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I'm reading text book that introduces some financial concepts, all of which are really new to me. I'm reading a passage on Return on Investment Capital. In this passage, they try to demonstrate ROIC with an example, and the example cites a Company A that has the following details:

In year 1, Company A has

  • Revenues: $1000
  • Earnings: $100
  • Investment: ($25)
  • Therefore, Cash Flow is : $75

These details suggests the following relationship between these key terms:

Earnings = Revenues - All Costs - Taxes

Cash Flow = Earnings - Investments

My confusion is that I currently understand that Earnings is defined as:

Cash Flow = Earnings = Revenues - Investments - All Costs - Taxes

I have this understanding because i read the following:

Cash Flow = the total amount of money being transferred into and out of a business.

Earnings = Earnings are the amount of profit that a company produces during a specific period

Can anyone help me clear up my understanding of these terms so that I can go on to understand what ROIC is?

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I think you are asking mainly about the difference between earnings (net income) and cash flow. The basic point is that the value of a business is not just the balance in its checking account. The business has assets other than cash, and it has revenue and expenses that are "on credit" (recorded in accounts receivable and payable). Changes in the non-cash position of the business are included in earnings but not in cash flow.

Investment (purchase of a long-term asset) does not immediately affect earnings if the asset is valued at its purchase price. The amount of investment needs to be subtracted from earnings as part of determining (total) cash flow, because cash was spent on the purchase.

But investment would not be subtracted if, as is common, one focuses on operating cash flow (OCF). Instead, OCF mainly differs from earnings due to OCF excluding gains or losses (changes in assigned value, including depreciation) on assets, the value of inventory bought/sold, and changes in accounts receivable/payable.

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  • To simplify (removing non-cash and purchase price concepts), investments do not affect earnings, but DO affect total cash flow if paid in cash. An investment is, say, buying a building. That purchase is not a cost - the building becomes an asset. (Yes, there are future costs like depreciation, etc., but those are not relevant to the original question).
    – D Stanley
    Jul 23, 2018 at 16:04

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