Many people believe that the measure of a company's performance is its profitability. However, many of the items of expense and income that are recorded on the balance sheet are not tied to real money. We are talking about depreciation charges and exchange rate revaluations of assets. Also, part of the profit goes to capital costs and ongoing activities. Free cash flow gives you a real understanding of the amount of money you earn.
Place of free cash flow among other financial indicators
During the operation of an enterprise, several types of cash flows arise. The total (gross) amount of money is recorded in the NCF () indicator, which is formed on the basis of the summation of all positive and negative financial transactions from the investment, financial and operating activities of the company. However, another indicator is much more expressive.
Free cash flow (FCF – ) is the amount of money that remains at the disposal of owners and investors after deducting all taxes and capital investments. In effect, it is cash that increases a company's shareholder value and expands its asset base. If FCF has a good positive indicator, then the company can develop and produce new products, pay increased dividends, acquire assets, and therefore become more attractive to its shareholders.
How is free cash flow calculated?
In the activities of any enterprise, there are two main types of free cash flows:
- Free enterprise flow (FCFF) is cash after subtracting capital expenditures and taxes, but before calculating interest. It is used to understand the real value of the enterprise itself and is important for lenders and investors.
- Free flow on equity (FCFE) is the cash remaining after borrowing interest, taxes, and operating expenses have been subtracted. The indicator is important for owners and shareholders, as it assesses the shareholder value of the company.
- net investments in working capital;
- net investments in fixed capital;
- money from the operating activities of a business after taxes.
The first two items are taken from the balance sheet. 
To search for an indicator free flow of enterprise The most commonly used formula is:
wherein:
- Tax – amount of income tax;
- DA – indicator of depreciation of assets (intangible and tangible);
- EBIT – profit before all taxes;
- ∆WCR – the amount of capital expenditures, the term CAPEX can also be used;
- CNWC – dynamics of working net capital (expenses for the purchase of new assets). It is calculated according to this principle: (Zi + ZDi – ZKi) – (Zo + ZDo – ZKo), where Z – inventories, ZD – accounts receivable, ZK – accounts payable. From the sum of these indicators for the current period (index i) the sum of similar values for the previous time period is subtracted (indexo).
There are other payment options. For example, in 2001 the following methodology was proposed:
wherein:
- CFO refers to the amount of money from a company's operating activities;
- Tax – income tax (interest rate);
- Interest expensive – interest costs;
- CFI – funds from investment activities.
Some use the simplest formula to calculate the value of the desired indicator:
FCFF = NCF – CAPEX , Where
- NCF – net cash flow;
- CAPEX – capital expenditures.
The FCFF flow is created by the company's assets (operating and production) and sent to investors, so its value is equal to the total amount of payments, this rule also applies in the reverse order. This rule is called the cash flow identity and is written graphically as follows: FCFF =FCFE (finance to owners) +FCFD (finance to creditors)
Index free flow on your capital(FCFE) indicates the amount remaining at the disposal of shareholders and owners after settlement of all tax obligations and mandatory investments in the operating activities of the enterprise. The most important criteria here are:
- NI (Net Income) – the company’s net profit, its value is taken from the accounting report;
- DA (Depletion, Depreciation & Amortization) - depreciation, depletion and wear, an accounting indicator;
- ∆WCR (CAPEX) – costs of current activities (capital expenditures), they can be found in the report on investment activities.
Ultimately, the general formula looks like this:
In addition to the abbreviations explained above, some more are used here:
- Investment – the volume of investments made by the company in short-term assets, source – balance sheet;
- Net borrowing is the delta between already repaid and newly received loans, source – financial statements.
However, some “expenditure” items (for example, depreciation) do not lead to actual expenditure of funds, so a slightly different system for calculating this indicator is often used. Here we use the amount of cash flow from production operations, which already takes into account changes in working capital, net profit, the indicator is also adjusted for depreciation and other non-cash transactions:
FCFE = CFFO - ∆WCR + Net borrowing
In fact, the main difference between the types of free cash flows discussed is that FCFE is calculated after debts are received (paid), and FCFF is calculated before that.
