In both historical and forecasted cash flow models, only the relevant cash flows should be used. I mentioned earlier that this pertains to only cash in the door and not revenues or accounting profits. At the end of the day, this means revenue minus all incremental expenses, not including depreciation or other non-cash expenses, and do include the effects of taxes. If you are looking at financial statements that include depreciation expenses, this is non-cash accounting item that represents the deterioration of an asset. In the accounting world, companies are allowed to take the expense of a capital asset over time instead of all at once up front when they show their period profit and losses on the income statement. This is achieved by “depreciating” the asset over the expected life of the asset and a charge, or depreciation expense, is applied each period. This does not represent cash out the door so should not be considered in the cash flow determination. If depreciation expenses are taken out of the historical financial information, add it back in to determine your growth rate. Taxes do result in actual cash out the door, so be sure to include the proper tax effect on the gross profits (revenue minus expenses). If depreciation was taken out before taxes, be sure to re-calculate taxes after adding back depreciation. This will result in the proper cash flow representation for an accurate website valuation. The spreadsheet included with this book is set up for you to just plug in the basic information and it does the calculating for you.

One other important cash flow issue to discuss is working capital. Working capital can be a fairly complex issue but I will try to simplify it here. Basically, working capital is the cash that needs to be extended in order to get through business operations for a given period. It primarily consists of two parts: inventory and the differential between accounts receivable and accounts payable. This item applies to your forecast only. The actual historical financial results of an operation have the effects of working capital embedded in it already. Primarily, you need to forecast for the change in working capital. It is not the working capital itself, but the change in working capital that affects your forecasted cash flows. Here is a closer look: Say you forecast a large period-to-period growth, with that growth comes more inventories (if your site sells a product and holds inventory) and bigger accounts receivable/payable differentials. By taking the historical financial data and forecasting that out, you are not considering the expenses of additional inventory since your expense line item is based on the cost of each item you sold. If you need to make larger purchases, that dollar amount affects cash flow but then all unsold items are sitting in inventory so the expense never hits the cash flow analysis. You should calculate how much additional inventory you will need on hand (not total inventory, just the amount more than purchased the prior period) and include this in the Change in Working Capital line item in the cash flow determination analysis.

Accounts receivable represents items or ad dollars that are owed to you that you have not yet received. If you sell ad clicks on your site each day but only get paid once a month there is always some dollar amount owed to you that you do not yet have. This is also true if you sell a product and the same time lag is involved. Accounts payable is just the opposite: if you pay for advertising monthly but get use out of it daily or buy your wholesale products on account, this represents accounts payable. The difference between the two is the working capital needed to run your business. Accounts receivable-accounts payable averaged over a period is a portion of working capital. The same as with inventory, it is the change in this amount that you want to capture in your cash flow forecast. You can take accounts receivable and payable as a percentage of historical sales and do the difference calculation going forward, using the forecasted revenue growth, as the model for the accounts receivable/accounts payable portion of the total change in working capital line item.

Now that we have the basis for establishing cash flows and forecasting we will look at the Simple approach vs. the more complex approach mentioned earlier. Here I will include the cash flow snapshots from the spreadsheet included with this book for each example.

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