Question

Define these business finance terms in your own words and then give a real world example of each.

Cash Flow from Assets (also known as FCF), Cash Flow Identity/Equation, Change in NWC, and Financial Leverage.

Answer 1

1.CASH FLOW FROM ASSETS (FCF)

Cash flow from assets is the aggregate total of all cash flows related to the assets of a business. This information is used to determine the net amount of cash being spun off by or used in the operations of a business. The concept is comprised of the following three types of cash flows:

• Cash flow generated by operations. This is net income plus all non-cash expenses, which usually include depreciation and amortization.

• Changes in working capital. This is the net change in accounts receivable, accounts payable, and inventory during the measurement period. An increase in working capital uses cash, while a decrease produces cash.

• Changes in fixed assets. This is the net change in fixed assets before the effects of depreciation.

For example, a business earns $10,000 during the measurement period, and reports $2,000 of depreciation. It also experiences an increase of $30,000 of accounts receivable and an increase of $10,000 in inventory, versus an increase of $15,000 in accounts payable. The business spends $10,000 to acquire new fixed assets during the period. This results in the following cash flow from assets calculation:

+$12,000 = Cash flow generated by operations ($10,000 earnings + $2,000 depreciation)

-$25,000 = Change in working capital (+$15,000 payables - $30,000 receivables - $10,000 inventory)

-$10,000 = Fixed assets (-$10,000 fixed asset purchases)

-$23,000 = Cash flow from assets

This measurement does not account for any financing sources, such as the use of debt or stock sales to offset any negative cash flow from assets.

2.CASH FLOWS IDENTITY

The cash flow identity states that the cash flow on the left-hand side of the balance sheet (the cash generated by the company) is equal to the cash flow on the right-hand side of the balance sheet (the cash flow given to the lenders and owners of the company).   

CASH FLOW FROM ASSETS = CASH FLOW TO CREDITORS+ CASH FLOW TO OWNERS              

3.CHANGE IN NWC

Change in the net working capital is the change in net working capital of the company from the one accounting period when compared with the other accounting period which is calculated to make sure that the sufficient working capital is maintained by the company in every accounting period so that there should not be any shortage of funds or the funds should not lie idle in future.

hanges in Net Working Capital = Working Capital (Current Year) – Working Capital (Previous Year)

Or

Change in a Net Working Capital = Change in Current Assets – Change in Current Liabilities.

EXAMPLE

Let us calculate the Working Capital for Colgate.

Working Capital (2016)

• Current Assets (2016) = 4,338
• Current Liabilities (2016) = 3,305
• Working Capital (2016) = 4,338 – 3,305 = $ 1,033 million

Working Capital (2015)

• Current Assets (2015) = 4,384
• Current Liabilities (2015) = 3,534
• Working Capital (2015) = 4,384 – 3,534 = $850 million

Net change in Working Capital = 1033 – 850 = $183 million (cash outflow)

4.FINANCIAL LEVERAGE

Financial leverage which is also known as leverage or trading on equity, refers to the use of debt to acquire additional assets.

The use of financial leverage to control a greater amount of assets (by borrowing money) will cause the returns on the owner's cash investment to be amplified. That is, with financial leverage:

• an increase in the value of the assets will result in a larger gain on the owner's cash, when the loan interest rate is less than the rate of increase in the asset's value
• a decrease in the value of the assets will result in a larger loss on the owner's cash

Examples of Financial Leverage

Mary uses $500,000 of her cash to purchase 40 acres of land with a total cost of $500,000. Mary is not using financial leverage.

Sue uses $500,000 of her cash and borrows $1,000,000 to purchase 120 acres of land having a total cost of $1,500,000. Sue is using financial leverage to own/control $1,500,000 of property with only $500,000 of her own money. Let's also assume that the interest on Sue's loan is $50,000 per year and it is paid at the beginning of each year.

NOTE - CASH FLOW FROM ASSETS EXAMPLE WILL BE SAME AS CASH FLOW IDENTITY