What's the difference between Accounting Profit (PAT) & Cash Flow from Operations?

PAT= Operating Income – Operating Expenditure+ Net Operating Income- Net Operating Expenditure

PAT-NOI-NOE= Operating Cash flows

Cash Flow from Operations is divided in two parts

1. Cash Outflow= Capital Exp.

2. Cash Inflow

Important Components of Calculating Op. Cash Flow

 Sales Forecast- Marketing

 Operating Exp.- Purchasing, HR
 Cap Ex.- Production

Financing and Investing activities need to be synchronized- If the financing and investing decisions they
need to be taken timely so that both are considered. Under financing decision the following are things
sources of funds, cost of capital, WACC whereas under investing for every project, it’s expected rate of
return (IRR) is calculated.

Implication if financing and investing is not synchronized: Shortage of Funds, Idle Use/No Liquidity

How to Calculate Op. C.F?

1. Calculate Revenue- Sales forecasting

2. Calculate Operating Exp.
3. Calculating Inflow

Note: Time: Useful life of an asset. For example, for a manufacturing we consider the useful life of plant
similarly we consider the useful life of a product the product

Principles of CF estimation:

 Separation Principle: Financing is a different decision compared to investing. EBIT(1-T). Under

investing decision, we will not consider financing cost, but under financing we would consider
financing cost. EBIT(1-T) = (EBT + I) (1-T) = EBT(1-T) + I(1-T) = PAT+ I(1-T) using this formula
we will calculate cashflows and discount it by the rate. We use this principle when the competition
is high or it is a new entrant or for conservative companies.
 Pecking Order Theory: Cost of financing increases with asymmetric information. Financing comes
from three sources, internal funds, debt and new equity. Companies prioritize their sources of
financing, first preferring internal financing, and then debt, lastly raising equity as a "last resort".
Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no
longer sensible to issue any more debt, equity is issued. This theory maintains that businesses
adhere to a hierarchy of financing sources and prefer internal financing when available, and debt
is preferred over equity if external financing is required (equity would mean issuing shares which
meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can
act as a signal of its need for external finance. More applicable to manufacturing companies. Note
Separation Theory and Pecking Order Theory are both aligned.
 Incremental Principle: Project Cashflow= Cashflow for the firm with the project- Cashflow for the
firm without the project. This theorem provides for considering the opportunity cost for carrying out
the project. Important points under this principle:
i. Product Cannibalization* Read this.
 ii. Ignore Sunk Cost- It’s a one-time cost and a part of the preliminary expenditure. There
maybe over absorbed fixed cost hence we need to ignore sunk cost.
iii. Include Opportunity Cost- Opportunity cost can be adjusted in either cashflows (revenues
gained over the lost) or on the WACC (discounting rate); if we adjust with cashflows- it’s a
absolute adjustment that could lower the cashflows whereas WACC would be adjusted
easily because: .Therefore it is better to adjust to WACC.
iv. Allocation of Overhead Cost-
v. Estimate WC properly
 Post -Tax Principle: Assumptions:
i. CF should be post-tax basis
ii. Discounting Rates should be post-tax basis
iii. We should take marginal tax rate
iv. Treatment of Losses
 When the project is incurring loss and the firm is also incurring loss we should
take deferred tax scenario.
 When the project t is incurring loss and the firm is incurring profit, the action
should be to take tax savings in the year of loss
 When the project make profit but the firm incurs loss, the action should be to
defer taxes until the firm makes profit.
 When the project makes profit and firm also makes profit, the action should be
consider taxes in the year of profit.
 When it is a stand-alone project, then defer tax savings until the project makes
profit
 Consistency Principle: CF and discount rate must be consistent w.r.t investor. Therefore, CF for
all investors= PBIT (1-T) + Depreciation- Cap Ex. – Change in Working Capital, and for equity
shareholders= PAT+ depreciation- Dividend on preference capital- Cap. Ex- Change in W.C.-
Repayment of debt + Proceed from Debt Issue- Redemption of Preference+ Proceeds from
preference. D= Ke