112 Impact of growth and decline on cash ﬂ ow
Chapter 13 explains how to get from net income (the bottom line
of the income statement) to the cash ﬂ ow yield from net income
(in the ﬁ rst section of the statement of cash ﬂ ows). Cash ﬂ ow can
be higher or lower than net income for the period. Why? There
are three main reasons: (1) depreciation (and any other noncash
expenses and losses recorded in the year), (2) changes in operat-
ing assets, and (3) changes in operating liabilities.
1. Depreciation (and Other Noncash Expenses and Losses):
Sales revenue reimburses a business for the expenses it
incurs in making sales. Proﬁ t is the margin of sales revenue
in excess of expenses. One expense is depreciation . A busi-
ness records depreciation expense each period by writing
down the cost balance of its property, plant, and equip-
ment (except land). There is no cash outlay in recording
this expense. Therefore, depreciation is an “ add back ” to
net income for determining cash ﬂ ow.
In addition to depreciation, a business may record other
noncash expenses and losses. For example, a company may
record amortization expense to recognize the loss of value of
its intangible assets. Or, a business may record an uninsured
loss that occurred during the year. Neither asset write down
involves a decrease in cash. Therefore, amortization expense
and asset write-down losses are added back to net income
(just like depreciation).
2. Operating Assets: Changes in a company ’ s operating assets
(accounts receivable, inventory, and prepaid expenses)
affect cash ﬂ ow from proﬁ t. An accounts receivable
increase delays cash inﬂ ow, and increases in other operat-
ing assets require cash outﬂ ow. In contrast, an accounts
receivable decrease accelerates cash inﬂ ow, and decreases
in other operating assets generate cash. The business, in
effect, liquidates part of its investments in these operating
3. Operating Liabilities: Increases in operating liabilities
(accounts payable, accrued expenses payable, and income
tax payable) help cash ﬂ ow during the year. The business
avoids cash outlay to the extent of the increases. In other
words, part of total expenses for the year are not paid
but instead are recorded by increases in these liabilities.
Decreases in operating liabilities have the opposite effect:
More cash is paid out than the amount of expenses for the
year, because the liabilities were paid down.
Caution: Simply adding back depreciation (plus any other non-
cash expenses and losses) to net income does not give you a true
measure of cash ﬂ ow from operating activities (proﬁ t). Changes
in operating assets and liabilities during the year cause impacts
on cash ﬂ ow, which can be very sizable in some cases.
Setting the Stage for Cash Flow Analysis
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