Let us simply picture a company as a cash-based entity. Cash flows into the company in the form of revenue as it sells its products and services, and cash flows out as it pays its cash operating expenses such as salaries and taxes (except for interest expense which is a financing expense and not an operating expense). The company takes the cash that is left over and makes short term net investments in working capital (for example, in inventories and receivables), and long-term investments in property, plant and equipment (PP&E). The cash that remains is available to pay out to the company’s investors such as bond holders and shareholders. This cash that is remaining is called the free cash flows (FCF) because it is free to pay out to the company’s investors.
The FCF is nothing but the excess cash left from the gross receipts after –
- Paying all the fixed and variable operating expenses i.e., the expenses incurred in running the business, like cost of goods sold, salaries and other administrative expense
- Taxes which are to be paid on the net income of the company
- All investment in fixed assets i.e., expenditures on its property, plant, and equipment and also includes the cost of intangible assets. These are required to run the company smoothly in the long run. Imagine how would the company earn revenues in the absence of fixed assets. Even if it didn’t want to expand, the existing ones will depreciate away and the company would be required to replace them.
- Investments made that particular year on the short-term working capital in other to run the business smoothly, it is taken as the excess of net working capital of current year over the previous year.
Think of FCFF as the cash flows generated by the company’s core business. Borrowing is not generated by the company’s core business, so net borrowing has no impact on FCFF. On the other hand, think of FCFE as cash that could be given to the shareholders. Since the company has paid interest to the bond holders for the period, the remaining amount of borrowing for this period is freely available to the shareholders. Net borrowing increases FCFE.
Computing FCFF from Profit After Tax
As mentioned earlier, FCFF is the cash flow available to all the company’s suppliers of capital after operating expenses (including taxes but excluding interest payments) have been paid and necessary investments in fixed and working capital have been made.
FCFF can be calculated from Profit After Tax available to common shareholders (PAT) as follows:
FCFF = PAT + NCC + Int (1 – Tax Rate) – Capex – WCInv
Profit After Tax (PAT) or Net income (NI) is the bottom line of the Profit & Loss Statement. It represents income after depreciation, amortization, interest expense, income taxes, and dividend on preference shares (but not equity dividends).
Non-cash charges (NCC) reflect the net effect of non-cash expenses and non-cash gains on Profit After Tax. Non-cash expenses are those that do not result in an outflow of cash, but are subtracted from revenue to arrive at Profit After Tax. Since we are interested in determining cash flows here, non-cash expenses must be added back to Profit After Tax. Examples of non-cash expenses include depreciation, amortization, losses on sales of long-lived assets, non-cash restructuring charges, amortization of bond discounts, and increases in deferred tax liabilities that are not expected to reverse. Non-cash gains are those that do not result in an inflow of cash, but are added to revenue to arrive at Profit After Tax. Similarly, non-cash gains must be subtracted from Profit After Tax. Examples of non-cash gain include gains on sales of long-term assets, reversals of restructuring charges, amortizations of bond premium, and increases in deferred tax assets that are not expected to reverse. The cash flow effects of sales of long-term assets are incorporated in fixed capital investment.
The best place to find historical non-cash expenses on a company’s financial statements is the Cash Flow Statement (when presented in the indirect format).
If non-cash expenses exceed non-cash gains, the difference (net amount) is added to Profit After Tax. If non-cash gains exceed non-cash expenses, the difference (net amount) is subtracted from Profit After Tax.
An example of a non-cash restructuring charge is an asset write-down as part of a restructuring. An example of a cash restructuring charge is severance pay for laid-off employees. Therefore, there can be a difference in restructuring charges shown on the indirect cash flow statement (which presents just the non-cash amount) and the income statement (which presents the sum of cash and non-cash amounts).
| Non-Cash Item | Adjustment to PAT to arrive at FCFF |
| Depreciation | Added back |
| Amortisation and Impairment | Added back |
| Restructuring charges (expense) | Added back |
| Restructuring charges (income from reversal) | Subtracted |
| Losses | Added |
| Gains | Subtracted |
| Deferred Taxes | Added but required special attention |
The impact of interest expense (Int) on Profit After Tax must be reversed because we are trying to calculate FCFF (which represents cash flow available to all the company’s providers of capital) and interest payments are due to one of the company’s capital providers (bondholders). Therefore, interest expense net of the interest tax shield, or after-tax interest expense, Int (1 – Tax rate), is added back to Profit After Tax to determine FCFF.
Investment in fixed capital or Capital Expenditure (Capex) over the period refers to outflows of cash to purchase fixed capital (e.g., PP&E, trademarks). Investments in fixed assets must be netted off with the amount of cash proceeds from sales of fixed assets. The net amount spent on acquiring fixed capital cannot be distributed to the company’s providers of capital, hence the deduction from Profit After Tax in calculating FCFF.
