By analyzing the profitability of a company, Is it better to use cash flows or accounting profits?As in any economic decision, there is a trade-off or a decision to make between two alternatives, which necessarily implies a cost somewhere. Either thoroughness is sacrificed and a more appropriate calculation in terms of post-greater speed and simplicity for decision-making, or it is decided to spend more resources in terms of time and money in making a more detailed analysis to find a better analysis basis to make a more right decision.
Earnings by action
There is the belief that an increase in gains per share will increase the share price, even if the biggest gains do not represent any underlying economic change. But the market is more prepared than one believes and is not fooled by the oldest method of analysis based on gains by action. As I mentioned above, the gains by action arise from a simple calculation that responds well to many business questions.But the advantage of relying on simplicity can often become a mistake, since gains by action are based on accounting rules that are likely to be manipulated and can lead business executives to make decisions that destroy long-term value.Increasingly the price of a short-term action is evicted and tries to reconsider the fallacy of the gains by action as the main driver. Only the cash flow generated by the business can be used to increase consumption or investment.The only case where the comparison is valid is given when the profit is a good proxy of the cash flow, i.e. when generating a cash flow similar to the profits.But in practice, most companies do not generate the same cash flow for every dollar of profits. If investors are concerned about the health of the company in the long term, the price of the action would systematically reflect the trend of cash flows.And the funds flow discount method (discounted cash-flow, or DCF) is the technique to use to make investment decisions, and less and less the gains per action, as it makes use of all the elements that affect the value of a long-term company.In its most extreme form, the accounting approach tells us that only the gains of this year or the next. A more complex way deducts the future flow of earnings at a given rate. On the other hand, in the DCF approach, the value of a company is the future flow of funds discounted at a rate that reflects the risk of this flow of funds.The DCF contemplates this difference of value as it incorporates the analysis of capital expenditure and other expenses necessary to generate profits. The analysis through the DCF is based on the idea that an investment adds value is generated a return on investment higher than the return that can be gained in similar risk investments. It is very common to use by companies to evaluate a capital investment project. The DCF applies this concept to all business of a company, which are no more than the sum of individual projects.The accounting approach is still used because it works well in some cases: when the gains reflect the cash flow, the accounting approach provides a reasonable proxy of the DCF.It is important to mention that the inflation rate should be incorporated into the nominal cash flows and discount rates when conducting the analysis of a company and its effects on value depend, in part, on whether it is expected or unexpected (not anticipated).The exchange rate is another of the very important aspects to take into account. This is no longer difficult for a domestic service company and without assets or liabilities in foreign currency, since the only thing to do to pass the flow of local currency funds to dollars is to divide it by the estimated exchange rate for that period. An average exchange rate of the period is usually taken. However, since there are companies indebted in foreign currency, it should be corrected by imputing to financial results a loss if the domestic currency is devalued and vice versa for foreign currency assets.How to get to the flow of funds from the state of results
Although there are several ways to do so, the net result (or net profit, or net income) is determined as follows:Sales/interests (revenues)
- Cost of sold goods
- Amortizations and depreciations
== sync, corrected by elderman == Gross value
- Administrative expenditure
- Commercial expenditure
== sync, corrected by elderman == Operating result (or earnings before interest and taxes, EBIT)
+/- financial results (liquid interests, exposure to inflation and outcomes per year)
== sync, corrected by elderman == Gains before taxes (EBT)
- Taxes on profits and assets
= Benefit/result/organisation/net income
As depreciations and depreciations do not represent an effective cash erogation, but an accounting convention to reflect the loss of value of the use goods, intangible assets and activated structure expenses, the EBITDA is built by adding these headings to the operational result:== sync, corrected by elderman == Operating result (EBIT)
+ refunds and depreciations
== sync, corrected by elderman == Gains before interest, taxes, depreciations and amortizations (EBITDA)
EBITDA, acronyms of Earnings Before Interests, Taxes, Depreciation and Amortization, is a widely used measure to evaluate the company's performance as it is a measure of what generates the business of the company itself measured through a proxy of the cash generation.It also allows a better comparison of companies by debugging the effect of different tax systems and depreciation and accounting depreciation and amortization of countries, as well as of financial leverage between companies, since it is about observing the gains before interest, taxes, depreciations and amortizations.Now, starting from the profit/result- /genence/net energy, which is a given “countable” and non-financial, one can reach the flow of effective funds from the stock capital, i.e. to the shareholders (FCFE):== sync, corrected by elderman == Result/genesis/liquid pain
+ Depreciation
== sync, corrected by elderman == Flow of operations funds
- Favorite Dividends
- Expenditure on capital goods (capital expenditures or CAPEX)
- Labour capital needs
- Repayments of the debt capital (A)
+ New emissions yield
debt (B)
= Flow of equity capital (FCFE)
The flow of funds from the previous example corresponds to a company funded with stock capital and debt. In case of being financed only with stock capital, they disappear (A) and (B).In general, FCFE can be both positive and negative, depending on the type of industry and the phase of the cycle in which the company is located. If the company has important capital investments to make, the flow will be negative in the first years to then increase the flow of funds based on the expected maturity of these projects.Two companies with equal funds flows for the shareholder can have different prices according to the debt level. It is not the same as the company paying dividends with the profits of the business or by hiring new debt. In the latter case, the discount rate or cost of the capital will be higher, because the risk is; that is, although the funds flows are equal, the current value will differ.In summary, accounting gains are useful to evaluate when earnings are a good proxy of the company's long-term expected cash flow. But in most cases, it is not, and it is convenient to adopt the cash flow criterion.
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