From income statement to cash flow

In the previous post we have discussed the importance of cash. Cash is king not only for the fiscal health of a business but also when it comes to any investment analysis. Hence, all financial analyses evaluating future returns need to be based on cash flows. Sometimes, however, the financial data is only available as accounting flows on an income statement. In those cases accounting flows need to be translated into cash flows. Here it’s how.

It’s very common and most of the time easy for companies to create an income statement describing an investment project. Incremental units are translated into revenues and cost of sales. The actual investments in engineering and marketing activities are subtracted from the resulting gross margin. And the resulting operating income is used to determine taxes, which then leads to net income or net profit.

However, net income on an income statement doesn’t represent cash flows. As described in the previous post, a company may record revenues now but it may receive cash from customers for these sales much later. Or it may record cost of raw materials as cost of sales now but pay bills from the supplier much later. Instead of identifying these detailed cash flows, there are five adjustments that can be used to translate net income into cash flows.

First, capital depreciation needs to be added back to net income. Capital depreciation is an expense representing the depreciation of capital expenditures. Accounting (and tax) rules sometimes require companies to spread the cost of equipment or property over its useful life. This capital depreciation results in smaller periodic expenses over longer period of time. In reality, however, the company may pay for the equipment or property with a one-time cash payment leading to a one-time impact from the cash flow perspective. Hence, capital depreciation needs to be added back to net income to arrive at cash flows. At the same time, capital investment needs to be subtracted since it consumes cash due to this one-time payment. This is then the second adjustment. These two adjustments have a net zero effect over a longer period of time, but they lead to changes in periodic, e.g., monthly, cash flows.

The third adjustment addresses the fact that the company may receive money from its customers a while after it has billed them and after it has recorded these sales as revenues. As mentioned in the previous post, accounts receivable is where these expected payments from customers are recorded. Changes in accounts receivable can be used to translate net income into cash flows. These changes describe how much more or how much less cash has been tied in accounts receivable. There is a metric in accounting called days sales outstanding (DSO), which describes the number of days between the time a sale is recorded in the accounting systems and the time the company receives cash for that sale. With DSO the changes to cash flows can be easily calculated from revenues. These changes usually lead to cash from customers being available at a later time than the corresponding revenues.

Similarly to changes in accounts receivable, changes in accounts payable is the fourth adjustment used to translate net income into cash flows. Accounts payable represent how much cash is waiting to be used to pay suppliers. Changes in accounts payable describe how much more or how much less cash payments to suppliers have been delayed. Here too there is an accounting metric called days payables outstanding (DPO), which describes the number of days between the time a purchase is booked in the accounting systems and the time the supplier is paid for that purchase. DPO can be used to easily calculate changes in accounts payable from cost of sales. These changes usually lead to cash owed to suppliers being available for some time before the corresponding purchases are paid.

The final fifth adjustment are changes in inventory to reflect that some of the cash is tied in inventory, which is not reflected on the income statement. Net income only reflects the cost of sales of the company’s products and assumes that these products are turned into revenues once a sale is made. However, the products may spend some time in inventory where raw materials are turned into finished goods. Finished goods may even continue staying in inventory if the products cannot be sold right away. The accounting metric inventory turns per year represents the number of times the average inventory is sold during a year. Together with cost of sales, this metric can be used to calculate the additional cash tied in inventory.

To summarize, cash flows cannot be always identified easily but an income statement is usually readily available. Periodic net income can then be translated into periodic cash flows using the five adjustments described above. Some of FinanceIsland’s tools use this technique to derive cash flows from the income statement.

Leave a Reply

 

 

 

You can use these HTML tags

<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>