Evaluation of the Sources and Uses of Cash
Analysts should assess the sources and uses of cash between the three main categories and investigate what factors drive the change of cash flow within each category. For example, if operating cash flow is growing, does that indicate success as the result of increasing sales or expense reductions? Are working capital investments increasing or decreasing? Is the company dependent on external financing? Answers to questions like these are critical for analysts and can help form a foundation for evaluating the financial health of an industry or company.
Please refer to the textbook for specific examples.
Common-Size Analysis of the Statement of Cash Flows
This topic will be discussed in detail in Reading 26 [Financial Analysis Techniques].
Free Cash Flow to the Firm and Free Cash Flow to Equity
From an analyst's point of view, cash flows from operation activities have two major drawbacks:
Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business.
The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity.
Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.
The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.
Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):
Calculate the FCFF for Proust for the year.
NCC = Depreciation + non-cash restructuring charges - Cash expenses during the year in which they are capitalized = 130 + 30 - 200 = -$40 million
FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv = 250 + (-40) + 50 (1 - 0.3) - 20 - 100 = $125 million
FCFF can also be computed from cash flow from operating activities (CFO).
The convenience of this approach to calculation of FCFF is that CFO is already adjusted for non-cash charges and changes in working capital accounts.
Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).
Calculate the FCFF for the company for the year.
FCFF = CFO + Int (1 - tax rate) - Investment in fixed capital = 250 + 50 (1 - 0.3) - 240 = $45 million
As CFO is given, information on WCInv and non-cash charges is not required.
Free Cash Flow to Equity (FCFE): Cash available to stockholders after payments to and inflows from bondholders. This is the cash flow from operations net of capital expenditures and debt payments (including both interest and repayment of principal).
FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv. Then:
FCFE can be calculated from CFO.
This is different from the formula given in the textbook since net debt repayment should be included in net borrowing!
Cash Flow Ratios
The cash flow statement may also be used in financial ratios measuring a company's profitability, performance, and financial strength.
|wundac: CFO is already adjusted for non-cash charges and changes in working capital accounts: CFO = NI + NCC - WCInv|
|uformula: how does CFO not measure equipment replacement? Wouldn't it count as an investment activity as a purchase? or an operating activity for COGS as a labor cost?|
|thammy: Precisely what u said (uformula), investment cost for the new equipment goes under CFI not CFO.|
|nayagan: do we really need to know all these formulas?|
|soorajiyer: @nayagan - Yes, according to some folks, this is heavily tested.|
| omya: Free Cash Flows = CFO - Capital Expenditure.|
Free Cash Flow to firm (Equity and Bondholders) = NI + Non cash expenses + Interest(1-t) - WC Exp - FC exp.
FCFF = CFO + Interest(1-t) - FC Exp.
Free Cash Flow to Equity = FCFF + Net borrowing - Interest(1-t).
Free Cash Flow to Equity = NI + NCC - WC -FC +Net Borrowings.
|Saxonomy: LOL @ these formulas. These people think I have all day???|
|leloupsolitaire: I hate the idea of memorizing all these formula|
| oneashok: Interest Coverage=CFO+Interest Paid+Tax Paid/Interest Outflow.|
CFO already has accounted for Interest and Tax paid. Why do we add it again in numerator.?
|majesty: The formulas are easy as they are pretty logical.|
| ybavly: @oneashok - we are looking for the percentage of operating income that will go to cover interest.|
Excluding interest from the equation will show how much of income after interest will cover interest... this is incorrect.
--we want to know how much of total income will cover interest--
|moneyguy: The memorization part of studying for this exam is very frustrating. In the real world we will have access to these. Even if all equations were provided, it would still be a scary test. Knowing how to use them is really the important part in my opinion.|
| johntan1979: Just for fun:|
FCF = CFO - CAPEX
FCFF = CFO + Int(1-t) - InvFC
and InvFC = CAPEX - sale of fixed asset
FCFF = FCF + Int(1-t) + sale of fixed asset
|Shaan23: John -- Was that fun?|
|something: Interest Coverage = EBIT/Interest paid. So how come EBIT translates to CFO + Interest paid + Taxes Paid? I thought EBIT is NI + int paid + T paid... Where am I missing..|
|fobucina: Can't FCFF also be stated as --> NOPAT (EBIT * 1-T) + NCC - Net CAPEX - WCInv ??|
|etrefemme: I think practicing with problems helps memorize the formula. The real challenge is "storing" in all this info as you progress into the curriculum. How much "going back to previous readings" can we do as the test nears. Any suggestions?|
|khalifa92: the treatment of working capital in both direct and indirect are typically the same which makes the rest of the work easier.|
|pigletin: there will only be one question on this section, if any. not worth my time.|