Question

The business’s financial statements (profit & loss statement and balance sheet) prepared by the accountant, are the most readily available financial information that a business has access to. Given this, provide some comments on what adjustments would need to be made to this financial information to be in a form consistent with residual cash flows for undertaking time value of money calculations? That is, given the basis as to how the accountant prepares financial statements for a business is not directly consistent with its cash flows, can they be manipulated in a manner suitable to that required in finance –if so, what items require adjustment and how?

Answer 1

Income statements are prepared on accrual basis and not on cash flows basis. Hence, income statements don't give us the cash flows that can be straightway discounted.

We need free cash flows to discount under the time value of money concept. HEnce we need to make the following changes:

• Start with net income
• Add back non cash expenses such as: Depreciation, amortization and deferred tax liability
• Make the following adjustments:
  • Subtract the increase in net non cash working capital (this item has to come from balance sheet)
• Subtract the capital expenditure

Thus,

Free cash flow = EBIT x (1 - T) + Depreciation - increase in working capital - Capital expenditure

This is the cash flow that is discounted under time value of money concept.