LOS I requires us to:
calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.
1. Free Cash Flow to the Firm (FCFF)
FCFF is the free cash that is available to all its investors, be it the equity shareholders or the debt providers. It is the cash flow available to the suppliers of capital after all the expenditure and reinvestment are done.
The simple formula for calculating the FCFF is:
FCFF = CFO – CAPEX
Where,
FCFF = Free Cash Flow to the Firm
CFO = Cash from Operations
CAPEX = Capital Expenditures
This formula can be expanded into the following equation:
FCFF = NI + NCC + [Int. × (1 – T)] – FCI – WCI
where,
FCFF = Free Cash Flow to the Firm
NCC = Non-Cash Charges
NI = Net Income
Int. = Interest Expense
T = Tax Rate
FCI = Fixed Capital Investment
WCI = Working Capital Investment
Here, one thing that needs to be noted is that:
CFO = NI + NCC – FCI – WCI
i.e. the cash from operations includes the net income and non-cash charges, as reduced by the changes in balance sheet items that impact the working capital.
Thus, we can also re-write the equation for FCFF as:
FCFF = CFO + [Int. × (1 – T)] – FCI
Also, another point worth noting is that the interesting part (net of taxes) would only be added if the interest paid has been included in the operating activities while preparing the cash flow statement. We need to note, that IFRS gives the flexibility to include interest paid under both operating activities as well as financing activities.
Also, if the dividend paid were a part of operating activities in the cash flows, they need to be added back, and if the interest and dividend received were placed in investing activity they are also added back.
2. Free Cash Flow to Equity (FCFE)
FCFE is the value of cash flow that is available to the equity shareholders. It can be calculated using the following equation:
FCFE = CFO – FCI + Net Borrowings
3. Other Cash Flow Ratios
Performance Ratios
Some of the important performance ratios are:
Ratio |
Formula |
Interpretations |
Cash-Flow-to-Revenue |
(Cash Flow from Operations)/(Net Revenues) |
This ratio measures the operating cash flow generated per unit of revenues |
Cash-Returns-on-Assets |
(CFO)/(Average Total Assets) |
This ratio measures the operating cash flow generated per dollar of assets invested. |
Cash-to-Income |
(CFO)/(Operating Income) |
This ratio measures the cash-generating ability of operations. |
Cash- Return-on-Equity |
(CFO)/(Average Equity Shares) |
This ratio measures the cash generated per dollar of the owner’s investment |
Cash Flow per Share |
(CFO – Preference Dividends) / (Shares Outstanding) |
This ratio measures operating cash per share |
Coverage Ratios
Following major coverage ratios can be calculated using the information available from the cash flow statement:
Ratio |
Formula |
Interpretation |
Debt Coverage Ratio |
(CFO) / (Total Debt) |
This ratio is the measure of financial risk and leverage. |
Interest Coverage Ratio |
(CFO + Interest Paid + Taxes Paid) / (Interest Paid) |
This ratio measures the firm’s ability to meet its interest obligations. |
Reinvestment Ratio |
(CFO) / (Cash Paid for Long-Term Assets) |
This ratio measures the firm’s ability to acquire long-term assets with the operating cash flows. |
Debt Payment Ratio |
(CFO) / (Cash Long-Term Debt Repayment) |
This ratio measures the firm’s ability to satisfy long-term debts with the operating cash flows. |
Dividend Payment Ratio |
(CFO) / (Dividend Paid) |
This ratio measures the firm’s ability to pay dividends with the operating cash flows. |
Investing and Financing Ratios |
(CFO) / (Cash Outflows from Investing and Financing Activities) |
This ratio measures the firm’s ability to purchase assets, satisfy a debt and pay dividends with operating cash flows. |