Reflection: From Cash Flow to Business Thinking

📌 What I’ve Learned

• In both business and investing, cash flow matters more than earnings. Earnings can be delayed or adjusted, but cash flow shows the real financial health.

• I experienced this in my freelance work: even after selling services on Rednote, I didn’t receive the money right away due to a required deposit. So while it looked like I had sales, the cash hadn’t reached me — it wasn’t real income yet.

This made me ask a bigger question: How do businesses generate sustainable cash flow? I’m starting to realize this is the heart of every solid business model.

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💡 Small Actions in Personal Life

1. Increase income
   Through jobs, freelance work, or creative side projects.

2. Cut unnecessary expenses
   I track my spending. If I don’t need it now, I don’t buy it. That’s the key!!🤫😹

3. Start investing
   Begin with safer options like index funds, bonds, or retirement accounts, while learning how each works.

4. Invest in myself
   The best investment is personal growth — learning business, finance, coding, data science, and health. I stay curious across fields.😉

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🧠 Thinking Like an Owner, Every Day

• When I visit a buffet, I ask: How is it designed to attract customers? How do they manage such a wide menu? How do they train and schedule staff? What systems help them operate efficiently?

• When I watch YouTubers or influencers, I wonder: How do they come up with content ideas? What’s their brand voice or visual style? Are they focused on one topic? Do they sell products or earn through other channels? How do they monetize?

I’ve started seeing the world through the lens of business models — how people create value, build systems, and turn ideas into income.

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Explanation

01 Cash Flows versus Earnings

🧾 1. Accrual Accounting vs. Cash Flow

• Accrual accounting records revenues and expenses when they are earned or incurred, not when cash is actually received or paid.

• This can distort timing:

  • A company might record revenue today even if the customer will pay in 90 days.

  • Similarly, expenses like rent or supplier payments might be recorded even if the cash hasn’t gone out yet.

📌 Impact: You can have high earnings but negative cash flow (or vice versa) because earnings are not directly tied to when cash moves.

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🧮 2. Expense Classification in Accounting

• Accounting divides expenses into three buckets:

  1. Operating expenses: day-to-day costs (salaries, rent, etc.)

  2. Financing expenses: interest payments on debt

  3. Capital expenses: buying assets like equipment or buildings

How they’re treated:

• Operating + Financing: Fully deducted in the income statement immediately.

• Capital expenses: Not fully deducted right away. Instead, they are:

  • Capitalized: recorded as an asset

  • Then depreciated/amortized: gradually expensed over time.

📌 Impact: A company that spends a lot on new equipment might still show high earnings (because depreciation is small), but its cash flow could be low because the actual cash went out immediately.

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🎯 Bottom Line

Accounting earnings ≠ cash flow.

• Earnings give a smoothed view over time (great for GAAP reporting).

• But for valuation or liquidity analysis, cash flow is king — especially Free Cash Flow to the Firm (FCFF).

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02 What is depreciation

Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life.

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🛠 Imagine this:

You buy a machine for your business for $10,000\ast \ast ,anditwillbeusefulfor\ast \ast 5years\ast \ast .Insteadofrecordinga\ast \ast$10,000 expense all at once, you spread the cost over 5 years — say $2,000 per year.

That $2,000/year is called depreciation.

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🔍 Why is depreciation used?

1. Matching principle (in accrual accounting):
   It aligns the cost of an asset with the revenue it helps generate over time.

2. Smooths out expenses:
   Large capital expenses are not deducted all at once, which helps prevent big swings in reported profits.

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📊 How does it affect financial statements?

Statement	Impact of Depreciation
Income Statement	Shown as an expense, reducing net income.
Cash Flow Statement	Added back in the operating cash flows section because it’s a non-cash expense.
Balance Sheet	Reduces the book value of the asset over time.

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🧾 Common Methods of Depreciation

1. Straight-Line (most common):
   Equal expense each year.

2. Declining Balance:
   More depreciation in early years.

3. Units of Production:
   Based on usage or output.

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💡 Key Point for Investors:

• Depreciation affects accounting earnings but not cash flow.

