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Free Cash Flow

 Concept of free cash flow
 Future cash flows generated from an investment that are free to
distribute to the investors (including stockholders and creditors)
that determine the value of the investment.
 Financial cash flow presents free cash flow (FCF); by “free”, we
mean it is after necessary expenses (reinvestments) needed for
continuing operations.
 Financial cash flow differs from accounting cash flow
 The accounting cash flow statement determines accounting cash flows,
which explains the change in cash and equivalents.
 The cash flow statement mixes cash flows from operating and
financing activities, so it does not directly give the information on
financial cash flow.
Cash Flows and Financial Forecast 1

Free Cash Flow
FCF=(R-E)*(1-t)+t*Dep-cap exp- change in WC

 The FCF formula
Cap. Exp

Free cash flow (FCF) = OCF – NCS – NWC
 Operating cash flow (OCF): from a company’s normal

business activities; typically calculated based on EBIT or
net income.
Top down!

OCF = EBIT + Depreciation – Taxes
= EBIT( 1 – Tax rate) + Depreciation
where, Taxes = EBIT × Tax rate

Bottom up

OCF = Net income + Depreciation + (1– Tax rate) Interest expense
where, Net income = ( EBIT – Interest expense)(1– Tax rate)
Unleavened CF , irrelevant to capital structure!!
Cash Flows and Financial Forecast 2

Free Cash Flow
 Investment on fixed assets
 Net capital spending (NCS), or capital expenditure, represents
the amounts paid by the firm for investments in fixed assets,
which is the net money spent on fixed assets less money
received from sales of fixed assets.

 NCS is a function of how fast a firm is growing or expecting to
grow. High growth firms will have much higher capital spending
than low growth firms.
 Given changes in net fixed assets, NFA, and depreciation, net
capital spending is calculated as:
NCS = NFA + Depreciation
Note: Ending NFA = Beginning NFA – Depreciation+ NCS
Cash Flows and Financial Forecast 3

Free Cash Flow  Investment on working capital  Increase in net working capital. For valuation purposes. the calculation of NWC needs to exclude the effects of non-operating current assets and liabilities (next slide). NWC. NWC is the difference between current assets (cash. NWC= cash+inventory+receivable-payable Cash Flows and Financial Forecast 4 . inventory and accounts receivable) and current liabilities (accounts payable and debt due within the next year). represents the firm’s investment on its working capital. NWC = Ending NWC – Beginning NWC  In accounting terms.

Free Cash Flow  Non-operating CA and CL Some components of the accounting measures of current assets and current liabilities (such as excess cash and debt interests) are not operation or production related.  Cash: When a company increased its cash by increasing retained earnings (reducing dividend payment). does increased cash mean reduced free cash flow?  Short-term debt: When a company changed its capital structure by borrowing less while raising more equity capital. does the reduction in short-term debt mean reduced free cash flow? Cash Flows and Financial Forecast 5 . and hence their changes do not adequately reflect requirement for working capital investment.

we often determine NWC as a proportion of revenues. an increases (decreases) in working capital will reduce (increase) FCF in that period. a cleaner definition of working capital from the cash flow perspective is: NWC = Non-cash CA – Non-debt CL As any investment in this measure of working capital ties up cash. This alternative method is the “percentage-of-sales” approach to financial forecast.  Working capital calculated using above formula tends to be volatile from year to year. which is to be discussed below. alternatively.Free Cash Flow  Therefore. So. Cash Flows and Financial Forecast 6 .

