What Does Cash Disbursement Mean?

There are two different aspects of an expense from accounting perspective. On one side, there is the accounting record, which describes the nature of the operation and on the other side, there is the actual payment of the transaction.

From a financial standpoint, these events doesn’t have to occur necessarily at the same time, since companies can acquired debt (which indicates that the payment will be made in the future, and not at the moment of the purchase) or, the company can sell through credit (which indicates that the money involved in the sale will be delivered in the future too). In both scenarios, the actual cash is spent or received in the future.

In this regard, a cash disbursement is the operation that involves an actual money outflow either from the company’s cash (petty boxes, bank accounts) or from cash equivalents like short term investments. These cash disbursement are normally issued following an organized schedule to make sure the company is properly funded to meet all its financial commitments. The Finance Manager is normally the person in charge of planning, organizing and executing these disbursements in a timely manner.

Example

Relentless Collectors Co. are an account receivables collection company that specializes in the health care industry. They serve clinics and independent practices helping them to collect debts from their overdue clients. Relentless’ clients are normally physicians that charge some of their commercial clients through credit.

After a period of 60 days has passed, the debt is passed on to Relentless Collectors and their job is to contact these companies to recover the amount owed. For these companies, the expense is already recorded, since it occurred at the time the patient received the medical attention, but the cash disbursement required to fulfill the commitment hasn’t been issued yet.

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What Does Disbursement Mean?

When a business spends money it can pay for it at the moment the items or services are delivered or it can do it some days later, through commercial credit. A expense, from an accounting perspective, must be recorded at the time it occurs, regardless of the moment when it is paid for. On the other hand, a disbursement is a cash flow item. This means that the moment when the expense occur and the moment when the disbursement takes place might be different.

A disbursement is a term that is most commonly employed to describe a cash flow event, not an accounting record. These disbursements are normally paid with the company’s bank balance or with petty cash, depending on the size of the expense. Some examples of disbursements are payroll expenses, rent, taxes or insurance premiums. In organizational structures, the Finance Department is often the one that handles the disbursement program where all the company’s financial commitments are scheduled to be paid at certain moment.

Example

A company called Protelco Co. is a large manufacturer of electric outlet’s voltage protectors. The business is currently growing and the Board of Directors decided to invest in a large project to enhance the manufacturing facilities through the purchase of machinery. The amount of the purchase is estimated to be $95,000,000 and the supplier established a payment plan of 4 consecutive quarterly payments, each for a sum of $23,750,000.

From an accounting perspective, the assets will be immediately recorded at the time the agreement is signed and the invoice and the assets are received. Nevertheless, the actual disbursement of money will take place on a quarterly basis, starting three months after the deal is signed. This illustrates the difference between an expense and a disbursement.

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This is an important concept in capital rationing and budgeting because it shows management how much of their investment will be recouped by the company at the end of the project. Thus, management must include this figure in their earnings and return estimates before they decide to accept or turn down a job.

What Does Terminal Cash Flow Mean?

For example, if a company decided to take on a construction job that required a crane, they would have to purchase one. They do not however have to keep this crane forever. After the job is finished, they can sell or dispose of the crane and recoup much of the crane’s cost. This last payment received from disposing the crane is part of the terminal cash flow.

The terminal cash flow formula is calculated by adding the after tax proceeds from disposal to the change in working capital after the equipment has been disposed. Here is the equation:

TCF = After Tax Proceeds from Equipment Disposal + Any Change in Working Capital

Let’s look at an example.

Example

Let’s go back to our construction example for a minute. Assume that Bill’s Construction Company is debating whether or not to accept a contract to build a building because it needs to purchase a crane. The crane originally costs $50,000 and has a salvage value of $20,000.

Here are the key components to the terminal cash flow equation:

• Salvage value of the crane: $20,000
• Net working capital recoupment: $10,000
• Tax reduction from disposal loss because the salvage is less than the book value: $2,000
• Net terminal cash flow: $32,000

Bill would have to add up the operating cash flows from the total building project and add them to the net TCF in order to decide whether this project was worth pursuing or not. If the total cash flow was positive and gave Bill a good return, he should pursue it. If it’s negative, Bill would end up with a loss and he should look for other opportunities.

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What Does Operating Cash Flow Mean?

What is the definition of operating cash flow? OCF is exclusively related to a firm’s operating activities during a specific time period or business cycle (year, quarter or month), and it is used to assess a firm’s profitability by including a firm’s cash flow. A high OCF helps a firm expand into new markets, develop a new product, and lower its debt. It also indicates a solvent firm that can return shareholder value by distributing cash dividends.

In contrast, firms with a negative operating cash flow for an extended period tend to struggle to meet their financial obligations and are typically forced to borrow money to stay in business.

Let’s look at an example.

