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 27 [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.
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