Question

Why do we focus on cash flows rather than accounting profits in making our capitalbudgeting decisions? Why are we interested only in incremental cash flows rather than total cash flows?

Answer 1

We focus on cash flows because, at the end of day, cash flow is what keeps businesses going. Businesses have a number of different expenses that they have to take care of on a regular basis such as employee salaries, interest on debt etc. These expenses have to be paid for in cash. Now, the way accounting profits are calculated, they include a lot of non cash flow items. For example, when a company sells on credit. Even though its sales go up, which is eventually reflected in its net profit, there is no real cash flow that has happened. And so that means less cash available to this company to service its expenses. Imagine an extreme case, when a company is selling everything on credit. Its net profit, in this case, will be positive but because there is no cash flow, this business will not survive . So, it very important, while analyzing a project, to understand the cash flows that it will produce and the timing of those cash flows as opposed to accounting profit.

Incremental cash flows are the cash flows arising out of a particular project as opposed to the whole company. Now, companies face a number of business decisions on a regular basis such as which project to take?, which machine to buy? etc. Now, while analyzing different projects, all you care about is what kind of cash flow will that particular project lead to, which is why we focus on incremental cash flows and not total cash flows.