Example

Christina is an accountant in a construction company. She is asked to construct the statement of cash flows and check out the trend of the cash flow from operating activities over the past four years.

Christina inputs the numbers in the statement from 2012 to 2015, and she finds out that the firm’s OCF suggests an upward trend, with a slight decline in 2014. The increase in the OCF has allowed the firm to increase its cash dividends by 12.3% in from 2013 to 2014 and to lower its debt at the same time.

Here is the statement she put together.

You can also see that the changes in working capital indicate that the firm effectively manages its inventories, accounts receivable, accounts payable, and cash, thereby lower its current liabilities.

If Christina wants to find out what percentage of cash from operations is generated by the firm’s annual sales, she can use the Operating Cash Flow to Sales Ratio formula:

OCF / Sales = $483.2 / $3,200 = 15.10% in 2015

Summary Definition

Define Operating Cash Flow: OCF is the amount of cash a business generates from its core activities.

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What Does Operating Activities Mean?

These cash inflows and outflows from operating activities are reported on two different financial statements.  First, they show up on the income statement and are used to compute net income. Second, they are reported on the statement of cash flows. This statement shows how cash from three main sources (operating activities, investing activities, and financing activities) increased or decreased during the period. Let’s look at an example.

Example

Take Best Buy for instance. Best Buy purchases electronics and appliances from manufacturers and sells them to customers. So any activity that is involved in Best Buy purchasing inventory or selling inventory to customers is considered an operating activity. This can even include administrative expenses. As long as the activity is related to selling goods to customers, it is considered an operating activity.

Best Buy also has activities that are not directly related to selling products to customers like selling fixed assets, getting loans from banks, or paying dividends to shareholders. None of these activities are considered operating activities because they can’t be related back to Best Buy’s principle business activity: selling products to customers. These activities would either be considered investing or financing activities. Sometimes these three categories can get confusing.

Just remember that principle activities include any cash inflows or outflows that relate to the primary business activity or the activity that business performs to earn a profit. Every other activity is not considered an operating activity.

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This metric is typically an indicator of a firm’s financial strength, providing it with the ability to operate, develop new products, expand into new markets, invest in research, reduce debt, and increase shareholder value.

What Does Net Cash Flow Mean?

What is the definition of net cash flow? Firms with long-term positive cash flows are financially healthy and meet their short-term obligations without the need to liquidate their assets. Conversely, companies with long-term low or negative cash flows are financially weak or even on the verge of bankruptcy.

Short-term negative cash flows may also indicate that the company has invested in the construction of a second factory or in expensive new equipment. As soon as the investment begins to generate revenue, it will outweigh the failing of short-term weak cash flow.

Let’s look at an example.

Example

Company ABC is a manufacturing company and a leader in the sector. The company seeks to expand its operations and has invested in the construction of a second manufacturing plant for a total cost of $1.8 million. As a result, the company incurred a negative net cash flows for 2015.

The company’s cash flows from Operating Activities, Investing Activities, and Financing Activities are presented below:

The company’s total net cash flow formula is the sum of the operating cash flow, the investing cash flow and the financing cash flow for each year.

Therefore:

• Year 2015 = 1,720,000 – 1,700,000 – 570,000 = -$550,000
• Year 2014 = 350,000 – 450,000 + 900,000 = $800,000
• Year 2013 = 410,000 – 550,000 – 790,000 = $650,000

Although the investment in the second manufacturing plan justifies the negative cash flow for 2015, the company cannot sustain a poor NCF for many subsequent quarters because such signs may indicate financial danger.

Furthermore, financial analysts are using cash flows as an indication of financial health, but they compare them to the company’s debt, changes in fixed assets and other indicators that can justify an increase or a decrease in the NCF.

Summary Definition

Define Net Cash Flows: Net cash flow means the difference between the money a company generated in sales and the money it spent to generate the sales.

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What Does Levered Free Cash Flow Mean?

What is the definition of levered free cash flow? The levered free cash flow is an important measure of a firm’s ability to grow. When a firm seeks expansion into a new market or the development of a new product, it needs additional cash. Small businesses are often capable of financing their operations without raising additional capital. However, larger firms need to raise additional capital through equity financing, i.e. their investors, or debt financing, i.e. through a bank to help their business grow.

Businesses that generate strong LFCF are financially healthy because they are able to cover their obligations, distribute dividend payments and grow. Conversely, a weak or negative LFCF indicates that the company generates insufficient cash to cover all its financial obligations. To calculate the LFCF, we need to know the cash flow from operation (OCF), the capital expenditures (CapEx), the interest income and the interest expenses.

Let’s look at an example.