• Understanding it is essential when moving from net income to free cash flow, which is core to valuation models like DCF.

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03 Three adjustments that convert accounting earnings (net income) into actual cash flows

Let’s break down the three adjustments that convert accounting earnings (net income) into actual cash flows, usually Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE).

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✅ Step 1: Add Back Non-Cash Expenses

• Most common: Depreciation and Amortization

• These reduce earnings (on paper), but no cash actually left the company in that period.

Example:
If net income = $100,depreciation=$20 → you add back $20, because it’s a paper expense.

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✅ Step 2: Subtract Capital Expenditures (CapEx)

• These are actual cash outflows used to buy long-term assets (equipment, buildings, etc.)

• CapEx isn’t shown as an expense in the income statement, but it does reduce real cash.

Example:
If you spent $30onnewmachinerythisyear\to \ast \ast subtract$30** from cash flows.

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✅ Step 3: Subtract Change in Non-Cash Working Capital

• Working capital = current assets – current liabilities

• You only care about non-cash components (like accounts receivable, inventory, and accounts payable)

• A positive change (e.g., more receivables/inventory) means cash is tied up → subtract it

• A negative change (e.g., paying off suppliers slower) means more free cash → add it

Example:
If accounts receivable increased by $15\to \ast \ast subtract$15**, because that cash hasn’t been received yet.

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🔁 Why Cash Flow > Earnings in Analysis

• Earnings can be “manipulated” with aggressive accounting

• Cash flows reveal economic reality

• Value investors (like Buffett or Damodaran) care far more about how much cash a business actually generates

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🏢 Example Company – Year 1 Financials

Let’s say the company has the following values:

Item	Amount ($)
Net Income (Earnings)	120
Depreciation	30
Capital Expenditures (CapEx)	50
Change in Working Capital	+20

• Depreciation is a non-cash expense, so we add it back

• CapEx is a real cash outflow, so we subtract it

• Working capital increased (e.g., more inventory or unpaid receivables), so we subtract it

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💰 Step-by-Step Conversion to Free Cash Flow

1. Start with Net Income:
   → $120

2. Add Back Depreciation (non-cash):
   → $120+$30 = $150

3. Subtract Capital Expenditures (real cash out):
   → $150–$50 = $100

4. Subtract Increase in Working Capital:
   → $100–$20 = $80

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✅ Free Cash Flow = $80

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🧠 Interpretation:

Even though the company reported $120\ast \ast inaccountingprofit(netincome),theactual\ast \ast cashflowavailable\ast \ast afterinvestinginassetsandfundingoperationsisonly\ast \ast$80.

This is what investors care about — how much real cash is left over to pay dividends, reduce debt, or reinvest.

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04 Types of Cash Flows

1. Contractual Cash Flow Claims

These are legally binding payment obligations where:

• The payment amount and timing are defined (though sometimes they vary),

• And the company must pay, regardless of business performance.

These are common with loans and bonds.

2. Residual Cash Flow Claims

A residual cash flow is:

• The leftover cash after a company pays all its contractual obligations, such as:

  • Interest to lenders

  • Repayment of principal

  • Taxes

  • Capital expenditures (e.g., maintaining or expanding assets)

In other words:

Revenue – Operating Costs – Taxes – Interest – Debt Repayments – CapEx = Residual Cash Flow to Equity

🧾 Who Gets This Residual? 👉 Equity holders (i.e., shareholders)

They have a residual claim, meaning:

• They only get paid if there’s anything left

• But they also get all the upside after other claims are met

3. Contingent Cash Flow Claims?

These are cash flows that:

• Only occur if a certain event happens

• They’re not guaranteed, even under a contract

• The cash flow is contingent (dependent) on future outcomes

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📌 Example Situations:

• A biotech firm only receives cash if its new drug passes FDA approval.

• A tech startup will generate cash flows only if user growth hits a certain threshold.

• A natural resource company only earns profits if commodity prices exceed a certain level.

🔑 What is Option Pricing About?

Option pricing is a way to put a dollar value on uncertainty + potential.

It asks:

“How much is it worth to have the right — but not the obligation — to do something valuable in the future, if things go well?”