462 $1. respectively. The following table reports its current assets and current liabilities at the end of the 2013 and 2014 financial years. has substantial working capital needs.067 Short-term debt $392 $395 Other non-debt CL $778 $702 Cash Flows and Financial Forecast 7 . as a retailer.Free Cash Flow  Example: The Gap.704 $285 $335 2013 2014 Accounts payable $806 $1. Current assets Cash Inventory Other non-cash CA Current liabilities 2013 2014 $466 $350 $1.

predict changes in NWC for 2015-2017.450 $286 1.Free Cash Flow  The following table summarizes the calculations of NWC in years 2013 and 2014 as a percent of revenues.0% $107 $13.841 $306 1. If NWC will change proportionally with sales at the average percent of sales during 2013-2014.635 Forecast 2015E 2016E 2017E $263 1.584 $163 2014 $2. History Non-cash CA Non-debt CL NWC NWC as % of revenues NWC Revenues 2013 $1.020 Cash Flows and Financial Forecast 8 .747 $1. and 7% in 2017.039 $1.7% $20 $18.7% $23 $16.7% -$7 $15.  Suppose that revenues will grow at 13% in 2015. 9% in 2016.769 $270 1.673 $11.4% 2.

243 – 291) – (1.709 – 1.644 + 65 = $130 Based on operating CA and CL: NWC = Ending NWC – Beginning NWC = (1.Free Cash Flow  Example: Calculating FCF (using next two slides) OCF = EBIT + Depreciation – Taxes = 694 + 65 – 208 = $551 NCS = Ending NFA – Beginning NFA + Depreciation = 1.008 – 271) = $215 FCF = 551 – 130 – 215 = $206 Cash Flows and Financial Forecast 9 .

Free Cash Flow Global Corporation 2012 Income Statement ($million) Net sales (Revenues) Cost of goods sold (COGS) Depreciation Earnings before interest and taxes (EBIT) Interest paid Taxable income (EBT) Taxes (at 30%) Net income (NI) Dividends Addition to retained earnings $1.509 750 65 $ 694 70 $ 624 187 $ 437 $109 328 Cash Flows and Financial Forecast 10 .

112 Liabilities and Equity 2011 2012 Current liabilities: Accounts payable Notes payable Accrued expenses Total current liabilities $232 157 39 $428 $266 98 25 $389 Long-term debt $408 $454 Owners’ equity Common stock and paid-in surplus Retained earnings Total equity Total liabilities and equity 600 640 1.233 Intangible assets and others 411 Total fixed assets $1.112 Cash Flows and Financial Forecast 11 .280 429 $1.Free Cash Flow Global Corporation 2012 and 2013 Balance Sheet ($millions) Assets Current assets: Cash and equivalents Accounts receivable Inventory Total current assets 2011 $104 455 553 $1. plant and equip.403 $1.756 $3.756 2012 $160 688 555 $1.920 $2.629 $1. $1.709 $3.269 $2.644 Total assets $2.112 Fixed assets: Property.320 1.

Cash Flows and Financial Forecast 12 .1-31/12 China  From most recent half-year or quarterly reports  Most recent annualized earnings  Most recent balance sheet items  May have to use some items from latest annual report  Example on the next slide Make sure earning is updated  Obtaining the updated earnings information is particularly important for smaller and more volatile firms.Adjusting Earnings  Obtaining most recent financial information  Constructing “trailing 12-month” data 7/1-6/30 1.

Updated Financial Status Sept 2009 Mar 2010 Sept 2010 Mar 2011 Sept 2011 April 11 Bs: direct use half yearly INCOME ITEM: Cash Flows and Financial Forecast 13 .

 R&D expenses do not show up on the balance sheet as part of the total assets of the firm. Cash Flows and Financial Forecast 14 .  R&D expenses are included in operating expenses.  Accounting standards however require that all R&D spending be expensed in the period in which they occur.Adjusting Earnings  Adjustments for R&D expenses  R&D expenses are to generate future growth. so are long-term investment in nature. Hence.  To capitalize R&D expenses  Correct earnings & shareholder equity for R&D expenses  R&D assets need to be amortized.

The assets from R&D expenses equals the sum of all unamortized portions of all previous years’ R&D expenses.Adjusting Earnings  The effect of R&D expenses on equity Adjusted equity = Equity + Value of R&D assets As capital investment. Cash Flows and Financial Forecast 15 . and are amortized over time.  The effect of R&D expenses on earnings Adjusted operating earnings = Operating earnings EBIT + Current-year’s R&D expenses – Amortization of R&D assets where amortization is the total amortization of all assets from R&D expenses of previous years. R&D expenses increase long-term assets and hence equity.

