IESE Research Papers,
IESE Business School

Abstract: A company's profit after tax (or net income) is quite an arbitrary figure, obtained after assuming certain accounting hypotheses regarding expenses and revenues. On the other hand, its cash flow is an objective measure, a single figure that is not subject to any personal criterion. In general, to study a company's situation, it is more useful to operate with the cash flow (equity cash flow, free cash flow or capital cash flow) as it is a single figure, while the net income is one of several that can be obtained, depending on the criteria applied. Profit after tax (PAT) is equal to the equity cash flow when the company is not growing, buys fixed assets for an amount identical to depreciation, keeps debt constant, and only writes off or sells fully depreciated assets. Profit after tax (PAT) is also equal to the equity cash flow when the company collects in cash, pays in cash, holds no stock (this company's working capital requirements are zero), and buys fixed assets for an amount identical to depreciation. When making projections, the dividends and other forecast payments to shareholders must be exactly equal to expected equity cash flows.

Keywords: Cash flow; Net income; Equity cash flow; Free cash flow; Capital cash flow

17 pages, May 17, 2006

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