🏗️ In Business Valuation: Real Options

Some business investments behave like options:

Example: A Biotech Company

• Spends $10M today on R&D (the “price” of the option)

• If drug is approved → It earns $500M over 10 years

• If not → It earns nothing

This is a contingent cash flow — uncertain but highly asymmetric

• Small downside (fixed loss)

• Huge upside (drug approval)

🔑 So instead of doing a basic DCF (which would say: “It’s worthless if there’s no guaranteed cash”), we use option pricing models to value:

What is the current value of this future potential, adjusting for uncertainty?

🧾 Question Recap:

Which of the following is not a non-cash expense?

To convert accounting earnings to cash flows, we add back non-cash expenses — these are items that reduce accounting profit but don’t involve actual cash leaving the company.

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🔍 Let’s break down each option:

a. Amortization of goodwill

This is a non-cash accounting charge applied to intangible assets like goodwill over time.
✔ It’s recorded as an expense but no money is spent when it happens.

b. Depreciation of plant and equipment

This spreads the cost of physical assets (like machinery) over several years.
✔ It’s non-cash — the cash went out when the asset was purchased, not during depreciation.

c. Accounting write-off on a past investment

A company might write down the value of an investment (e.g. it failed or lost value), reducing profit.
✔ It’s non-cash because no money leaves the company at the time of the write-off — it’s just an accounting adjustment.

e. Increase in provision for bad debts

This means the company expects some customers won’t pay — so it records an expense now.
✔ It’s non-cash — it’s an estimate, not actual cash leaving.

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❗️ d. A one-time charge to cover a lawsuit settlement

This is different.

• A lawsuit settlement typically involves actual cash outflow — the company has to pay money to another party.

• Even if the expense is labeled as “one-time” or “exceptional,” it still reflects a real use of cash, not just an accounting adjustment.

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✅ Final Answer: d. A one-time charge to cover a lawsuit settlement

Because it represents real cash leaving the business, unlike the others which are paper-only (non-cash) expenses.

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🧾 Question Recap:

Which of the following is not a capital expense (CapEx) for a non-financial service firm, in terms of cash flow?

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🧠 What is Capital Expense (CapEx)?

Capital expenses are long-term investments made by a company to acquire or improve assets that will help generate revenue over time — like buildings, machines, patents, or renovations.

These expenses reduce free cash flow, and are usually found in the “investing activities” section of the cash flow statement.

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🔍 Option-by-option breakdown:

✅ b. Investment in new plant and equipment

• Classic example of CapEx: buying physical assets used in operations.

• Used to expand or improve production capacity.

✅ c. Cash acquisition of another company

• While technically an investment, it’s treated as strategic CapEx because it expands operations or capabilities.

✅ d. Acquisition of a patent (for commercial use)

• Buying intellectual property is CapEx — the company is acquiring a long-term intangible asset to use in its business.

✅ e. Capital renovation of existing assembly lines

• Upgrading existing assets is CapEx — it extends the useful life or increases efficiency.

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❌ a. Investment in marketable securities (like T-bills, commercial paper)

• These are short-term financial investments, not operational or productive assets.

• For a non-financial firm, these are classified as financial asset allocations, not CapEx.

• They don’t improve the company’s ability to produce goods or services.

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✅ Correct Answer: a. Investment in marketable securities

Because it’s a financial decision, not an investment in the firm’s productive capabilities — and thus not a capital expense for cash flow purposes.

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📊 Working Capital Items & Their Effect on Cash Flow:

a. Increase in inventory
→ Cash flow decreases
You’ve spent cash to buy more inventory that hasn’t been sold yet.

b. Increase in accounts payable
→ Cash flow increases
You’re delaying payments to suppliers, so you’re keeping more cash.

c. Increase in accounts receivable
→ Cash flow decreases
You made sales, but haven’t collected the cash yet.

d. Increase in taxes due
→ Cash flow increases (temporarily)
You owe more in taxes but haven’t paid yet — cash hasn’t left the business yet.

e. Increase in cash balance
→ No impact (in this context)
Cash is the result, not a driver. It’s where the cash goes, not what changes it.