Cash flows or accounting flows?
When assessing a particular business investment opportunity, should the business
identify and discount cash payments and receipts or should it discount profits arising
from the project? This is an important question, as it seems that many businesses use
projections of accounting figures as the starting point for an investment appraisal. As
we saw in Chapter 4, cash flows from a particular project, in a particular time period,
will rarely equal the accounting profit for the project during the same period.
If we go back to the principles on which the concept of NPV is based, we see that
discounting takes account of the opportunity cost of making the investment. It is not
until cash needs to be expended in the project that the opportunity for it to produce
income from some other source will be lost. Only when cash flows back from the project can the business use it to pay dividends, repay borrowings, lend it or reinvest it in
another project.
Over the life of a project the accounting profits will equal the net cash flows
(undiscounted) in total; it is the timing that will be different. Why should this be
the case?
The roles of financial accounting and investment appraisal
Financial accounting, as we saw in Chapter 3, sets out to assess profit (increase in
wealth) for a period, perhaps a year. In doing so it needs to treat each period as a selfcontained unit. This is despite the fact that most of the business’s investment projects
will not be self-contained within that same period. Non-current assets (for example, an
item of machinery), perhaps acquired in a previous period, may be used in the period
and continue to be owned and used in future periods. Inventories (stock in trade)
acquired in a previous period may be sold in the current one. Sales made (on credit)
in the current period may be paid for by customers in the following period. Financial
accounting tends to ignore the timing of payments and receipts of cash and concentrates on wealth generated and extinguished during the period. Costs, less anticipated
disposal proceeds, of certain non-current assets are spread in some equitable way
(depreciated) over their lives so that each period gets a share of the cost, irrespective
of whether or not any cash is actually paid out to suppliers of non-current assets in the
particular accounting period under consideration. Sales revenues are usually recognised and credit taken for them by the selling business when the goods change hands
or the service is rendered even though the cash receipt may lag some weeks behind.
The reduction in wealth suffered by using up inventories in making sales is recognised
when the sale is made – and not when the inventories are purchased or when they are
paid for.
The problem of financial accounting is to try to make an assessment of the amount of wealth
generated by all of the business’s projects during a particular period when not all of each
project’s cash flows are self-contained within that period.
Converting accounting flows to cash flows
When using the NPV approach it is projected cash flows, not accounting profits, that
should be discounted; yet frequently when projects are being assessed in advance of
possible implementation they are expressed in terms of anticipated profit, so we need
to convert such information to cash flows.
There are two areas where accounting profit needs to be adjusted: working capital; and depreciation.
As regards the operating items, that is, those items concerned with sales revenue
and material, labour and overhead costs, the adjustment to convert accounting flows
to cash flows can be done by taking account of the working capital requirement of the
project.
Investment appraisal has a somewhat different objective from that of financial
accounting, however. This is to assess a project over its entire life, not to assess it for a
particular portion of that life. This difference of purpose is represented graphically in
Figure 5.1. This shows a business with six investment projects (A to F), each of which
starts and ends at a different time. Financial accounting seeks to assess the profit for a
period such as p. During this period one project (Project E) ends, one (Project B) starts,
while the other four run throughout period p. Investment appraisal seeks to assess
whether any particular project is a viable one, before it starts. Profit measurement
tends to be cross-sectional, investment appraisal longitudinal.