Updated Financial Status Year 1: Adjusted Equity : Cash Flows and Financial Forecast 16 .

Adjusting Earnings  Adjustments for lease expenses Operating lease vs Finance lease OL shorter than item life Else for 10 year VS 30 year  Operating lease expenses are financial expenses.  Converting operating leases into debt Adjusted debt = Debt + Value of lease commitments where value of lease commitments equals the present value of lease commitments discounted at kd. but are treated as operating expenses (often revealed in footnotes).  The effect on operating earnings Adjusted operating earnings = Operating earnings + (Operating lease expenses – Depreciation on leased assets)  Operating earnings + Value of lease × RD Cash Flows and Financial Forecast 17 .

every 3 years). In this case.. and not one-time items. Cash Flows and Financial Forecast 18 . but still recur at some regular intervals (e.g.Adjusting Earnings  Extraordinary and unusual items Earnings that can be used as a basis for projections should reflect continuing operations. a large restructuring charge): should be excluded in the calculation of earnings..  One-time expense or income items (e. one option is to spread the expense out by calculating its effect on earnings annually.g.  Some items may appear less frequently than annually.

 With the percentage-of-sales approach  We start with sales forecast. Cash Flows and Financial Forecast 19 .  Then the needs for external financing can be identified. we can obtain the financial statement forecast based on a sales forecast. we determine pro-forma (forecasted) financial statements.  Then based upon it.Forecast and Cash Flows  Forecast using the percentage-of-sales approach  When most balance sheet and income statement accounts vary with sales.

Forecast and Cash Flows Determine the growth of company  Sales forecast  Sales forecast is the starting point of financial forecast. and is key to long-term planning. and make reasonable assumptions about the future overall market for the company’s products.  Get help in estimating sales from businesses that specialize in macroeconomic and industry projections Cash Flows and Financial Forecast 20 .  Perfect knowledge is impossible since sales depend on the uncertain future state of the economy  Try to identify all valuable investment opportunities within the company.

 Managerial efficiency.  More useful for more analyst coverage (e..  Less reliable for greater variation in analyst forecasts. for larger firms).  Understanding fundamental factors Know about the company.g. payout policy. including other public information and even private information. financing policy  The company’s long-term plan Cash Flows and Financial Forecast 21 .Forecast and Cash Flows  Using historical growth information to predict future growth  Historical average growth Technical analysis  Liner or log-linear regression models  More sophisticated time series models  Using information from analyst forecasts of earnings growth  Analyst forecasts of growth can be better because they can use information other than historical.

 To obtain free cash flows.  For items that do not necessarily change directly with sales.Forecast and Cash Flows  Income statement forecast  For many income statement items that vary directly with sales (e. Interest / dividend. costs). For example:  Interest expense depends on debt. we only need to forecast income items down to EBIT. Mature companies in developed countries hv stable dividend policy.g. understand the specific mechanism. Not relate to SALES Cash Flows and Financial Forecast 22 . But China and HK don't usually pay dividend.  Dividends depend on the firm’s payout policy. use historical data to determine their relations with (as a percent of) sales.

the safer choice is the marginal tax rate.  If the same tax rate has to be applied to earnings every period.  Most of the taxable income of publicly traded firms is at the highest marginal tax bracket. marginal tax rate  The effective tax rate is computed from the reported income statement as: Effective tax rate = Taxes due / Taxable income  The marginal tax rate depends on the tax code and reflects what firms have to pay as taxes on their marginal income.MTR not useful in near future. Cash Flows and Financial Forecast 23 .Forecast and Cash Flows  Effective vs. .  Most tax-reduction benefits cannot sustained in perpetuity. Use the highest. Suffer loss.

