Understanding Business Accounting For Dummies, 2nd Edition (52 page)

Depreciation expense recorded in the period is both the simplest cash flow effect to understand and, at the same time, one of the most misunderstood elements in calculating cash flow from profit. (Refer to Chapters 5 and 6 for more about depreciation.) To start with, depreciation is not a cash outlay during the period. The amount of depreciation expense recorded in the period is simply a fraction of the original cost of the business's fixed assets that were bought and paid for years ago. (Well, if you want to nit-pick here, some of the fixed assets may have been bought during this period, and their cost is reported in the investing activities section of the cash flow statement.) Because the depreciation expense is not a cash outlay this period, the amount is added back to net income in the calculation of cash flow from profit - so far so good.

When measuring profit on the accrual basis of accounting you count depreciation as an expense. The fixed assets of a business are on an irreversible journey to the junk heap. Fixed assets have a limited, finite life of usefulness to a business (except for land); depreciation is the accounting method that allocates the total cost of fixed assets to each year of their use in helping the business generate sales revenue. Part of the total sales revenue of a business constitutes
recovery of cost invested in its fixed assets
.
In a real sense, a business ‘sells' some of its fixed assets each period to its customers - it factors the cost of fixed assets into the sales prices that it charges its customers. For example, when you go to a supermarket, a very small slice of the price you pay for that box of cereal goes toward the cost of the building, the shelves, the refrigeration equipment, and so on. (No wonder they charge so much for a box of cornflakes!)

Each period, a business recoups part of the cost invested in its fixed assets. In other words, £1.2 million of sales revenue (in the example) went toward reimbursing the business for the use of its fixed assets during the year. The problem regarding depreciation in cash flow analysis is that many people simply add back depreciation for the year to bottom-line profit and then stop, as if this is the proper number for cash flow from profit. It ain't so. The changes in other assets as well as the changes in liabilities also affect cash flow from profit. You should factor in
all
the changes that determine cash flow from profit, as explained in the following section.

Adding net income and depreciation to determine cash flow from profit is mixing apples and oranges. The business did not realise £1,600,000 cash increase from its £1,600,000 net income. The total of the increases of its debtors, stock, and prepaid expenses is £1,920,000 (refer to Figure 7-1), which wipes out the net income amount and leaves the business with a cash balance hole of £320,000. This cash deficit is offset by the £220,000 increase in liabilities (explained later), leaving a £100,000 net income
deficit
as far as cash flow is concerned. Depreciation recovery increased cash flow £1.2 million. So the final cash flow from profit equals £1.1 million. But you'd never know this if you simply added depreciation expense to net income for the period.

The managers did not have to go outside the business for the £1.1 million cash increase generated from its profit for the year. Cash flow from profit is an
internal
source of money generated by the business itself, in contrast to
external
money that the business raises from lenders and owners. A business does not have to ‘go begging' for external money if its internal cash flow from profit is sufficient to provide for its growth.

In passing, we should mention that a business could have a negative cash flow from profit for a year - meaning that despite posting a net income for the period, the changes in the company's assets and liabilities caused its cash balance to decrease. In reverse, a business could report a bottom line
loss
in its income statement yet have a
positive
cash flow from its operating activities: The positive contribution from depreciation expense plus decreases in its debtors and stock could amount to more than the amount of loss. More realistically, a loss often leads to negative cash flow or very little positive cash flow.

Operating liabilities increases

The business in the example, like almost all businesses, has three basic liabilities that are inextricably intertwined with its expenses: creditors, accrued expenses payable, and income tax payable. When the beginning balance of one of these liability accounts is the same as the ending balance of the same account (not too likely, of course), the business breaks even on cash flow for that account. When the end-of-period balance is higher than the start-of-period balance, the business did not pay out as much money as was actually recorded as an expense on the period's income statement.

In the example we've been using, the business disbursed £720,000 to pay off last period's creditors balance. (This £720,000 was reported as the creditors balance on last period's ending balance sheet.) Its cash flow this period decreased by £720,000 because of these payments. But this period's ending balance sheet shows the amount of creditors that the business will need to pay next period - £800,000. The business actually paid off £720,000 and recorded £800,000 of expenses to the year, so this time, cash flow is
richer
than what's reflected in the business's net income figure by £80,000 - in other words, the increase in creditors has a positive cash flow effect. The increases in accrued expenses payable and income tax payable work the same way.

Therefore, liability increases are favourable to cash flow - in a sense the business borrowed more than it paid off. Such an increase means that the business delayed paying cash for certain things until next year. So you need to add the increases in the three liabilities to net income to determine cash flow from profit, following the same logic as adding back depreciation to net income. The business did not have cash outlays to the extent of increases in these three liabilities.

The analysis of the changes in assets and liabilities of the business that affect cash flow from profit is complete for the business example. The bottom line (oops, we shouldn't use that term when referring to a cash flow amount) is that the company's cash balance increased £1.1 million from profit. You could argue that cash should have increased £2.8 million - £1.6 million net income plus £1.2 million depreciation that was recovered during the year - so the business is £1.7 million behind in turning its profit into cash flow (£2.8 million less the £1.1 million cash flow from profit). This £1.7 million lag in converting profit into cash flow is caused by the £1,920,000 increase in assets less the £220,000 increase in liabilities, as shown in Figure 7-1.