Billionaire Warren Buffett uses the most conservative method for assessing this indicator, which he calls Owner's earnings. In his calculations, in addition to the usual indicators, he also takes into account the average annual amount of funds that should be invested in fixed assets to maintain a market competitive position and production volumes in the long term.
How is FCF used in practice?
Ideally, a stable operating enterprise in a normal economic situation should have a positive FCF indicator at the end of the year or other reporting period. This state of affairs allows the company to repay all its obligations in a timely manner, as well as expand (produce new products, modernize equipment, diversify markets, open new facilities).
In other words, the owner can withdraw the FCF amount from circulation without the risk of reducing the company’s capitalization and losing its market position.
If FCF is above zero, it means the following:
- timely payment of dividends to shareholders;
- increase in the value of the company's securities;
- the possibility of carrying out an additional issue of shares;
- the owners and management of the enterprise are effective managers.
If free cash flow is negative, this may indicate two possible options for the company's state:
- the enterprise is unprofitable;
- The management of the enterprise invests large amounts of money in its development, which can provide returns in the long term due to the high level of profitability.
To understand the real state of the company, it is necessary, in addition to the current situation, to also study its development strategy. To increase the value of a company, you need to use growth levers, which include:
- tax optimization;
- review of the direction of capital investments;
- increasing revenue and reducing costs to increase EBIT;
- bringing assets to an acceptable minimum by increasing their efficiency.
Investors often use the free cash flow indicator to calculate a number of statistical and dynamic coefficients that evaluate the operating efficiency and profitability of an enterprise, including IRR (internal rate of return), DPP (discounted payback period), ARR (investment project profitability), NV (current value ).
An organization's cash flow is the receipts (inflows) and payments (outflows) of its cash and cash equivalents. Cash inflows are also often referred to as positive cash flows, while cash outflows are often referred to as negative cash flows. What is meant by net cash flow?
What is net cash flow?
Net cash flow is the difference between an organization's positive and negative cash flows over a given period. This indicator, often abbreviated as NCF (Net Cash Flow), is widely used in assessing the attractiveness of investments, as well as in comparing different investment options. After all, if NCF is greater than zero, i.e., cash inflows exceed their outflows, the investment is considered effective. Of course, it is advisable to calculate the indicator over a relatively long period of time, including the payback period for investments. The effect of time in the calculation can be taken into account by applying .
Net cash flow in financial statements
Information about the organization's net cash flows for the reporting period can be obtained from financial statements. For greater analyticality, the organization’s net cash flows can be examined in the context of current, investment and financial operations.
Thus, the net cash flow from current operations for the reporting period corresponds to the amount reflected in line 4100 “Balance of cash flows from current operations” of the Cash Flow Statement, the net cash flow from investment operations corresponds to the amount reflected in line 4200 “Balance of cash flows from investment operations” ”, and from financial transactions - the amount on line 4300 “Balance of cash flows from financial transactions”.
The formula for determining the total net cash flow of an organization for the reporting period according to the Cash Flow Statement is extremely simple. This indicator corresponds to the balance of line 4400 “Balance of cash flows for the reporting period.” Both in the context of operations and in total, the net cash flow of an organization can be either positive when inflows exceed outflows of funds, or negative when the situation is reversed.
What is FCF
By definition, FCF (Free Cash Flow) represents the cash for a certain period that a company has after investing in maintaining or expanding its asset base (Capex). It is a measurement of a company's financial performance and health.
There are two types of free cash flow: free cash flow to the firm (FCFF) and free cash flow to shareholders (FCFE).
Free cash flow (FCF) is the cash flow available to all investors in a company, including shareholders and creditors.
This indicator is not a standardized accounting indicator, i.e. you won't be able to find it in the company's reporting. Company management can calculate FCF separately and uses it to visualize the company's financial position. Most often, the calculated FCF can be found in a company presentation, press release, or management's analysis of the company's financial condition and results of operations (MD&A).
There are 3 main methods for calculating FCF
The choice of calculation method depends on how deeply you want to analyze the company’s cash flows and on what data the indicator is calculated (historical or forecast).