The second approach is often used when the firm already has positive earnings but has a large net operating loss carried forward.Forecast and Cash Flows  The effect of net operating losses  There are tax savings for firms having large net operating losses carried forward or continuing operating losses. and then adding them up. Change gradually from 0 to MTR  Approach 2: Valuing the expected tax savings generated by net operating losses and the firm without considering the tax savings separately. There are two ways of capturing this effect:  Approach 1: Changing tax rates over time (from zero to positive and then to the marginal tax rate). Cash Flows and Financial Forecast 24 .

long-term debt. Fixed asset :%/sales  Notes payable. Cash Flows and Financial Forecast 25 .  Change in the retained earnings portion of equity will come from the dividend decision. Ending retained earnings = Beginning retained earnings + (Net income – Dividends) BS: State variable IS: flow variables. use historical data to determine their relations with (as a percentage of) sales. they depend on management decisions on capital structure.Forecast and Cash Flows  Balance sheet forecast  For assets items that vary directly with sales. and equity generally do not vary with sales.

You may hv too much cash.Forecast and Cash Flows  External funding needed (EFN) LTD/ SH equity : No relationship with SALES. OR increase RE -: make future investment or just pay dividend. So need EFN. ( special dividend ) Cash Flows and Financial Forecast 26 . EFN = Total assets – (Liabilities + Shareholders’ equity)  Understanding EFN To support yr forecast . u need more fund to support your asset. +: need to decide how to get additional capital . Imbalance: LHS&RHS. +EFT: need more Equity or debt.  Negative or positive EFN  Dealing with EFN: the firm’s financing strategy  Evaluating the financial forecast and plan -EFN: asset requirement is less than what u load.  External funding needed: the difference between the forecast increase in assets and the forecast increase in liabilities and equity.

internal financing will not be enough. internal financing (retained earnings) may exceed the required investment in assets. stock market conditions)  To borrow money (cost of debt. credit risk)  Is the sales growth forecast realistic? FF need revise and revise again and then achieve balance. and the company can do the following:  To increase profit margin (higher operating efficiency) More realistic.  At high levels of growth. Make sure it is realistic ! Cash Flows and Financial Forecast 27 .Forecast and Cash Flows Get additional finance:  Growth and (internal & external) financing  At low levels of growth. This is called FINANCIAL PLANNING --company's LT plan. !!!!!  To increase asset turnover (higher asset-use efficiency)  To reduce dividend payout (more internal financing)  To raise equity capital (cost of equity.

started refrigeration and electric supply with a single refrigeration and electric supply store on East Markham Street in Little Rock. ventilation. Carl Miller Sr. Arkansas in 1935. located in Little Rock. air conditioning and refrigeration industry). Arkansas. Cash Flows and Financial Forecast 28 . The company currently has an annual revenue of $10 to 20 million and employs a staff of 20 to 50.Financial Forecast: Example R&E Supply is a modest-size wholesaler of plumbing and electrical supplies (in the heating.

December 31 ($thousand) 2002 2003 2004 2005* Cash Flows and Financial Forecast 29 .Financial Statements for R&E Supplies. Inc.

2002 2003 2004 2005* Didn't issue additional and repurchase Cash Flows and Financial Forecast 30 .

86 12 28 14 45 50 Cash Flows and Financial Forecast 31 . expenses (% sales) Total current assets (% sales) Current liabilities excluding debt (% sales) 84 9 28 9 Tax/earnings before tax Dividends/earnings after tax Other ratios in percent (%) 45 45 45 45 50 50 50 50 2006 25% Average. Forecast 2005 28% Ratios tied to sales (%) 85 86 86 9 10 11 27 29 27 11 15 16 Cost of goods sold (% sales) General.Financial Forecast: Example  Selected historical financial ratios History Annual growth rate in sales 2002 -- 2003 23% 2004 17% . selling & admin.

