Equity

Equity includes the stockholders’ investment in the firm, both capital at par and additional paid-

in capital, and the cumulative profits and losses retained in the business from its inception up to

the date of the balance sheet.

The Cash Flow Statement and the Concept of Free Cash Flows

Although an income statement measures a company’s profits, as stated earlier, the reported

profits are not the same as cash. Accounting profit, or book profit, is calculated on a noncash

accounting accrual basis where revenues and expenses are matched in time and certain noncash

transactions such as depreciation and amortization are recorded. Under these accounting rules,

revenue is earned and cost incurred whether or not the actual cash has been received or disbursed

in that period. Therefore, in finance we require a method to translate the accrual-based

accounting profit back to its cash component. The statement that converts the accrual-based

accounting statements into a cash basis is called the free cash flow statement.

By definition, the free cash flows that are generated from the firm’s operations and investments

in assets must always be equal to the free cash flows paid to or received from the company’s

investor financing. Therefore, free cash flows can be calculated from two perspectives, the

operating perspective and the financing perspective.