Question

Consider you have prepared Pro-forma income statements of a new venture that show a net income of PKR 50,000, PKR 100,000, and PKR 150,000 for the first three years of starting the business. You are excited to see a positive cash inflow of PKR 300,000 for the first three years. However, your classmate with business majors in finance has highlighted that you may not have PKR 300,000 in cash, although your Pro-forma income statements show that you will earn that much amount of money.

Answer 1

Net income of PFR 50,000, PKR 100000 and PKR 150000 for first three years of starting the business if added in the absolute sense gives a positive cash inflow of PKR 300000.

However there are two aspects to this when we compare to real business; one is an income statement does not reflect cash as it is a statement of revenue and expenses both of which may or may have not been realized in cash/expensed in cash or only been done partially. For example our revenues are accrued in a business with credit terms and the expenses booked are also accrued and we have credit terms with vendors. Hence income statement is an indication of the net income we have in our books as per accounts. For actual cash inflow, we have to check and prepare our cashflow statement.

This cashflow statement is a combination of several aspects such as cashflow from operating activities in the business, cashflow from investing activities in the business (related to investing in plant, property, etc) and cash flow from financing activities (repaying or borrowing loan, etc). This cashflow can be prepared once we also understand how the Balance sheet of our company looks like in conjunction with our income statement. That will be correct indication of cash in hand after 3 years

Additionally another point to be noted is even if we assume that our pro-forma income statement is reflective of our cashflow and whatever revenues and expenses in the income statement are all realized in cash in that particular year with no other financing or investing activity undertaken, we are still ignoring the time value of money while adding the net income of the three years. There has to be adequate discounting rate considered while adding the three incomes since value of money today is higher than value of money tomorrow due to the interest you earn on today's money. Hence 100000 income in year 2 will be worth less today depending on the discount factor we consider. So the cash in hand will be much lesser than 300000