Cash flow statement in the business case
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Revised 2013-05-20.
This entry explains the structure, content, and meaning of the cash flow (CF) statements in business case analysis. (For an overview of the financial accounting CF statements, see the encyclopedia entry statement of changes in financial position.)
A dictionary definition for business case might run as follows: "The business case is a decision support and planning tool that projects the financial results and other business consequences of potential actions or decisions."
• The word "projects" means the case looks forward in time, estimating future business
results from one or more actions or decision options under consideration.
• A good business case anticipates financial business results as well as
non financial results ("other business consequences").
This encyclopedia entry concerns only the projected financial results that are summarized and analyzed in the business case. For more on non financial costs and benefits, see the encyclopedia entries for business benefit and key performance indicator.
• Simple example: Business case cash flow statements
• Incremental cash flow statements: What changes with an action
– Calculating incremental cash flow
– Finding cost savings and avoided costs
− Incremental costs from benefit items
– Multiple proposal scenarios and multiple incremental statements
• Cash flow analysis and "proof:" Scenarios make the case
– Net cash flow
– Return on investment (ROI)
– Net present value (NPV)
– Payback Period
– Internal rate of return (IRR)
– Financial metrics conclusion
• Business case vs. financial accounting CF statements
• Cash flow statement structures
• Requirements for building the cash flow statements
Simple example: Scenarios make the case
Business case analysis is undertaken to address questions such as these:
• Is there financial justification for the proposed asset purchase?
• If we implement the proposed initiative, what are the funding requirements
from our capital budget? From our operating budget?
• Which investment proposals is the most promising? Which is least risky?
• Which course of action represents the better business decision?
The analysis attempts to answer such questions by predicting future business outcomes under one or more scenarios.
The case includes one scenario for each possible action, decision, or
investment under consideration. Recommendations for action are based on
analysis and comparison of the scenarios.
The simple example cash flow statements at left show how expected financial results under each scenario are summarized. The financial outcomes expected under each scenario begin with Financial outcomes under each scenario begin predicted cash inflows and outflows for a number of cost and benefit items.
This case analyses two possible action scenarios. One scenario (upper panel) represents a new product launch. The other scenario (middle panel) represents "Business as Usual" that is, continuing business without launching a new product. Management will choose one or the other scenario for implementation.
The business case analyst predicts cash inflows for two Benefit items in each scenario, "New product gross profit" and "Other product gross profit." Cash inflows are predicted for each year of the time period covered by the case. These figures are clearly inflows, not outflows, because they appear as positive numbers. The analyst also predicts cash outflows for three Cost items, which are entered on the cash flow statements as negative numbers (using the accounting convention of putting negative numbers in parenthesis).
The upper two panels are labeled full value cash
flow scenarios, to distinguish them from the "investment" cash flow
statement below them (described in the following section). The name
means simply that each cash inflow or outflow is given at its full
value: a full value outflow estimated as $510 means simply that
$510 is the expected size of the outflow. Full value data in these
statements are essential for budgeting and planning purposes.
Note that both scenarios have exactly the same benefit and cost line items, even though one scenario (Business as Usual) anticipates 0 cash inflow for all years of the analysis on one item (New product gross profits). Matching cost and benefit items for all scenarios in this way ensures that comparisons between scenarios are fair and objective. Matching scenario line items this way also makes possible the creation of an incremental cash flow statement (described in the next section).
Which
scenario should the analyst recommend? More analysis is called for
before giving an answer, but it noteworthy that even from the cash flow
figures in the upper two panels that the expected three-year net cash
flow is greater under the Proposal Scenario (7,170) than it is under
Business as Usual (4,400)
Incremental cash flow statements: What changes with an action
Each full value CF statement has the expected inflows and outflows for one possible action scenario, only. For comparing two or more scenarios, however, it is helpful to construct an incremental statement such as the example in the image above beneath the two full value statements.
The
incremental statement shows clearly only "what changes" when the
proposal is implemented (compared to proceeding with Business as Usual).
For this reason, the incremental statement is central when decision
makers are choosing which scenario to implement. In the case of this
example, the incremental scenario shows only the expected gains and
losses that would follow from implementing a product launch.
At
first glance, it might not be apparent that the incremental statement
has exactly the same set of line items as the full value versions: line
item names clearly indicate they represent incremental data, by the use
of terms like "increase," "decrease," and "savings." In addition, the
item "Service delivery cost..." now appears under "Incremental Benefits"
instead of a cost category, and the item "Other product gross profit"
is now under "Incremental Costs" but not "Benefits." The reason these
items changed categories is explained below.
