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 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:

• CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO.
• CFO does not include cash outlays for replacing old equipment.

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 = CFO - capital expenditure

Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment.

FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv

• NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends.
• NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies.
• Int (1 - Tax rate): After-tax interest expense. Add this back to net income because:
  • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and
  • Interest expense net of the related tax savings was deducted in arriving at net income.
  The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis.
• FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets.
• WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities.

Example

Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions):

• Net income: $250
• Interest expense: $50
• Depreciation: $130
• Investment in working capital: $20
• Investment in fixed capital: $100
• Tax rate: 30%
• Net borrowing: $180
• Proust has launched a new product in the market. It has capitalized $200 as an intangible asset out of a product launch expense of $240.
• During the year, Proust has written down restructuring non-cash charges amounting to $30.
• The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

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).

FCFF = CFO + Int (1 - Tax rate) - FCInv

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.

Example

Uwe is doing a valuation of TechnoSchaft for fiscal year 2004, using the following information (in millions).

• CFO: $250
• Depreciation: $80
• Interest expense: $50
• Tax rate: 30%
• Investment in working capital: $60
• Investment in fixed capital: $240
• Net borrowing: $180

Calculate the FCFF for the company for the year.

Solution

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 = FCFF + Net borrowing - Int ( 1- Tax rate)

FCFE can be calculated from net income. Recall that FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv. Then:

FCFE = NI + NCC + Net borrowing - FCInv - WCInv

FCFE can be calculated from CFO.

FCFE = CFO + Net borrowing - FCInv

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.

Performance Ratios

• Cash flow to revenue = CFO / Net revenue: cash generated per dollar of revenue.
• Cash return on assets = CFO / Average total assets: cash generated from all resources.
• Cash return on equity = CFO / average shareholders' equity: cash generated from owner resources.
• Cash to income = CFO / Operating income: cash-generating ability of operations.
• Cash flow per share = (CFO - Preferred dividends) / number of common shares outstanding: operating cash flow on a per-share basis.

Coverage Ratios

• Debt coverage = CFO / Total debt: financial risk and financial leverage.
• Interest coverage = (CFO + Interest Paid + Taxes paid) / Interest paid: ability to meet interest obligations.
• Reinvestment = CFO / Cash paid for long-term assets: ability to acquire assets with operating cash flows.
• Debt payment = CFO / Cash paid for long-term debt repayment: ability to pay debt with operating cash flows.
• Dividend payment: CFO / Dividends paid: ability to pay dividends with operating cash flows.
• Investing and financing: CFO / Cash outflows for investing and financing activities: ability to acquire assets, pay debts, and make distributions to owners.