When we looked at the profit and loss account, the emphasis was on profit after tax (also called the bottom line). In finance, however, the focus is on cash flow.
A firm’s cash flow generally differs from its profit after tax because some of the revenues / expenses shown on it profit and loss account may not have been received / paid in cash during the year. The relationship between net cash flow and profit after tax is as follows:
Net cash flow = Profit after tax – Non cash revenues + Non cash expenses
An example of non cash revenue is accrued interest income that has not yet been received. It increases the bottom line but is not matched by a cash inflow during the accounting period, the cash inflow would occur in a subsequent period. An example of a non cash expenses is depreciation.
In practice, analysts define the net cash flow as,
Net cash = Profit after tax + Depreciation + Amortization.
However, note that the above expression will not reflect net cash flow accurately if there are significant non cash items beyond depreciation and amortizations.
Accounting Income versus Economic Income:
The economic income of a period is defined as the change in wealth during the period. Suppose you buy a share for Rs 50 at the beginning of a year. If you receive a dividend of Rs 2 and the price of the share moves up to Rs 60 at the end of the year then the economic income from the share is Rs 12 the increase in your wealth.
While it is easy to measure the change in the wealth of an investor, it is somewhat difficult to measure the change in the value of a firm. The profit and loss account represents the accountant’s attempt to measure the change in the wealth of shareholders. Accounting income diverges from economic income due to the following reasons.
Use of the Accrual Principle: The accountant uses the accrual principle and not the cash principle. Hence the computation of accounting income is not based on cash flows, even though it is cash though it is cash that really matters in the determination of economic income.
Omission of Changes in Value: The accountant records only those changes in value which arise from definite transactions. He does not bother about things like development of new products, emergence of competition, and changes in regulation that significantly alter the future revenues and costs of the firm and, hence, its value.
Depreciation: Economic depreciation represents the decline in the value of asset during the year. Since it is difficult to measure economic depreciation, the accountant often follows a fairly straight forward method for allocating the historical cost of the assets over its useful life. For example, under the straight line method, a commonly adopted method, the historical cost of the asset is allocated evenly over its life. Understandably, there is often a discrepancy between economic depreciation (loss of economic value) and accounting depreciation (allocation of historical cost during using some arbitrary rule).
Treatment of R&D and Advertising Expenditures: R&D expenditures increase a firm’s technical know how which enhances revenues and lowers costs in the future; likewise, advertising that build brand equity benefit the firm over a period of time. Hence these expenditures are akin to capital expenditures. Yet, for purposes of accounting, these expenditures are typically written off in the year in which they are incurred. This naturally causes a discrepancy between accounting income and economic income.
Inflation: Inflation raises the market value of the firm’s assets. However, under historical cost accounting this is not acknowledged. Hence, the depreciation charge is based on the historical cost, and not the replacement cost, of assets. This leads to a divergence between accounting income and economic income.
Creative accounting: Firms may manage their accounting income by resorting to various creative accounting techniques like change on the method of stock valuation. Change in the method and rate of depreciation, and sale and leaseback arrangement. Generally, the motive for creative accounting is to artificially boost the reported income. Obviously, such tactics cause a discrepancy between accounting income and economic income.