By James Bell
Determining Free Cash Flow is very useful in your Discounted Cash Flow valuations. Discounted Cash Flow valuations allow you to find the present value of all of the expected future cash flows. This is called the intrinsic value of the company.
Please keep in mind that while this is similar to the indirect and direct method of determing cash flows in Accounting practice, the way that we calculate cash flows in Finance is different.
If you are used to the Accounting methods, this may seem a little quick and dirty, but it is highly accepted in both academia and the professional world of finance. It is faster and used for further calculations, not for reporting.
+Depreciation and Amortization
-Capital Expenditures (CAPEX)
-Changes in Net Working Capital
= Unlevered Cash Flow
We use EBIT because it’s an easy number to grab. It’s on most 10K’s where as Earnings Before Interest After Taxes (EBIAT) typically isn’t available.
This is the dollar amount paid in taxes. While this not the tax rate as it is when we calculate Cost of Debt, multiplying EBIT by (1-tax rate) to account for taxes is another method to calculate Free Cash Flow.
We add back Depreciation and Amortization because these are non-cash expenses that reduce income to get to EBIT. We need to add these back in.
Capital Expenditures require cash. EBIT does not include payments made to acquire property, plant, and equipment. They depreciate or amortize over their useful life. This is part of backing out the accounting to get to cash flows.
This aggregates many changes to the cash flow. Essentially it is Current Assets – Current Liabilities. Current Assets include Cash, Marketable Securities, Accounts Recievable, Inventory, Deferred Tax Assets, and Short Term Notes Receivable. Current Liabilities include Accounts Payable, Short-Term Debt, Accrued Compensation & Benefits, Deferred Income, and other Accrued Liabilities.
As you can see, it’s easier to include these as one number to make our formula simpler to communicate. If you see a 10K that lists Current Assets and Current Liabilities, use that list.
This is the amount of cash available to meet financing obligations. This is the cash that we use to pay interest for the debt portion of Capital. Business desires expansion, but they need capital to do it. Both levered and unlevered cash flows are important indicators to investors. Both investors and banks look very carefully at free cash flows in determining the health of the business when making decisions about investments and debt.
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