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 = D...