Cash flow refers to the cash revenues less cash expenses.
Accounting profit refers to the figure of profit as shown in the profit and loss account.
This cash flow is preferable over the accounting profit due to the following reasons:
- The main objective of a firm is to maximise the wealth of the shareholders which depends on the cash flow but not the profit.
- The existence of certain accounting ambiguities in accounting makes cash flow preferable than the accounting profit.
- The cash flow also takes into account the time value of money which is ignored by accounting profit.
Conventional and Non-conventional cash flow
In conventional cash flow, an initial cash outflow i.e., initial investment is followed by a series of uniform or unequal cash inflows.
In non-conventional cash flows, there exists a series of cash inflows and cash outflows.
Incremental cash flows
The screening of investment proposals involves the determination of cash flows. They may be absolute cash flows or incremental cash flows.
- If there is only one proposal and the decision of the investment is to be taken then the absolute cash flows are considered.
- If there are more than one proposal, the relative cash flows are considered which is also called as the incremental cash flows.
TYPES OF CASH FLOWS:
- Initial Investment or Cash outlay
- Operating cash flow or net annual cash flows
- Terminal cash flows
Initial Investment or Cash outlay:
Operating cash flow or net annual cash flows
These are the cash flows calculated after charging the tax but before depreciation.
Cash Revenues – Cash Expenses – Tax
Net Earnings After Tax + Depreciation – Tax
Determination of Net Annual Cash Flows:
Terminal cash flows
These are the cash flows recovered at the end of the useful life of the asset.
Replacemeng of Projects
Replacement of projects is an unavoidable necessity. Replacement may be of two kinds:
- Replacement of like for like ——- due to physical wear and tear
- Replacement due to obsolescence—– due to the technological advancements
In case of replacement of an existing asset, the tax is computed on the excess of its sale
Value over its book salvage value.
If the cash salvage value exceeds the book salvage value, the difference is treated as ordinary income and taxed. This tax liability is added to the initial outlay.
Depreciation Tax Field
Depreciation is an allocation of the cost of fixed assets. Though it involves an accounting entry as an expense, as it is not a cash expense and hence does not constitute part of the computation of cash flow.
And hence has no direct impact on the cash flow. But has an impact on the cash flow in the form of reduction of tax liability. Hence it is considered for the computation of after-tax cash flow in spite of the fact that it does not form a part of the cash flow.