The evaluation of the firm’s financial performance and status of revenue in a determined time frame be it short term or long term and the financial status of the firm can be used as a reference to compare firms with the same production scheme. In a firm with stakeholders evaluate their investment to know the value of the firm. Different firms may need different approaches but the best valuation uses more than one method. Free cash flow is the measure of a company’s capacity to take assets in the initial state or primary mode of the business and generate revenue in an efficient manner.
There are three known approaches to value a firm and these are the income approach, the asset approach and the market-based business approach. The free cash flow falls under the income approach to evaluate a firm and this method estimates the net cash flow and the investment required to maintain the cash flow. It also determines the long term price at which the firm can be sold. Free cash flow method of valuing a firm is basically an internally used method which is also is also used by investors. The growth rate in the future of the firm, the cash currently used in the company as well as the benefits it generates are all aspects used to know how free cash can be used to reinvest in the firm to stimulate its growth.
Free Cash Flow
Free Cash Flow (FCF) of a company is a representation of the cash it operates with when the net-working capital and the amount needed to run the capital expenditures have been deducted. In the process to predict free cash flow, the capital expenditure with its fluctuating nature makes it difficult to assign an exact figure directly so the firm uses an average of the historical expenditures of the capital expenditure. The free cash flow is the additional amount of money that can be used to run the firm and differs from the amount currently used to operate the firm.
Firm’s analysis involving free cash flow
When a firm is in its beginning it acquires land, makes expenditures to infrastructure and gets equipment. After operating for some time it is necessary to know the free cash flow and the dividend of the investors paid. The excess amount made by the firm can be used to expand the horizons of the firm by investing in the production of new products or to reduce the debt of the firm.
FCF is estimated by investors as the best means through which they can know if the company is progressing over time. However, it should be noted that negative cash flow can exist, but this does not mean that the firm is operating in a lost but it could be a situation in which the company has reinvested all that it had earned as FCF and is expecting to make a larger gain in a long run.
FCF as a motivator for investors
Once a firm seeks to grow and make more profit, and one of the ways to do this is to get investors. An investor can be motivated by a good FCF generated and presented by the firm not only the FCF at the present state of the company but also an extrapolation of how the FCF will increase in 3 to five years. Once such information is available the investor feels secured to put his money into the company knowing it will yield him much benefit. Subsequently, if the FCF of a firm increases over time it shows that the firm can easily pay its debts, dividends and use some of the money to expand production. Similarly, the growth of the FCF with time increases the prices of stock in the firm.
The cash position of the firm
The amount of money a firm has at its disposal at a particular point in time as cash is referred to as its cash position.The cash position of a firm gives it an image of financial strength and also liquidity. The cash position is verified on daily bases by stakeholders and by investors daily and quarterly respectively using the cash flow statement to determine the firm’s performance.
Various estimate of cash flow
A number of cash flow formulae exist to calculate cash flow depending on the data and the addresses of concern.
The diversity of firms in terms of the way they do production the way they operate makes it difficult to get only one cash flow formula. As a matter of fact there exists different kinds of cash flows and hence different kinds of cash flow formulae that are used to estimate the extra cash in the firm. One of the first cash flow formula which is the simplest known form of cash flow formula is the earnings before depreciation and amortization (EBDA). This cash flow is at times called the accounting cash flow, the information used to do this calculation only requires the income statement. It is the sum of the Net income, depreciation and amortization.
It is obtained by calculating the net income based on the primary non-cash expense.
In evaluating a firm the cash flow before any interest was generated can be calculated to give the net income. After this cash flow is known the interest of the creditors and the investors of the firm can be obtained. This kind of cash flow and the formula that is used to derive it is known as earnings before interest, depreciation, and amortization (EBITDA).
The results of this mathematical cash flow formula EBITDA can be used when gathered from different firms offering the same goods and services to evaluate which one do better than the other for example by an investor who wants to choose the most likely of the firms to invest and the one with the greatest free cash flow will probably be his choice. But the EBITDA is limited in application as it does not fully represent the cash flow of a firm.
