondholders)
Capital Expenditures = Change in Net Fixed Assets + Depreciation (a non-cash decrease in Net Fixed Assets)
Change in Working Capital = Difference between ending and beginning Working Capital
(an increase is a use of cash and a decrease is a source)
2. Cash from/to Bondholders is comprised of two elements:
Interest expense paid to them for lending the money (a use of cash)
+/- the change in amount outstanding to these lenders (an increase is a source of cash and a decrease is a use of cash)
3. Cash from/to Shareholders is similarly comprised of two elements:
Dividends paid to them as a return on their ownership investment (a use of cash)
+/- the change in the amount of equity o/s to these investors (an increase is a source of cash and a decrease is a use of cash)
Application of this Cash Flow Identity relationship is illustrated in an example company that follows on the next page.
MyCo, Inc.
Year 2 Income Statement
($ Millions)
Net sales $1,384
Less: Cost of goods sold 605
Less: Depreciation 180
Earnings before interest and taxes 599
Less: Interest paid 80
Taxable income 519
Less: Taxes 156
Net income $363
Addition to retained earnings $254
Dividends paid 109
MyCo, Inc.
Balance Sheets
($ Millions)
Yr 1 Yr 2 Yr 1 Yr 2
Assets Liabilities
Cash $ 100 $ 121 Accounts payable $ 400 $ 350
Accounts rec. 350 425 Notes payable 390 370
Inventory 440 410 Total $ 790 $ 720
