Hi everybody. In this class we are going to learn one of the most important concepts of finance, that is cash flow. We are going to learn how to determine this cash flow. We know that the value of a firms assets is equal to the sum of the value of it's liabilities and equity, and it is called the balance sheet identity. Similarly the cash flow from the firms assets must equal the sum of the cash flow to creditors and cash flow to stockholders or owners. This is called the cash flow identity. Cash flow from assets include three components. Operating cash flow, capital spending, and change in net working capital. Operating cash flow refers to the cash flow from the firm's day to day operations. It is important to note that expenses, such as interest, are not included in the operating cash flow, because they are not operating expenses. Capital spending means purchases of fixed assets minus sales of fixed assets, that is net spending on fixed assets. Change in net working capital is the amount spent on net working capital. As we learned already, net working capital is the difference between the current assets and current liabilities. In order to calculate operating cash flow we have to add depreciation to earnings before interest and taxes. Since depreciation is not a cash outflow, but we have to subtract taxes from EBIT, because taxes are actual cash outflows. For example, if EBIT is $1,000 depreciation is $100 and tax is $200, then operating cash flow is $900. Negative operating cash flow means that a firm's cash inflow is less than its cash outflow, so it is a sign of trouble. In finance, operating cash flow is measured as EBIT + Dep- Taxes. But in accounting, operating cash flow is net income plus depreciation. So it is important to note that the accounting definition of operating cash flow considers interest paid to the operating expense. While the financial definition of operating cash flow treats interest as a financing expense In order to find cash flow from assets we need to find capital spending too. Net capital spending is money you spent on fixed assets minus money received from the sale of fixed assets. Net capital spending equation is from the following equation, that is, ending net fixed assets is equal to beginning net fixed assets minus depreciation plus net capital spending. Rearranging this equation to solve for net capital spending, we can get the equation for net capital spending as, net capital spending is equal to ending net fixed assets minus beginning net fixed assets plus depreciation. Let's take a look at an example. Suppose a firm's ending net fixed asset is $1,000, beginning net fixed asset is $900. Depreciation is $100. Then net capital spending is $1,000 minus $900 plus $100 is equal to $200. Net capital spending could be negative if ending net fixed assets are smaller than beginning net fixed assets. That is firm sold more assets than it purchased. However, in most cases ending net fixed assets are greater than the beginning net fixed assets. Whether it is negative or positive, net capital spending is often called CAPEX or capital expenditures. In addition to investing in fixed assets, a firm will also invest in current assets. For example, suppose Walmart opens a new store in New York. Walmart has to fill the new store with new inventory. Even though part of the inventory can be financed by suppliers credit, not all of inventory can be sold within the credit period. Then part of the inventory should be financed by Walmart’s own capital. This is an increase in net working capital. We can find change in Net Working Capital by taking the difference between the beginning and ending Net Working Capital. For example, suppose a firm has ending Net Working Capital of $500 And beginning net working capital of $400. Then change in net working capital is $500 minus $400 is equal to $100. Given the figure we have come up with we can calculate cashflow from assets. Operating cashflow is $900. Net capital spending is $200. Change in net working capital is 100. So cash flow from assets is $900 minus $200 minus $100 is equal to $600. Next, let's talk about cash flow to creditors and owners. The cash flows to creditors and owners mean net payment to creditors and owners during the year. We can find cash flows to creditors from interest paid minus net new borrowing. For example, suppose a company paid $100 of interest and long-term debt grows from $400 to $450. Then firms net new borrowing is 450 minus 400 is equal to $50, and interest paid is $100. So the cash flow to creditor is 100 minus 50 is equal to $50. The cash flow to stockholders is dividends paid to stockholders minus net new equity. For example, suppose a company paid $600 of dividend, and its beginning equity was $1,000 and ending equity is $1,050. Then cash flow to stockholders is dividends of $600 minus net new equity of 50, so it is $550. From the previous class we know that cash flow from assets is $600. Cash flow to creditors and stockholders is $50 plus $550 equal to $600. So we make sure that cash flow identity holds true.