Calculating incremental cash flow
Incremental cash flows are computed directly from the full value figures by subtracting the "Business as Usual" value from the corresponding "Proposal Scenario." That is, each incremental value, or Δ (delta) is calculated as:
Δ i , j = Proposal scenario cash flow i , j – Business as Usual cash flow i , j
Where Δi , j is the incremental cash flow for line item i in year j.
Full value cash flow figures were described in the previous section with a sign convention: Cash inflows are shown as positive values and cash outflows are shown with negative values. This convention plays an important role in making sure that incremental values have the correct sign: a positive increment means increasing inflows and a negative incremental value means that outflows increase.
Consider, for instance the Year 2012 incremental value for "New product gross profit." The estimated value under the Proposal Scenario is 1,500 and under Business as Usual it is 0. The incremental value is:
Δ = 1,500 − 0
= 1,500
New product cash flow increases 1,500 in 2012. A positive number or 0 subtracted from a larger positive number yields a positive number.
Similarly, consider the 2012 incremental value for the cost item "IT support." The full value IT support cost is a cash outflow under both scenarios, but the −800 outflow under the Proposal scenario is larger than the −700 outflow under Business as Usual.
Δ = (− 800) − (−700)
= −100
IT
support costs (outflows) increase by 100 during 2012. A smaller
negative number subtracted from a positive negative number yields a
negative number result.
The most interesting incremental results occur when they reveal cost savings or avoided costs. Consider the line item "Service delivery costs" for year 2012. Service delivery costs are non zero under both scenarios. Under the Proposal Scenario they are 420, but under Business as Usual they are larger (510). Here, the incremental result will be a positive number.
Δ = (− 420) − (−510)
= 90
A
larger negative number subtracted from a smaller negative number yields
a positive number result. This mathematical twist is the mechanism by
which cost savings and avoided costs are identified and measured for the
case (next section).
Finding cost savings and avoided costs
Some people are confused when attempting to show how proposed actions lead to cost savings, or avoided costs. A cost savings definitely seems like a "benefit" but it has to do with "costs." They ask: How do I find, measure, and present cost savings in my business case?
Remember that savings is a relative term. One cannot find or measure savings without a baseline. In the business case, the Business as Usual scenario serves as baseline, and all savings (and avoided costs) discovered have meaning only as a relative to the baseline.
In the example full value cash flow statements above, for instance, "Service delivery costs" are estimated as cash outflows of 420, 420, and 400, across three years, in the Proposal scenario. However, the same costs for the same years are estimated as 510, 520, and 540 under Business as Usual. Thus the proposal scenario shows a cost savings of 90, 100, and 140 for these years.
These savings are captured on the Incremental cash flow statement as positive cash flow, and labeled as "Service delivery cost savings" under "Incremental Benefits." On the full value statements, "Service delivery costs" appear under "Costs" because they are cash outflows on both (full value) statements. The "Service delivery" item has been elevated to the Benefits category on the incremental statement.
It is also quite possible to discover avoided costs on the incremental statement. An avoided cost has the same mathematical properties as a cost savings, except that the term avoided cost refers to large costs that have not yet occurred, but which certainly will occur under Business as Usual. Preventative maintenance and preventative health care are examples of activities meant to create avoided costs: changing oil on the automobile at prescribed intervals, for instance, leads to an avoided cost for engine replacement, which would certainly come under "Business as Usual" (that is, making no oil changes).
Some
finance professionals are reluctant to allow avoided costs into a
business case, probably because the future costs to be avoided have not
occurred yet, or possibly for other reasons. Nevertheless, if the
analyst can argue credibly that a cost is coming under "Business as Usual" and also show credibly that the cost will not come with a proposed action, the avoided cost is a legitimate incremental cash inflow and benefit for the business case.
Incremental costs from benefit items
You may have noticed one final result on the incremental cash flow statement involving another line item that changed categories, moving this time from "Benefit" to "Incremental Cost" categories. The item here is "Other product gross profit" which is less each year under the "Proposal Scenario" than under "Business as Usual."
The
cash flow statements show that this company will give up some profits
for existing products ("Other products"), in exchange for a much larger
incremental gain with "New product gross profit. However, the decrease
in Other products gross profit" scores as an "Incremental Cost" on the
incremental statement.