1 way- the simplest, designed for the initial assessment of the company’s cash flows based on actual data:
FCF = Net cash flows provided by operating activities - capital expenditures (Capex).
That is, from the money received during the period from core activities, we subtract capital costs for maintaining or expanding production.
Let's calculate free cash flow for the first quarter of 2018 using the example of Severstal.
We can take all the calculation values from the company's cash flow statement.
We can find capital expenditures in the investment activity report. In this case, they consist of two articles - Acquisition of fixed assets + acquisition of intangible assets.
(The figure corresponding to the line in the reporting above is signed in brackets).
Method 2- more complex, which reveals in more detail the reasons for changes in free cash flow:
FCF = EBITDA - income tax paid - capital costs (Capex) - changes in working capital (NWC, Net working capital change)
Let's analyze the types of cash flows of an enterprise: the economic meaning of the indicators - net cash flow (NCF) and free cash flow, their construction formula and practical examples of calculation.
Net cash flow. Economic sense
Net cash flow (EnglishNetCashflow,NetValueNCF, present value) – is a key indicator of investment analysis and shows the difference between positive and negative cash flow for a selected period of time. This indicator determines the financial condition of the enterprise and the ability of the enterprise to increase its value and investment attractiveness. Net cash flow is the sum of the cash flow from the operating, financing and investing activities of an enterprise.
Consumers of the net cash flow indicator
Net cash flow is used by investors, owners and creditors to evaluate the effectiveness of an investment in an investment project/enterprise. The value of the net cash flow indicator is used in assessing the value of an enterprise or investment project. Since investment projects can have a long implementation period, all future cash flows lead to the value at the present time (discounted), resulting in the NPV indicator ( NetPresentValue). If the project is short-term, then discounting can be neglected when calculating the cost of the project based on cash flows.
Estimation of NCF indicator values
The higher the net cash flow value, the more investment attractive the project is in the eyes of the investor and lender.
Formula for calculating net cash flow
Let's consider two formulas for calculating net cash flow. So net cash flow is calculated as the sum of all cash flows and outflows of the enterprise. And the general formula can be represented as:
NCF – net cash flow;
C.I. (Cash Inflow) – incoming cash flow, which has a positive sign;
CO (Cash Outflow) – outgoing cash flow with a negative sign;
n – number of periods for assessing cash flows.
Let us describe in more detail the net cash flow by type of activity of the enterprise; as a result, the formula will take the following form:
Where:
NCF – net cash flow;
CFO – cash flow from operating activities;
CFF – cash flow from financing activities;
Example calculation of net cash flow
Let's look at a practical example of calculating net cash flow. The figure below shows the method of generating cash flows from operating, financing and investing activities.
Types of cash flows of an enterprise
All cash flows of an enterprise that form net cash flow can be divided into several groups. So, depending on the purpose of use, the appraiser distinguishes the following types of cash flows of an enterprise:
- FCFF is the free cash flow of the company (assets). Used in valuation models for investors and lenders;
- FCFE – free cash flow from capital. Used in models for assessing value by shareholders and owners of the enterprise.
Free cash flow of the company and capital FCFF, FCFE
A. Damodaran distinguishes two types of free cash flows of an enterprise:
- Free cash flow of the company (FreeCashFlowtoFirm,FCFFFCF) is the cash flow of an enterprise from its operating activities, excluding investments in fixed capital. A firm's free cash flow is often simply called free cash flow, i.e. FCF = FCFF. This type of cash flow shows how much cash the company has left after investing in capital assets. This flow is created by the assets of the enterprise and therefore in practice it is called free cash flow from assets. FCFF is used by the company's investors.
- Free cash flow to equity (FreeCashFlowtoEquity,FCFE) is the cash flow of an enterprise only from the equity capital of the enterprise. This cash flow is usually used by the company's shareholders.
A firm's free cash flow (FCFF) is used to assess enterprise value, while free cash flow to equity (FCFE) is used to assess shareholder value. The main difference is that FCFF evaluates all cash flows from both equity and debt, while FCFE evaluates cash flows from equity only.