092 76 439 198 $ 241 Comments 25% increase 86% of sales 12% sales 45% tax rate Cash Flows and Financial Forecast 32 . 2006 Income Statement (December 31. $thousand) Net sales Cost of goods sold Gross profit Expenses: General.assuming LTD doesn't change ! Tax Earnings after tax $ 25.Financial Forecast: Example  Pro forma income statement.607 3. 2006. Earnings before tax .766 22. selling and admin expenses Net interest expense (760 @ 10%) 15:LTD.159 3.

2006 Balance Sheet (December 31. $thousand) Assets Current assets Net fixed assets Total assets $ 7.217 External funding required $ 1.Financial Forecast: Example  Pro forma balance sheet.214 412 7.6% sales As in 2005 14% sales Existing debt As in 2005 As explained Cash Flows and Financial Forecast 33 .607 3.707 660 150 1. 2006.700 $ 6.626 Liabilities and Owners’ Equity Current portion of long-term debt Other current liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and owners’ equity 100 3.409 Comments 28% sales 1.

which in turn depends on the external funding required. $760 thousands.626 .409 = $7. without taking into account any new debt needed in the year. on the other hand. Complicated. the required $1409: need at external funding depends on interest expenses.217  Interest expense  The interest expense is calculated for existing debt at the beginning of the financial year.end of the year: NP.580 + $241 .700 = $1. then there would be a circularity problem: On the one hand. WE assume interest expense at the beginning of year based on existing level of debt !! Cash Flows and Financial Forecast 34 .  If interest expense needs to be calculated for both existing and new debt. -start of the year : CP! Change interest expense and then change the ETN again.$6. . interest expenses depend on total debt.Financial Forecast: Example  Balance-sheet items  Retained earnings: $1.$121  External funding needed: $1. WONT affect current year interest expense.

6% 14.0% 86. & admin.0% 12. sell.Forecasting with a Computer Spreadsheet: Pro-Forma Financial Forecast for R&E Supplies ASSUMPTIONS BOX A 1 2 Year 3 4 5 6 7 8 9 10 11 12 13 14 15 Net sales Growth rate in net sales Cost of good sold/net sales Gen.0% 50..0% 45.730 Cash Flows and Financial Forecast 35 .0% 28.613 $760 $100 25.0% 1. expenses/net sales Long-term debt Current portion long-term debt Interest rate Tax rate Dividend/earnings after tax Current assets/net sales Net fixed assets Current liabilities/net sales Owners' equity C B 2005 Actual 2006 $20.0% $1.0% $660 $100 10.

exp.627 Current liabilities without debt Long-term debt Equity Total liabilities & shareholders' equity =C14*C19 =B7 =B15+C28 =C35+C36+C37 3. sell.851 6.092 76 439 198 242 121 121 $1.766 22.159 3.218 External Capital Required =C33-C38 $25.215 412 7.607 760 1. Interest expense Earnings before tax Tax Earnings after tax Dividends paid Additions to retained earnings =B3+B3*C4 =C5*C19 =C19-C20 =C6*C19 =C9*(C7+C8) =C21-C22-C23 =C10*C24 =C24-C25 =C11*C26 =C26-C27 Balance Sheet (2006) Current assets Net fixed assets Total assets =C12*C19 =C13*C19 =C31+C32 7.16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 A B Equations C Forecast Income Statement Forecast (2006) Net sales Cost of goods sold Gross profit Gen.607 3.409 Cash Flows and Financial Forecast 36 . & admin.

external funding required) to a single factor (e. Cash Flows and Financial Forecast 37 . which deepen our understanding of the project and help us make a better decision (though we don’t get any guidance as to what to do)..g. holding other factors constant  Scenario analysis: determining the effect on our forecast by changing a set of factors at a time Scenario and sensitivity analyses generate various possibilities some are good and some are bad. sales growth or the cost of goods sold). which is unavoidable because uncertainty is involved in financial planning  Sensitivity analysis: identifying the sensitivity of a key decision variable (e.Sensitivity and scenario analyses  Forecasting risk: the possibility that errors in projected cash flows will lead to incorrect decisions..g.