Operating cash flow
There is another cash flow formula that is used for financial analysis and this type of cash flow formula is used to calculate the cash flow that is found in the cash flow statement. In the calculation of this cash flow the cash flow formula statement takes into consideration the separation of the cash flow by investment, financing and operating cash flow activities. The key factor of cash flow when doing both the analysis and the valuation is the operational activities of the cash flow (CFO). In the calculation there is adjustment of the net income for non-cash income and expenses together with the changes in the account for working capital. The cash flow formula in this case is generated using information from the firm’s balance sheet and the firm’s income statement and it is given as follows
CFO = Net income + Depreciation + Amortization + other non-cash charges (income) – Increase in net working capital
From the above expression networking capital is the difference between the current assets and current liabilities
The relationship of net working capital and cash flow is that the more the net working capital required to run the firm the less the cash flow the firm generates. It is difficult to reinvest into the firm in such a situation. In a situation where the net working capital is low then the cash flow becomes high and there is more cash available for investment in the firm.
Free cash flow formulae
Just as a recall, free cash flow is used to estimate the firm’s long term cash flow of the firm. Free cash flow is also expressed as
Free cash flow = CFO – capital expenditure necessary to maintain the current growth
Where CFO, is the operating cash flow
It’s rather unfortunate that the cost for operating the company today might not be the same in other years eliminates the current growth in the formula above equation.
Determining Dividends Ratio
The free cash to equity is used to distribute dividends to shareholders. This is that part of the cash flow that is calculated to meet up with the debt cash flow. The debt cash flow is the initial investment that helped to run the firm’s operations before they make the free cash flow that can motivate other investors to invest knowing they will be rewarded. To apply the cash flow formula for free cash flow for equity (FCFE), the net borrowing is first determined from the difference in new debt financing and debt repayment
FCFE = operation cash flow – capital expenditures + net borrowing
FCFE = Net income + Non-cash charges (income) – capital expenditures + net borrowing
Free cash flow to the firm (FCFF)
Using the operational cash flow, the FCFF can be calculated:
FCFF = operation cash flow + [interest (1 – tax rate)] – capital expenditure
Alternatively, we can use earnings and this gives:
FCFF = EBIT (1 – tax rate) + non-cash charges (income) – capital expenditures – increase in working capital
EBIT (1-tax rate) = net income + [interest (1 – tax rate)]
Firm’s valuation using cash flow formula
Valuation of a firm is important because when it is done especially using the cash flow method, and the value of the firm is seen to be high it turns to attract investors. The forecasted free cash flow is the part of cash flow used to value a firm. The variable r, represents cost of capital, let g, represent estimated growth rate and let t, represent the period. The following cash flow formulae can be used to value a firm
In the first case of no growth of the firm we use the Perprtuity’s model cash flow formula to have the firm’s value as
Value = FCF/r
- Constant growth uses the Gordon growth model,
Value = FCF1/(r – g)
The entire run down of the activities of the company are summarized in what is called the income statement. In the income statement what is seen first is the sales or the revenues the firm obtains during the year and at the end of the day we can see the net income that comes last. The income statement as a result of carrying all financial information is also referred to as the profit statement or the lost statement.
Cash flow statement
The cash flow statement is the most important financial statement to some financial analysts because it is prepared in the firm in such a way that it links the net income to the cash flow. For this to be done the firm combines both the balance sheet of the firm and the income statement of that firm for a given period. The cash flow statement is very important to the financial analyst who is to evaluate the value of the stock of the firm in order to tell if the prices are to increase with an increase in the achievements of the firm either in terms of assets or in terms of cash. The firm’s cash flow financial statement is usually found in the annual report and if the financial data from the cash flow statement are positive in the favor of the firm it will stimulate investment for the firm.