Cash Flow is Irrelevant in the Accounting Book

The depiction in the accounting book shows how net operating assets and net financial liabilities evolve. Cash flow from the business is free cash flow (FCF) so,

NOA_t = NOA_t-1 + Operating Income_t – FCF_t

ND_t = ND_t-1  + Net Financial Expense_t – (FCF_t ‒ Net Payout to Shareholders_t)

Now, Common Shareholders’ Equity = NOA – ND so the change in Common Shareholders’ Equity is given by the first equation minus the second:

NOA_t-1 + Operating Income_t – FCF_t

‒ ND_t-1  + Net Financial Expense_t – (FCF_t ‒ Net Payout to Shareholders_t)

= Change in CSE_t = Operating Income_t – Net Financial Expense_t – Net Payout to Shareholders_t

                                                    = Comprehensive Income_{t –} Net Payout to Shareholders_t

Do you notice something? Free cash flow (FCF) drops out in the updating of shareholders’ equity! When accounting for equity with accrual accounting, free cash flow is irrelevant. That surely resonates with the point in Chapter 3 that DCF valuation based on free cash flow does not capture value added. This is accounting for value by the book.