Understanding Cash Flow

1. Understanding Cash Flow FIL 341 Prepared by Keldon Bauer

2. Cash Flow: Basic to Valuation • The basic valuation formula in finance is a discounted cash flow model:

3. Bond Valuation • Cash flows for bonds come in the form semi-annual interest and a balloon principal payment:

4. Firm Value • The value of the whole firm is therefore the present value of all expected cash flows to the equity holders and those to the debt holders. • Firm Value = Equity Value + Debt Value. • Either value is determined using the first formula presented here.

5. Firm Value • Other theorists have looked at total operating cash flows. • Discounting at the weighted average cost of capital, and subtracting the value of the debt should give us the value of the equity.

6. Cash Flow in Practice • Practitioners tend to look at several measures of cash flow: • Accounting Cash Flow • Indirect Cash Flow Statement • Direct Cash Flow Statement • Operating Cash Flow • EBITDA • EBIT • Net Cash Flow • Quick and Dirty • Free Cash Flow

7. Accounting Cash Flow • The purpose of the cash flow statement is to reconcile the balance sheet account cash and cash equivalents from one year to the next. • There are two primary formats used: • Direct: Formatted much like an income statement, where cash flows are easily interpretable. • Indirect: A list of adjustment to the income statement, reflecting the line’s cash effect.

8. Accounting Cash Flow • The direct cash flow statement would be easier for most people to understand. • The SEC allows companies to disclose direct and/or indirect cash flow statements as long as they disclose the indirect statement. • You can disclose the direct cash flow statement as well as the indirect, but you must disclose the indirect.

9. The Quasi Direct CF Statement • The analyst can go back to the income statement, and make all indicated adjustments from the indirect cash flow statement, and end up with some kind of like a direct cash flow statement. • It would then be easier for most novices to read and interpret. • Click here for Rocky Shoe example

10. Quasi Direct CF Statement • Because the direct CF statement is in the same form as the income statement, we can: • Create a common-size direct cash flow statement to spot trends. • Calculate cash flow based ratios to analyze the effectiveness of operations on cash flow. • Critique financing policies based on operating cash flows.

11. Operating Cash Flow • Many firms need to judge how much cash their operations are generating: • EBIT (Earnings Before Interest and Taxes) is used in many texts, but not by many practitioners. • EBITDA (Earnings Before Interest, Taxes Depreciation and Amortization) is used by most practitioners in corporate finance and lending. • We used both of these measures as numerators in ratios we introduced earlier in the course.

12. Net Cash Flow • Net cash flow is cash flow to the equity holders. • This is relevant in calculating value to the common stockholder or risk to the preferred shareholder. • The problem is these measures tend to be imprecise, or somewhat subjective.

13. Quick and Dirty • This is my name for this estimate, although many lenders will use it: • It is calculated by adding depreciation and amortization back to net income: CF = Net Income + Depreciation/Amortization • The problem with this method is it does not take into consideration, the cost of replacing and maintaining fixed assets.

14. Free Cash Flow • Free Cash Flow is an attempt to adjust for the problems inherent in the Quick and Dirty method. • The problem here is that the measure is never calculated with the exact same formula in two separate sources.

15. Free Cash Flow • Formulas: FCF = Operating Cash Flow – Cash Investments FCF = Operating Cash Flows – Change in Net Operating Assets FCF = Operating Cash Flows – Cash Capital Investments + Net Debt