© 2000 John Petroff

4)- Other concepts and measurements of cash flows

a)- annual cash flow of each project

A major field where cash flows are used is in capital budgeting which was introduced in Chapter 3 Section G, and which is extensively analyzed in Chapter 10 Section E. The decision to undertake a project is based on net present value or internal rate of return. That decision essentially compares the cash outlay to the cash flows over the years, discounting them at an appropriate discount rate. The cash flows used in this calculation are those solely attributable to the project under consideration. As explained in Chapter 2 Section B, they are calculated as the increase in revenue net of the additional expenses including relevant taxes (i.e. the tax expense for the net profit from the project, calculated at the marginal rate for the firm), and exclusive of non-cash expenses, such as depreciation, depletion and amortization, in particular. This can be put into the widely used formula for cash flow (CF) in each year of a project as

CF = net profit after tax + depreciation

b)- cash to repay debt

Another use of cash flow involves repayment of a long term liability such as a bond. For instance, a projection is made to determine how much cash must be accumulated in a sinking fund specially set up to pay off the debt. Depending on the pattern of the sinking fund accumulation, a firm may decide to buy back some of the bonds to reduce its exposure (see Chapter 12 Section D-2). Thus, a schedule is developed with dates and amounts to be retired. Based on this schedule, the firm may include a call provision in the covenants of the indenture. Some bondholders see a serial call provision (one that specifies which bond serial numbers are to be retired and at which date) as an desirable feature because it shows management's intention and strategy to pay it obligations timely. (Note, however, that some bondholders do not like call provisions because that may cause them to have to look for another bond when their bond has to be redeemed.)

A ratio that is occasionally used to verify the ability of a firm to generate cash flow sufficient to repay debt is the ratio of cash flow to current debt owed CFCD. In the current debt owed are included the current maturity of long term debt and current notes payable. The ratio CFCD is given by

CFCD = Cash Flow / (current portion of long term debt + notes payable)

A similar ratio that is used primarily by bank loan officers is relating cash flow to total debt CFTD, rather than to the current portion only. This ratio indicates whether a firm is currently capable of carrying its debt adequately, and therefore, whether an additional debt would be excessive or not. The ratio CFTD is given by

CFTD = Cash Flow / Total Debt

Further analysis of a company to carry and service its debt will be undertaken in Chapter 11 Section C-4, in context of coverage ratios.