Cash Flow Statement and Discounted Cash Flow Model

A cash flow statement is a visual representation of the flow of funds in and out of an account over a period of time. The income statement, balance sheet, statement of shareholder's equity, and cash-flow statement are the four main financial statements for any organization. All the revenues and expenses for a period are added together to show the balance for the month. Financial officers, CFOs, and CEOs rely heavily on this statement to know their runway before they run out of cash.

In a real estate project, a cash-flow statement shows the project's revenue and expenses for each period of time during the life-time of the project. To create a cash flow statement, all expenses and revenues for each month should be listed and estimated. Some of these line items are based on fixed contract amounts such as insurance, maintenance cost, and rental income. Some other items are not known ahead of time and can only be estimated, such as utility consumption, property taxes, etc. The important point is to list all the expense and revenue items, whether fixed or variable in nature, and provide a monthly amount for each item in each month.

Cash-flow statements can be difficult and time-consuming to produce. The first step is to record all the revenue and expenses items in a column. Then, create a column for each period, whether month or quarter. You then need to record or estimate the cost or revenue for each month of each item.

Oftentimes, the owner's equity is not enough to cover all the business costs. Based on the difference in revenue and expenses in any given period, the amount of required funding for the period can be calculated. These cash investments could come from either owner's equity, outside financing, or combination of the two. In the event that outside financing is used to pay for the expenses, the amount of interest for the fund, commonly called cost of borrowing, should also be added to the next period's expenses.

The soft cost items are different from a project to project, depending on the local laws and financing requirements. For example, while in commercial projects, phase II environmental study is required to obtain financing for most lenders in most jurisdictions, the residential projects in another jurisdiction might not have that cost item (unless situated in a particular area) as part of their financing requirements. Let's look at some of the soft costs:

Typically, you first draw from your own equity. This is called the equity draw. When the equity cannot cover all the costs less the revenue for a period, you are running a deficit for that period. To cover the shortage of funds, the draw is made from the financing's available balance. The interest on this amount is calculated and entered in a separate row for interest expenses. Typically, a separate section of the cash-flow statement is dedicated to interest expenses along with the debt and equity draws.

It becomes obvious very quickly that this can become very tedious and error-prone. Spreadsheets are usually used to create cash-flow statements. However, you are still on your own to estimate each month's revenue or cost for each item. For this reason, spreadsheets have their own utility capacity. At Develuppers, we create the cash-flow statement for you without you needing to worry about all the calculations, etc.

When it comes to accounting, there are two accounting methods, accrual basis and cash basis. In the accrual basis, a revenue is recognized when it is earned rather than when it is received. Similarly, an expense is recognized when it is payable and not when it is actually paid. The accrual basis of accounting is required by GAAP (Generally Accepted Accounting Principles). If the accounting method used for a company books is the accrual method, the cash flow calculation is called the indirect method. So, the cash flow is based on earned revenue and payable expenses rather than received cash and paid amount. That means in each period, we record all receivable amounts as well as all payable accounts. The net amount for each month would be the total revenue less total expenses for the period.

Using the concept of time value of money, we can calculate the present value of an investment based on the expected revenue it generates in the future. The value of the investment is the sum of the value of each period.

To explain this, let's assume that you have a rental suite in your house and you've rented it for $1,000 per month. How much is your rental suite worth at the end of the first year? To do that, we should first assume that you would get say 5% annual interest on your money investing it in your bank account. So, the first payment of $1,000 will earn you $1,000 plus the interest on each month up until the end of the year. Well, 5% annual interest would mean 5% / 12 monthly interest which is 0.004166 or 0.4166% or 0.42% rounded to two decimal places. Let's see how the first month of rent earns you interest month over month. Here is the table showing that:

Payment of $1,000 paid at the beginning of period 1 will earn:

It turns out that the formula to calculate the balance at the end of the 12th month is this very powerful formula:

The discounted cash-flow method tells us that the present value of the cash flow received from the basement suite by the end of the one year is equal to the sum of earned interest amount for each rental payment. As seen above, the first month of rent has 12 months to accumulate interest which amounts to $1,051.16 at the end of the year assuming 5% annual interest. The second month of rent has 11 months to earn interest, and each month has one less month of interest to earn. And, so on and so forth. It turns out that the formula to compute the total cash-flow value given the equal payments of $A at the end of each period is the following:

Note that this equation is for a uniform series of cash-flows. In other words, at the end of every period, there is $A net cash-flow amount we receive from the investment. If your cash-flow amounts are not the same, you need to treat each amount as a separate amount and find the present value of the estimated future cash-flow. Do that for each cash-flow amount and add them all up, which will give you the formula we started with:

If all this seems too much math for you, it's because it is. Even math enthusiasts might find the complete calculation for a large number of periods in an investment analysis a little too rich and tedious. This financial modeling is perhaps not part of your core business practice as a real estate developer, sales agent, architect, investor, or an underwriter. In a large project, the more time you spend on your Excel sheet and the more detailed the spreadsheet gets, the more chances you are going to break something somewhere. For a large project that hinges on complex and lengthy calculations, putting all that capital contingent on complex error-prone system is neither wise nor fun. As a professional, your job is not recreate the financial model wheel. Going back to old calculations and trying to audit aged spreadsheets is another huge headache. At Develuppers, we have already solved that problem for you to produce your cash flow statement without you doing anything at all. This reduces the costly error and frees up your time to build bigger and better projects.