Example

John is an investment analyst, and he follows the pharmaceutical sector. Lately, some of the companies in the portfolio of stocks that he manages for his clients, are underperforming the sector, and John wants to find an explanation for their weak performance. One of the companies has recently released quarterly financial results, and unlike what investors and analysts expected, the results were below expectations.

John creates an Excel spreadsheet to calculate the LFCF of the firm and determine its ability to grow. First, he uses the items for the calculation of the firm’s operating cash flow (OCF):

Then, he identifies the interest expense on the income statement and the capital expenditures on the cash flow statement. Now, John can calculate the levered free cash flow as follows:

The levered cash flow decreased by 24.7% YoY due to a decrease in net income by 36.9%, and an increase in capital expenditures by 45.2%. If the company seeks to grow, it should increase its sales, reduce its capital expenditures and generate a stronger net income that will allow the firm to be competitive but also to fund and expand its operations.

Summary Definition

Define Levered Free Cash Flows: LFCF means the money that is available to stockholders after debt servicing.

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What Does Investing Activities Mean?

The two main activities that fall in the investing section are long-term assets and investments. Long-term assets usually consist of fixed assets like vehicles, buildings, and machinery. When a company purchases a new vehicle with cash, the cash outflows are listed in the investing section. Likewise, if a company sells one of its vehicles, the cash proceeds are listed in this section as well.

Investments are a little more complicated than the long-term assets because it depends on the source of the investment. For example, cash paid for short-term investments like trading securities and cash equivalents are included in this section. Principle payments on third party notes are also included. However, payments on a note payable from a customer that resulted in a sale are typically listed in the operating activities section—not the investing. Likewise, FASB requires that all interest payments and receipts be classified as operating activities.

Example

Here’s a short list of common cash inflows and outflows listing in the investing section of the cash flows statement.

• Inflows
• Cash collected from:
• Selling trading, held for sale, and available for sale securities
• Selling discounted notes
• Selling long-term productive assets
• Collecting principle on third party notes that don’t generate sales

• Outflows
• Cash paid to:
• Purchase trading, held for sale, and available for sale securities
• Purchase long-term productive assets
• Pay principle on third party notes that don’t generate sales

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What Does Indirect Method Mean?

Both the direct and indirect methods can be used to format the statement of cash flows and the ending outcome will be the same. They will both show the operating, investing, and financing cash activities, but the formatting is much different. Both of these methods present the investing and financing activities the same. The only difference between a direct cash flow statement and indirect one is the operating activities section.

Unlike the direct method, the indirect method does not list the individual cash items and transactions that were made throughout the year in the operating section. Instead, only the adjustments to income are listed in this section. You can think of it like listing account changes and how they affect income and or cash.

Example

For example, let’s assume accounts receivable increased by $10,000 during the year. This means accounts receivable was debited $10k and income what credited $10k. So in order to adjust income for this non-cash transaction, we would reduce income by $10,000 in our operating activities section.

As you can see without having to list all transactions during a period, the statement becomes much easier to prepare and compute. It also shows how each account affects income. Although the FASB recommends preparing statements using the direct method, over 90% of companies use the indirect form of reporting.

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What Does Income Approach Mean?

What is the definition of income approach? Being one of the most widely implemented valuation methods, the income approach analyzes the expected economic benefits that investors anticipate from a real estate investment. The method discounts the property’s expected cash flows in their present value using the capitalization rate of the property.

The capitalization rate represents the risk of investment and is calculated based on a property’s Interest before Depreciation, Interest, and Taxes (IBDIT) considering the current interest rate on the property’s mortgages, the equity investment in the property, and a risk factor to reflect the real estate investment risks.

Let’s look at an example.

Example

Nicholas is an investment advisor. He is asked to calculate the capitalization rate of a real estate investment for a client using the income approach valuation method and determine the property’s present value.

Nicholas uses the income statements of the property to calculate the Interest before Depreciation, Interest, and Taxes (IBDIT) at $85,000. The calculation of the IBDIT includes the costs of building maintenance, the property’s operating expenses, and unusual expenses.

Then, Nicholas calculates the capitalization rate, based on the property value, the interest rate on the bank loan, the return on equity investment, and a risk factor, as follows:

The bank loan of $90,000 represents a weight of 64.3% of the property value. The equity investment of $50,000 represents a weight of 35.7% of the property value. By multiplying the weight of the bank loan by the annual interest rate and the weight of the equity investment by the expected return on investment, Nicholas calculates the weighted capitalization rates of each weight component. Then, by adding the risk factor of 4.50%, Nicholas calculates the capitalization rate of this investment at 16.93%.

Therefore, the present value of the property is calculated as follows:

Present value of the property = IBDIT / Capitalization rate = $85,000 / 16.93% = $502,110

Summary Definition

Define Income Approach: Income approach is a real estate valuation method used by investors to appraisal a piece of real estate based on its earnings, profitability, and risk.

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