The formula for calculating the free cash flow of a company (FCFF)
EBIT ( Earnings Before Interest and Taxes) – earnings before taxes and interest;
СNWC ( Change in Net Working Capital) – change in working capital, money spent on the acquisition of new assets;
Capital Expenditure) .
J. English (2001) proposes a variation of the formula for a firm's free cash flow, which is as follows:
CFO ( CashFlow from Operations)– cash flow from the operating activities of the enterprise;
Interest expensive – interest expenses;
Tax – interest rate of income tax;
CFI – cash flow from investment activities.
Formula for calculating free cash flow from capital (FCFE)
The formula for estimating free cash flow of capital is as follows:
NI ( Net Income) – net profit of the enterprise;
DA – depreciation of tangible and intangible assets;
∆WCR – net capital costs, also called Capex ( Capital Expenditure);
Investment – the amount of investments made;
Net borrowing is the difference between repaid and received loans.
The use of cash flows in various methods for assessing an investment project
Cash flows are used in investment analysis to evaluate various project performance indicators. Let's consider the main three groups of methods that are based on any type of cash flow (CF):
- Statistical methods for evaluating investment projects
- Payback period of the investment project (PP,PaybackPeriod)
- Profitability of an investment project (ARR, Accounting Rate of Return)
- Current value ( N.V.NetValue)
- Dynamic methods for evaluating investment projects
- Net present value (NPVNetPresentValue)
- Internal rate of return ( IRR, Internal Rate of Return)
- Profitability index (PI, Profitability index)
- Annual annuity equivalent (NUS, Net Uniform Series)
- Net rate of return ( NRR, Net Rate of Return)
- Net future value ( NFV,NetFutureValue)
- Discounted payback period (DPPDiscountedPayback Period)
- Methods that take into account discounting and reinvestment
- Modified net rate of return ( MNPV, Modified Net Rate of Return)
- Modified rate of return ( MIRR, Modified Internal Rate of Return)
- Modified net present value ( MNPV,ModifiedPresentValue)
All these models for assessing project performance are based on cash flows, on the basis of which conclusions are drawn about the degree of project effectiveness. Typically, investors use the firm's free cash flows (assets) to evaluate these ratios. The inclusion of free cash flows from equity in the formulas for calculating allows us to focus on assessing the attractiveness of the project/enterprise for shareholders.
Summary
In this article, we examined the economic meaning of net cash flow (NCF) and showed that this indicator allows us to judge the degree of investment attractiveness of the project. We examined various approaches to calculating free cash flows, which allow us to focus on valuation for both investors and shareholders of the enterprise. Increase the accuracy of the assessment of investment projects, Ivan Zhdanov was with you.
The company's profit, which is shown in the income statement, should in theory be an indicator of the effectiveness of its work. However, in reality, net profit is only partially related to the money a company makes in real terms. How much money a business actually makes can be found out from the cash flow statement.
The fact is that net profit does not fully reflect the money received in real terms. Some of the items in the income statement are purely “paper”, for example, depreciation, revaluation of assets due to exchange rate differences, and do not bring in real money. In addition, the company spends part of its profits on maintaining its current activities and on development (capital costs) - for example, the construction of new workshops and factories. Sometimes these costs can even exceed the net profit. Therefore, a company may be profitable on paper, but in reality suffer losses. Cash flow helps assess how much money a company actually makes. A company's cash flows are reported on the cash flow statement.
Company cash flows
There are three types of cash flows:
- from operating activities - shows how much money the company received from its core activities
- from investment activities - shows the movement of funds aimed at developing and maintaining current activities
- from financial activities - shows the flow of funds from financial transactions: raising and paying off debts, paying dividends, issuing or repurchasing shares
The summation of all three items gives net cash flow - Net Cash Flow. It is reported in the report as Net increase/decrease in cash and cash equivalents. Net cash flow can be either positive or negative (negative is indicated in parentheses). It can be used to judge whether the company is making money or losing it.
Now let's talk about what cash flows are used to value a company.
