In order to calculate the free cash flow (FCFE or FCFE), we can go back over the P&L. I’m not going to do an in-depth analysis, but I will give you a quick overview. Take a look at this –
Ideally, a company’s business activities should produce positive cash flow, which becomes their revenue. Once the cost of goods sold is paid, the company incurs expenses for sales and general administrative costs. This leaves them with ‘EBIT’ or ‘Earnings before Interest and tax’, which is an important margin metric we employ to assess companies.
The EBIT is first put towards paying the interest, resulting in Profit before tax or PBT. Afterwards, taxes for the financial year are accounted for, and the company reaches its bottom line – Profit after taxes or PAT.
It should be pretty intuitive that the source of free cash starts with a company’s operations after adjusting for costs and taxes. Identifying the true “Free cash flow” requires adding back all non-cash expenses to the Profit after taxes (PAT). This way you can easily see how much cash is available for the firm and its equity holders.
The cost of goods sold part typically involves depreciation too. This is merely a charge allocated, not a real expense. That is to say, it is an accounting entry. Similarly, amortization also fails to incur any actual cash outflow; this again being an arithmetic notation. The initial step when ascertaining the free cash flow (whether FCFE or FCFF) is increasing PAT by bringing in depreciation and amortization.
When it comes to deferred taxes, this is not an actual expense but rather a deferral of the tax payment that will occur at a future date. Therefore, it can be included in your calculations.
So we have –
PAT + Depreciation + Amortization + Deferred Taxes
We can consider this equation as our initial cash position. We also need to take into account the modifications in the company’s capital, such as working capital alterations and adjustments to the fixed assets.
In order to keep their business functioning, the company must invest in working capital. This includes funds used for regular activities such as purchase of goods on credit from suppliers, receiving prepayments from customers, stocking inventory and so forth. Working capital is represented by a balance sheet equation –
Working capital = Current Assets – Current Liabilities
Note, since both assets and liabilities are current, working capital is also current.
Assuming the normal working capital requirement for a company is 100Cr, yet due to specific circumstances it increases to 120Cr, this additional 20Cr must be taken into account when calculating free cash flow. This calculation would simply be PAT + depreciation + amortization + Deferred Taxes, reduced by this sum.
In turn, should the working capital diminish to 80Cr, 20Cr can be freed up for the company which can then be incorporated into the free cash flow calculation.
Subsequently, the company’s fixed assets must be taken into consideration. It is generally assumed that these investments will facilitate an increase in operating capital in the future. Generally speaking, the expenditure on fixed assets is predicted, however, like variations in working capital, alterations to such assets should also be taken into account.
Considering both the above, our free cash flow equation looks like this –
PAT + Depreciation + Amortization + Deferred Taxes – Change in working capital – change in fixed asset investments.
Now, here is an interesting bit. If you relook at this again –
To begin calculating free cash flow, we start with the company’s PAT. Prior to arriving at this figure, interest or finance charges have been paid out. To whom does this interest payment go? It belongs to the debt holders; thus, if we are considering free cash flow for the firm, we must factor in the interest when estimating the equation. The formula will read as follows –
PAT + Depreciation + Amortization + Deferred Taxes + Interest charges – Change in working capital – change in fixed asset investments.
The above equation is the free cash flow to the firm or the FCFF. Taking this free cash flow to the firm, you can separate out the portion dedicated to debt holders and see what belongs to equity holders. This can then be used as a way of working out a valuation for the company from an equity holder’s standpoint.
Consider the expectations of creditors from the company. While shareholders don’t view pay-outs in the same way, debt providers loan a particular sum to receive interest on top of it. Upon reaching the end of the accorded tenure, creditors expect to have their principal back in its entirety. Subsequently, after separating principal and interest in the equation for free cash flow, what’s left is ‘Free Cash Flow to Equity’.
I hope the above has been clear in explaining how to arrive at FCFF and FCFE. In the next chapter, we will be getting into more detail regarding implementation of absolute valuation within the financial model we are creating. For now, I intend to provide a general overview of what goes into the process of valuation.