Capex = Capital expenditures – Proceeds from sale of long-term assets
Note that acquisitions of fixed capital through an exchange for stock or debt will not appear on the statement of cash flows (but is required to be disclosed in the footnotes). These noncash expenditures have no impact on current FCFF, but such information should be used in developing forecasts of FCFF.
It should be noted that Capex need not strictly be in Fixed assets only. With the changing business models when companies try to keep their businesses asset-light, these Capex may even be in the form of Research & Development, Long term operating leases and sometimes even Advertisement expenses, the benefits of which are reaped over a long period.
Investment in working capital (WCInv) refers to the net increase in working capital over the period. Although working capital is generally defined as current assets minus current liabilities, for the valuation purposes, we exclude cash and short-term debt (notes payable and current portion of long-term debt) from the calculation to compute investment in working capital.
WCInv = Change in working capital over the year
Working capital = Current assets (exc. cash) – Current liabilities (exc. short-term debt)
- Cash and cash equivalents are excluded because it is the change in cash that we are trying to explain.
- Notes payable and current portion of long-term debt are excluded because they are liabilities that carry explicit interest costs, and are therefore financing rather than operating items.
Amounts spent on acquiring additional working capital cannot be distributed to the company’s providers of capital, hence the deduction from Profit After Tax in calculating FCFF.
Computing FCFF from Cash Flow from Operations (CFO)
Valuers often use cash flow from operations, CFO (taken from the Cash Flow Statement) as a starting point to calculate FCFF because CFO already accounts for adjustments (required to be made to PAT) for non-cash charges and investment in working capital.
In order to estimate FCFF starting with CFO, we must first understand the treatment of interest and dividends paid on the cash flow statement. CFO is calculated as PAT plus depreciation (NCC) minus increases (investment) in net working capital.
Under IFRS or Ind AS:
If Dividends paid is included as Operating Activity, then dividends paid to ordinary shareholders must be added back to CFO because they represent a use of cash available to providers of equity capital.
If Interest and Dividends received are classified as an investing activity, they should be added to CFO to calculate FCFF because they represent funds available to the company’s providers of capital. If they are included in operating activities, no adjustment to CFO is required.
If Interest paid is classified as a financing activity, after-tax interest expense has not been deducted from CFO, so no interest-related adjustment to CFO is required. If it is classified as an operating activity, after-tax interest expense must be added back to CFO to calculate FCFF.
Computing FCFF from EBIT
FCFF = EBIT (1 – Tax rate) + Dep – Capex – WCInv
Note that several non-cash items are charged in the income statement after the calculation of EBIT. Therefore, these charges do not need to be added back to EBIT when calculating FCFF. In our derivation, we have assumed that depreciation is the only non-cash charge that appears above (before) EBIT on the income statement.
Computing FCFF from EBITDA
FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – Capex – WCInv
Note that some non-charges affect taxes (and hence cash flow) while others do not. A noncash charge that affects taxes must be accounted for. Depreciation comes after EBITDA so we do not need to add depreciation back to EBITDA (like we did to EBIT). However, since depreciation is tax-deductible (results in tax savings, thereby increasing cash flow), we must add the depreciation tax shield, Dep(Tax rate), to EBITDA in order to calculate FCFF.
Computing FCFE from FCFF
FCFE is the cash flow available to holders of common equity after paying for all operating expenses (including taxes), making all necessary (fixed and working) capital investments and completing all transactions with other suppliers of capital (bondholders and preferred stockholders). It can be calculated by reducing FCFF by the after-tax amount of interest paid to debt holders, and adding net borrowing (debt issued less debt repaid over the period).
FCFE = FCFF – Int (1 – Tax rate) + Net borrowing
FCFE can be looked upon as the amount of cash flow available to be distributed as dividends to common shareholders. However, FCFE often differs from dividends because:
- The dividend payout ratio is established in light of investment opportunities available to the company.
- Companies try to make stable or gradually increasing dividend payments. They are very reluctant to reduce dividends even when profitability has declined.
Computing FCFE from Profit After Tax
FCFE = PAT + NCC – Capex – WCInv + Net borrowing
Computing FCFE from CFO
FCFE = CFO – Capex + Net borrowing
Computing FCFE from EBIT
FCFE = EBIT (1 – Tax rate) – Int(l – Tax rate) + Dep – Capex – WCInv + Net borrowing
Computing FCFE from EBITDA
FCFE = EBITDA(1 – Tax rate) – Int(l – Tax rate) + Dep(Tax rate) – Capex – WCInv + Net borrowing
As a summary, the flow of FCFF and FCFE from PAT may be seen as follows:
Profit After Tax
Add: Non Cash Charges
Less: Working Capital Investment [Or Changes in Non Cash Working Capital]
Cash Flow from Operations
Add: Interest x (1 – Tax Rate)
Less: Capex
Free Cash Flow for Firm (FCFF)
Add: Net Borrowing
Less: Interest x (1 – Tax Rate)
Free Cash Flow to Equity (FCFE)
To get your company valued and know more around business valuation call +91 8820001234 or email valuation@omnifinsolutions.com