Multiple proposal scenarios and incremental cash flow statements
The
examples above presented a business case with two action
scenarios, where one is the baseline or "Business as Usual" and the
other a "Proposal." In that situation two full value scenarios called
for one incremental cash flow statement. Very often, however, several
different possible actions are under consideration, and the business
case has two, three, four or more "Proposal" scenarios.
When there is more than one proposal scenario, how many "Business as Usual" and how many incremental cash flow statements are called for?
The good news is that only one "Business as Usual" scenario is needed, no matter how many "Proposal" scenarios appear in the case. As the figure above suggests, each full value proposal scenario is associated with its own incremental cash flow statement, obtained by subtracting the "Business as Usual" statement items from the corresponding scenario full value cash flow statement items.
• One "Proposal" scenario and one "Business as Usual" scenario call for three
cash flow statements: Two full value statements and one incremental statement.
• Two "Proposal" scenarios and one "Business as Usual" scenario calls for five
statements (as in the image above): Three full value statements and two incremental
statements.
Cash flow analysis and "proof:" Scenarios make the case
Which
scenario should the analyst recommend for action? A graph showing the
net cash flow expected under each scenario (from the full value cash
flow statements above) is shown in the image below.
Net Cash Flow
Analysis will begin with the full value cash flow statements for the two scenarios which, as the graph shows, reveal larger three-year net cash flow for the proposal scenario than for business as usual:
Three-year net cash flow, Proposal Scenario: 7,140
Three-year net cash flow, Business as Usual Scenario: 4,400
That much is a point in favor of recommending the Proposal. Further analysis for the comparison, however, will focus on the incremental cash flow statement. The incremental cash flow data make possible the use of investment metrics, including return on investment (ROI), Payback Period, and Internal Rate of Return.
Return on Investment (ROI)
Simple return on investment for the Proposal Scenario, compared to "Business as Usual" is large:
ROI = (Gains – Investment cost) / Investment Cost
= (5,780 – 2310) / 2310
= 150.2%
The HIGH ROI result is a point in favor of undertaking the action.
Net Present Value for the Incremental Cash Flow
Net present value (NPV) for the Proposal incremental cash flow is calculated as follows: NPV = ∑ FVj / (1+ i )n for j = 0 to n
where
FVj for each yearly period j = Net cash flow for the period
Discount rate i = 8.0% ( or 0.08) for this example
Period j = 0 (now) through 3 (Year 3)
NPV = –50 / (1+.08)1 + 1,560 / (1+.08)2 + 1,960 / (1+.08)3
= 3,213
Whether or not this is a strong point in favor of undertaking the action depends on what the cash flow NPV from potential alternative uses of the same funds. Compared to Business as Usual, however, this is a high positive result.
Payback Period
Using
the incremental cash flow for the Proposal Scenario compared to
Business as Usual, this action "pays for itself" in 1.03 years. Whether
or not this is a strong point in favor of undertaking the action
depends on the payback period from potential alternative uses of the
same funds. (See the encyclopedia entry payback period for more on calculating and interpreting payback period.)
Internal Rate of Return (IRR)
Using the incremental cash flow for the Proposal Scenario compared to Business as Usual, the internal rate of return for this cash flow stream is a very large 3,141%. (See the encyclopedia entry internal rate of return for more on calculating and interpreting IRR.)
Conclusion from the financial metrics
The
very large ROI, IRR, and NPV, and the relatively short payback period
all argue strongly for undertaking this action (launching the product).
However, before committing to action, management will also want to see a
thorough risk analysis for the proposal business case, which will show
the probabilities of actually achieving forecast results as well as the
probabilities of seeing very different results.
Business case vs. financial accounting cash flow statements
Business people with a background in finance or accounting who have little experiences with business case analysis sometimes ask questions like these:
• Are these business case statements legitimate cash flow statements?
• How do they compare with the more familiar financial accounting CF statement
the statement of changes in financial position?
The business case case flow statements shown here are by all criteria legitimately called "cash flow statements." The statements present estimated actual cash flow, and only real cash flow, in the time periods the flows actually occur. The statements report inflows and outflows separately, and then present their net result.
