cash flow

The amount of net cash generated by an investment or a business during a specific period. One measure of cash flow is earnings before interest, taxes, depreciation, and amortization. Because cash is the fuel that drives a business, many analysts consider cash flow to be a company's most important financial statistic. Firms with big cash flows are frequently takeover targets because acquiring firms know that the cash can be used to help pay off the costs of the acquisitions.

or
Cash that comes into or goes out of a person's or company's account. Cash flow can come from any number of sources and is crucial for a business' continued operation and a person's continued survival. Cash inflow may come from wages, salary, sales, loans, revenue from operations, or even personal gifts. Cash outflow usually comes from expenses and investments. It is crucially important to maintain a positive net cash flow insofar as possible.

Cash Flow from Operating Activities Measures the cash generated from the core business or operations of the business. The calculation is operating income before depreciation minus taxes and adjusted for changes in working capital. Operating Cash Flow (OCF) = Operating Income (revenue cost of sales) + Depreciation Taxes +/- Change in Working Capital Cash Flow from Investing Activities Measures the cash flow of an entitys investing activities, including items such as capital expenditures, acquisitions, or investments in other securities such as government bonds. Cash Flow from Financing Activities Measures the cash flow from financing activities, including issuing or buying back stock, issuing or repurchasing debt, and paying dividends to shareholders. Note: These 3 cash flows are segregated and detailed in the Statement of Cash Flow. The sum of the three makes up the Total Cash Flow for the entity. Total Cash Flow Cash Flow of the entity is the sum of the Cash Flow from all activities including operating, investing, and financing activities. The Cash Flow of a period of time will equal the difference between the entitys cash balance at the beginning and ending of the time period. Net Cash Flow Net Cash Flow is the profits (or loss) of the entity plus non-cash expenses (i.e. depreciation and amortization). Net cash flow includes the financing and investing activities that are included on the income statement, but excludes financing and investing activities affecting the balance sheet.

Free Cash Flow Free Cash Flow is operating cash flow less capital expenditures. It is the cash available to debt and equity holders after the expenses and taxes are paid and capital expenditures have been deducted. Net Free Cash Flow Net Free Cash Flow is Free Cash Flow less the current portion (amount to be paid over the next year) of capital expenditures, long term debt, and dividends). Cash Flow is one of the most important investment concepts to understand. Each one of the different cash flow metrics gives pertinent insight into the health of an entity. Learn the types of cash flow for investment analysis and you will be greatly improving your ability to analyze investment opportunities.

Definition of 'Time Value of Money - TVM'

The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value".

Investopedia explains 'Net Present Value - NPV'

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.

IRR:
The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. In more specific terms, the IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. Discounted cash flow (DCF) calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's DCF, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest DCF would be considered the best and undertaken first. A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.

Uses
Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is economically profitable). [edit]Calculation Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return. Given the (period, cash flow) pairs ( , periods , and the net present value ) where is a positive integer, the total number of , the internal rate of return is given by in:

The period is usually given in years, but the calculation may be made simpler if is calculated using the period in which the majority of the problem is defined (e.g., using months if most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter.

Any fixed time can be used in place of the present (e.g., the end of one interval of an annuity); the value obtained is zero if and only if the NPV is zero. In the case that the cash flows are random variables, such as in the case of a life annuity, the expected values are put into the above formula. Often, the value of cannot be found analytically. In this case, numerical methods or graphical methods must be used. [edit]Example If an investment may be given by the sequence of cash flows Year ( 0 1 2 3 4 ) Cash flow ( -4000 1200 1410 1875 1050 )

then the IRR

is given by

In this case, the answer is 14.3%. [edit]Numerical solution Since the above is a manifestation of the general problem of finding the roots of the equation , there are many numerical methods that can be used to estimate example, using the secant method, is given by . For

where This

is considered the

th

approximation of the IRR.

can be found to an arbitrary degree of accuracy.

The convergence behaviour of the sequence is governed by the following: If the function reproducibly towards has a single real root . , then the sequence will converge

If the function has real roots , then the sequence will converge to one of the roots and changing the values of the initial pairs may change the root to which it converges. If function has no real roots, then the sequence will tend towards +. or . when may speed up

Having when convergence of to

[edit]Numerical solution for single outflow and multiple inflows Of particular interest is the case where the stream of payments consists of a single outflow, followed by multiple inflows occurring at equal periods. In the above notation, this corresponds to:

In this case the NPV of the payment stream is a convex, strictly decreasing function of interest rate. There is always a single unique solution for IRR. Given two estimates and for IRR, the secant method equation (see above) with will always produce an improved estimate . This is sometimes referred to as the Hit and Trial (or Trial and Error) method. More accurate interpolation formulas can also be obtained: for instance the secant formula with correction

, (which is most accurate when ) has been shown to be almost 10 times more accurate than the secant formula for a wide range of interest rates and initial guesses. For example, using the stream of payments {4000, 1200, 1410, 1875, 1050} and initial guesses and the secant formula with correction gives an IRR estimate of 14.2% (0.7% error) as compared to IRR = 13.2% (7% error) from the secant method. Other improved [2] formulas may be found in

If applied iteratively, either the secant method or the improved formula will always converge to the correct solution. Both the secant method and the improved formula rely on initial guesses for IRR. The following initial guesses may be used:

where

[edit]Decision

criterion

If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

Internal Rate of Return Definition IRR. The rate of return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity. The internal rate of return is an important calculation used frequently to determine if a given investment is worthwhile. An investment is generally considered worthwhile if the internal rate of return is greater than the return of an average similar investment opportunity, or if it is greater than the cost of capital of the opportunity. also called dollar-weighted rate of return.