Cash-Flows Vs Accounting Profit
Capital budgeting is concerned with investment decisions which yield return over a period of time in future. The foremost requirement for evaluation of any capital investment proposal is to estimate the future benefits accruing from the investment proposal. Theoretically two alternative criteria are available to quantify the benefits (i) accounting profit and (ii) cash flows. The bask difference between them is primarily due to the inclusion of certain non-cash expenses in the profit and loss account, for instance; depreciation. Therefore, the accounting profit is to be adjusted for non-cash expenditures to determine the actual cash inflow. The cash flow. approach of measuring future benefits of a project is superior to the accounting approach as cash flows are theoretically better measures of the net economic benefits of costs associated with a proposed project.
In the first place, while considering an investment proposal, a firm is interested in estimating Its economic value. This economic value is determined by the economic outflows (costs) and inflows (benefits) related with the investment project, Only cash flows represent the cash transactions. The firm must pay for the purchase of an asset with cash, This cash outlay represents a foregone opportunity to use cash in some other productive alternatives. Consequently, the firm should measure the future net benefits in cash terms. On the other hand, under the accounting practices the cost of the investment” is allocated over its economic useful life in the nature of depreciation rather than at the time when Cost are actually incurred. The accounting treatment clearly does not reflect the original need for cash at the time of inflows and outflows in later years. Only cash flows reflect the actual cash transactions associated with the project, Since ‘investment analysis is concerned with finding out whether future economic inflows arc sufficiently large to warrant the innit investment only the cash flow method is appropriate for investment decision analysis?
Secondly, the use of cash flows avoids accounting ambiguities. There are various ways to value inventory., allocate costs, calculate depreciation and mortise various other expenses. Obviously different net incomes will be arrived at under different accounting procedures. But there is only one set of cash flows associated with the project. Clearly, the cash flow approach to project evaluation is better than tile net income low approach (accounting approach).
Thirdly, the cash flow approach takes cognizance of the time value of money whereas the accounting approach ignores it. Under the usual accounting practice revenue is recognized as being generated when the product is sold, not when the cash is collected from the.sale, revenue
may remain a paper figure for months or years before payment of he invoice is received. Expenditure too is recognized as being made when incurred and not when the actual payment is made. Depreciation is deducted from the gross revenues to determine the before-tax earnings. Such a procedure ignores the increased flow of funds potentially available for other uses. In other words, accounting profits which are quite useful as performance measures often are less useful as decision criteria. Therefore from the viewpoint of capital expenditure management the cash. low approach can be said to be the basis of estimating future benefits from investment proposals. The data required for the purpose would be cash revenues and cash expenses. The difference between the cash flow approach and the accounting profit approach is depicted in Table 10.1.