Corporate Finance Theory and Practice, Third Edition

Chapter 5

WALKING THROUGH FROM EARNINGS TO CASH FLOW

Or how to move mountains together!

Chapter 2 showed the structure of the cash flow statement, which brings together all the receipts and payments recorded during a given period and determines the change in net debt position.

Chapter 3 covered the structure of the income statement, which summarises all the revenues and charges during a period.

It may appear that these two radically different approaches have nothing in common. But common sense tells us that a rich woman will sooner or later have cash in her pocket, while a poor woman is likely to be strapped for cash – unless she should make her fortune along the way.

Although the complex workings of a business lead to differences between profits and cash, they converge at some point or another.

The aim of this chapter is to reconcile the cash flow and earnings approaches.

First of all, we will examine revenues and costs from a cash flow standpoint. Based on this analysis, we will establish a link between changes in wealth (earnings) and the change in net debt that bridges the two approaches.

We recommend that readers get to grips with this chapter, because understanding the transition from earnings to the change in net debt represents a key step in comprehending the financial workings of a business.

Section 5.1

ANALYSIS OF EARNINGS FROM A CASH FLOW PERSPECTIVE

This section is included merely for explanatory and conceptual purposes. Even so, it is vital to understand the basic ...