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.

First of all, sales are not sales. There are gross sales, which represent unit sales of products or services at list or gross price. This list price represents the price that a company may publish in its official price list. Most of the time, however, companies offer discounts off these list prices.

Discounts may include negotiated discounts with specific customers, which are then offered anytime to these customers as long as the negotiated contract is in place. Discounts may also include time- or deal-limited price reductions offered as part of a promotion activity. Some companies that use distribution partners to sell their products classify also costs associated with supporting these distribution partners as discounts.

Gross sales minus discounts lead to net sales or net revenues. Net revenues represent the money that the company receives from its customers.

Net revenues = gross sales – discounts = units * list price – discounts

Second, all of the products or services that are sold to customers need to be produced and delivered, which creates cost. This cost of sales (COS) is obvious in a manufacturing environment: all the materials and parts that are needed to assemble the product plus the people assembling it plus the manufacturing facility are all part of COS. In a service business cost of sales may not be obvious, but delivering the service usually requires people providing the service to customers. The cost of these employees represents COS in a service business.

Once all costs of sales are accounted for, they are subtracted from net sales to calculate gross margin or gross profit. Sometimes gross margin percentages, which are gross margins as percentage of net revenues, are used to compare companies in an industry to determine how efficient their operations are.

Gross margin = net revenues – cost of sales

Third, every company incurs costs associated with operating the business. These costs are called operating expenses. Operating expenses are usually divided in engineering expenses or research & development (R&D), marketing and sales expenses, and other expenses. Other expenses can include administrative expenses that are not accounted for anywhere else or allocations from headquarters in large organizations.

When subtracting operating expenses from gross margin we arrive at operating income or operating profit.

Operating income = gross margin – operating expenses

Most companies pay taxes. Taxes are based on the operating income the company achieves and are usually a percentage of the operating income. When subtracting taxes from operating income we get finally to net income or net profit. This net income is at the end the measure that can be used when talking about “making money”.

Net income = operating income – taxes
= units * list price – discounts – cost of sales – operating expenses – taxes

What we have reviewed here is the income statement or profit & loss statement (P&L). This statement is an important document describing the profitability of the company. It is used mostly for accounting and taxation purposes. For investment purposes, however, it is more appropriate to evaluate cash flows, which may differ from the measures described here. But on cash flows and why cash is king at some other time.

The profitability index, also known as benefit-cost ratio, is defined as the present value of future cash flows divided by the initial investment. The profitability index rule is to accept any investment project with an index greater than one. Profitability index most closely resembles net present value. When some people refer to return on investment (ROI) as a metric, they basically mean the profitability index, assuming of course that the ROI calculation is done correctly as described in one of the previous posts.

However, the key problem with the profitability index is that it’s a relative metric. A relative metric doesn’t allow to make reliable comparisons of investment alternatives. A ratio doesn’t tell you in absolute terms how profitable an investment is versus all investment options. It only tells you how profitable it is versus its own investment.

The payback period is determined by the number of periods – usually years – it takes until the cumulative cash flow becomes positive. Investment projects are accepted if the payback period meets some predefined cutoff period. Since this rule doesn’t take the time value of money into account, a slightly better version of this metric is the discounted payback period, which is based on cumulative discounted cash flows.

In either case, the payback period is a subjective measure. It is driven by an arbitrary choice of a cutoff period. This metric ignores any cash flows thereafter. Is an investment with a 2-year payback period better than one with a 3-year payback period? Without analyzing cash flows after these 2 or 3 years, i.e., without knowing the absolute profitability, it’s impossible to tell.

The internal rate of return (IRR) is defined as the discount rate at which an investment project would have zero NPV. According to the IRR rule, you should accept any investment project offering an IRR above the opportunity cost of capital. Although IRR is widely used in finance and is based on discounted cash flows, i.e., it takes time value of money into account, it has several drawbacks.

First, the calculation of IRR is iterative. Although most spreadsheets and financial calculators provide an IRR function, you have to start with a guess for the IRR. Spreadsheets or calculators try then to determine the true IRR through several iterations. This wouldn’t be problematic in itself, but this brings us to the second issue.

Second, if the cash flow changes across periods from positive to negative or vice versa more than once, there may be several IRRs or no IRR at all. The wrong initial guess of the IRR for the iterative calculation will lead to the wrong final IRR.

Finally, as with any relative metric, IRR is unreliable in ranking projects of different scale and risk. Is an investment with an IRR of 19% and the opportunity cost of capital of 12% better or worse than an investment with an IRR of 13% and the opportunity cost of capital of 6%? In both cases IRR is 7 percentage points above the opportunity cost of capital. But without knowing the absolute investment returns it’s impossible to tell which investment is financially sounder.

Although there were more shortcomings of IRR discussed here than of the other two metrics, it doesn’t mean that IRR is worse. However, since IRR is widely used but can be easily misinterpreted, we spent more time addressing its drawbacks. By the way, others agree with us regarding the weaknesses of IRR. The CFO Magazine, for example, published a McKinsey article that warns of using IRR and claims that the most straightforward way to avoid problems with IRR is to avoid it altogether.

To summarize, NPV rocks.