Setting the Stage

Chapter 16 explains how to get from net income (the bottom line of the income statement) to the cash flow yield from net income (which is found in the first section of the statement of cash flows). Cash flow almost always is higher or lower than net income for the period. There are three main reasons: (1) depreciation (and any noncash expenses and losses recorded in the period); (2) changes in operating assets; and, (3) changes in operating liabilities.

1. Depreciation (and noncash expenses and losses): Sales revenue reimburses a business for the expenses it incurs in making sales. Profit is the margin of sales revenue in excess of expenses. One expense is depreciation. A business records depreciation expense each period by writing down the cost balance of its property, plant, and equipment (except land). There is no cash outlay in recording this expense. Because depreciation is not a cash outlay the amount of the expense is an “add back” to net income for determining cash flow.
In addition to depreciation, a business may record 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. Such asset write-downs do not involve a decrease in cash. Therefore, amortization expense and asset write-down losses are added back to net income (just like depreciation). ...

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