For
those who are familiar with the financial accounting cash flow
statement, but less familiar with the business case statements,
the following table presents the major points of difference between the
two kinds of statements.
| Business Case Cash Flow Statement | Financial Reporting Cash Flow Statement | |
|---|---|---|
| Typical Statement Name | Proposal scenario cash flow statement. | Statement of changes in financial position. |
| Statements Published | At least one statement for each scenario analyzed in the case, including a "Business as usual" scenario. | One statement for the company, published at the end of each reporting period,usually the end of each fiscal quarter and year. |
| Major Sections | 1. Benefits. 2. Costs. | 1. Sources of Cash. 2. Uses of Cash. |
| Time Covered | A series of months, quarters, or years, into the future. |
The reporting period just ende,d quarter or year. |
Cash flow statement structures
Business case cash flow statements—like the financial accounting statements—have a very simple basic structure with two major sections: (1) Cash inflows (or Benefits, or Sources of Cash), and (2) Cash outflows (or Costs, or Uses of Cash). This is the basic structure of the example statements discussed above.
With just a little more detail, here is the basic structure again:
Notice especially the "Cash Flow Summary" at the bottom. For business case scenario cash flow statements, it is useful to have:
• A summary line totaling benefits
(cash inflows) and another
totaling costs (cash outflows).
In the full value statements,
these lines are helpful
for budgeting, planning,
and revenue forecasting.
• A summary line for net cash
flow, period by period, and in
total. This is the scenario's net
cash flow, for the cost and
benefit items analyzed.
• A summary line for cumulative cash flow, period by period. This helps show
when cumulative cash flow goes from negative to positive (that is, when "Payback occurs").
• A summary line for present values (discounted cash flow values), whose
total is the net present value (NPV) of the net cash flow stream.
A
slightly more complex cash flow statement is shown in the example
below. Here also the major sections are "Benefits" and "Costs," but the
"Costs" section has two sub-sections: (1) Assets (capital
spending) and (2) Expenses.
It
is useful to structure the "Costs" section this way only when both
kinds of spending are involved in the proposed action or investment
under consideration. The distinction is useful in those cases, because
capital spending (CAPEX) is planned and managed under a different budget from operating expenses (OPEX).
In other words, requests for the capital funding component of a
proposal may have to go to different managers, with different
priorities, and different spending criteria, than do requests for
funding the operating expenses.
The final business case cash flow statement structure shown here represents the "after tax" business case. Cash flow statements in this kind of case show the likely tax consequences of the estimated cash inflows and outflows.
Most business cases for decision support or planning purposes do not need to consider tax consequences of projected cash inflows and outflows, but there are a few situations where it is appropriate to build tax consequences into the case statements:
1. When the business case subject itself is concerned with tax consequences.
In "Lease vs. Buy" cases, for instance, one important consideration is the
different tax consequences for buying assets vs. leasing the same assets.
2. When senior management is concerned with the impacts of different action
alternatives on reported income after taxes. The cash flow statements will
enable computation of cash flow metrics such as net present value,
internal rate of return, payback period, and return on investment. However,
when management is also interested in the impacts on reported income for
the company, tax consequences must be factored into the scenario cash
flow statements.
Note that lines depreciation expenses shown in lines 7, 9, and 11 do not
contribute directly to the cash flow total Net Cash Flow in line 18.
However, the depreciation expenses do create the tax savings from
depreciation summarized in line 17. Tax savings from depreciation
expense are real cash flow. (For more on tax savings from depreciation,
see the encyclopedia entry on depreciation.)
Requirements for building cash flow statements
When can the analyst begin building the business case cash flow statements?
On the surface, the full value cash flow statements appear to be little more than a simple table, with a list of benefit and cost line items on the left, and columns indicating time periods (months, quarters, or years). Table cells will be filled with estimated cash inflows or outflows for each line item in each time period. The analyst must have this table structure in place before beginning to make cost and benefit cash flow estimates. Obviously, the structure is not known until several earlier business case design elements are determined. (For more on business case design and design elements, see the encyclopedia entry business case. Or, for more complete coverage, see the book Business Case Essentials.)
Business case design elements that should be in place before creating the cash flow statement structure include:
• A subject statement describing potential actions under consideration and
the business objectives addressed by the actions.
• A purpose statement, describing who will use the case results, for what purpose,
and specifically what information they need to meet that purpose.
• A list of the action scenarios under consideration for the case. Each cash flow
statement must include all cost and benefit items included in all scenarios.
• Scope and boundary statements for the case. That is, specification of the time
period covered by the case, and all information necessary for determining
whose costs and whose benefits are to be included.
• A cost model, identifying cost items appropriate for the case.
• A list or inventory of benefit items appropriate for the case.
By Marty Schmidt. Copyright © 2004 - Solution Matrix Limited and 
Marty Schmidt+. All Rights Reserved.
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