Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success (#4 in series)
Q: So traditional “cash flow” does not take into account Interest expense but EBITDA does?
A: Traditional "cash flow" removes non-cash charges – depreciation expense and amortization expense – from the income statement, so the result is net income increased by the amount of non-cash expenses, i.e., net income plus depreciation and amortization. Traditional "cash flow" does include interest expense.
If traditional "cash flow" is positive, it suggests that the company generated at least enough "cash flow" to pay its interest expense. The amount of positive "cash flow" is then measured against scheduled long-term debt repayment to see if the company's "cash flow" was sufficient to meet this component of debt service. If the result is positive "cash flow" after paying down long-term debt as scheduled, the company has, presumably, met its interest-bearing debt service from its "cash flow".
EBITDA, on the other hand, does not include depreciation expenses, amortization expense or interest expense, and also excludes other income and other expenses.
Traditional "cash flow" differs from EBITDA in that traditional "cash flow" includes interest expense, other income, and other expenses.
Q: It’s necessary to read Poll Question 4 carefully, right?
A: Poll Question 4 is as follows:
The difference between traditional “cash flow” of $221,628 and negative Business Cash Income of $163,945 in 2018 is explained completely by movements in balance sheet accounts.
The difference between traditional “cash flow” of $221,628 and negative Business Cash Income of $163,945 in 2018 is indeed explained completely by movements in balance sheet accounts. The steps to get from traditional “cash flow” to Business Cash Income are listed below:
- We start with net income plus depreciation from the income statement, the old traditional definition of “cash flow”, of $221,628.
- And then we adjust for distributions, which comes out of net worth. The $252,616 is a reduction in net worth, a balance sheet account.
- The $67,254 change in due from loans to shareholders is money out the door to Larry Crevin, an increase in an asset account
And then we account for all of the changes in these operating balance sheet accounts.
- Accounts Receivable
- Accounts / Notes Receivable – Other
- Prepaid Expenses
- Accounts Payable
- Operating Deposits
- Accrued Liabilities
After adjusting the amount of net income plus depreciation of $221,628 for all these changes in balance sheet accounts, we get Business Cash Income of negative $163,945. And so the answer is
Changes in the accounts on the Cash Flow Snapshot from distributions through accrued liabilities account for a collective cash outflow of $385,573. The collective change in these balance sheet accounts turns a positive traditional “cash flow” of $221,628 into a negative Business Cash Income of $163,945. $221,628 – $385,573 = ($163,945)
The intent of the question is to draw attention to the importance of using the changes in balance sheet accounts in constructing a cash flow statement. These changes can have a significant impact on a company's actual operating cash flow, as the difference between traditional "cash flow" and Business Cash Income for Total Coverage, Inc. illustrates.
To get a true cash flow number, we cannot use income statement information alone. We need to incorporate the changes in balance sheet accounts.
Course overview: Non-Financial Red Flags, Cash Flow and Second Necessary Condition for Business Success