There are two main approaches to business valuation - from the point of view of the value of the entire company, taking into account both equity and debt capital, and taking into account the value of only equity capital.
In the first case, cash flows generated by all sources of capital—own and borrowed—are discounted, and the discount rate is taken as the cost of attracting total capital (WACC). The cash flow generated by all capital is called the firm's free cash flow FCFF.
In the second case, the value of not the entire company is calculated, but only its equity capital. This is done by discounting free cash flow by FCFE's equity - after debt payments have been made.
FCFE - free cash flow to equity
FCFE is the amount of money left over from earnings after taxes, debt payments, and expenses to maintain and develop the company's operations. The calculation of free cash flow to FCFE's equity begins with the company's net income (Net Income), the value is taken from the income statement.
Depreciation, depletion and amortization from the income statement or cash flow statement is added to it, since in fact this expense exists only on paper, and in reality the money is not paid.
Next, capital expenditures are deducted - these are expenses for maintaining current activities, modernization and acquisition of equipment, construction of new facilities, etc. CAPEX is taken from the investment activity report.
The company invests something in short-term assets - for this, the change in the amount of working capital (Net working capital) is calculated. If working capital increases, cash flow decreases. Working capital is defined as the difference between current (current) assets and short-term (current) liabilities. In this case, it is necessary to use non-cash working capital, that is, adjust the value of current assets by the amount of cash and cash equivalents.
For a more conservative estimate, non-cash working capital is calculated as (Inventory + Accounts Receivable - Last Year's Accounts Payable) - (Inventory + Accounts Receivable - Previous Year's Accounts Payable), figures taken from the balance sheet.
In addition to paying off old debts, the company attracts new ones, this also affects the amount of cash flow, so it is necessary to calculate the difference between payments on old debts and obtaining new loans (net borrowings), the figures are taken from the statement of financial activities.
The general formula for calculating free cash flow to equity is:
FCFE = Net income + Depreciation - Capital expenditures +/- Change in working capital - Repayment of loans + Obtaining new loans
However, depreciation is not the only “paper” expense that reduces profit; there may be others. Therefore, a different formula can be used using cash flow from operations, which already includes net income, adjustment for non-cash transactions (including depreciation), and changes in working capital.
FCFE = Net Cash Flow from Operating Activities - Capital Expenditures - Loan Repayments + New Borrowings
FCFF is the firm's free cash flow.
A firm's free cash flow is the cash remaining after paying taxes and capital expenditures, but before subtracting interest and debt payments. To calculate FCFF, operating profit (EBIT) is taken and taxes and capital expenditures are subtracted from it, as is done when calculating FCFE.
FCFF = After Tax Operating Profit (NOPAT) + Depreciation - Capital Expenditure +/- Change in Working Capital
Or here's a simpler formula:
FCFF = Net Cash Flow from Operating Activities – Capital Expenditures
FCFF for Lukoil will be equal to 15568-14545=1023.
Cash flows can be negative if the company is unprofitable or capital expenditures exceed profits. The main difference between these values is that FCFF is calculated before the payment/receipt of debts, and FCFE after.
Owner's earnings
Warren Buffett uses what he calls owner's earnings as cash flow. He wrote about this in his 1986 address to Berkshire Hathaway shareholders. Owner's profit is calculated as net income plus depreciation and amortization and other non-cash items minus the average annual capital expenditures on property, plant and equipment required to maintain long-term competitive position and volumes. (If a business requires additional working capital to maintain its competitive position and volume, its increase should also be included in capital expenditures).
Owner's profit is considered to be the most conservative method of estimating cash flow.
Owner's Earnings = Net Income + Depreciation and Amortization + Other Non-Cash Transactions - Capital Expenditures (+/- Additional Working Capital)
In essence, free cash flow is the money that can be completely painlessly withdrawn from a business without fear that it will lose its position in the market.
If we compare all three parameters of Lukoil over the past 4 years, their dynamics will look like this. As can be seen from the graph, all three indicators are falling.
Cash flow is the money that remains with the company after all necessary expenses. Their analysis allows us to understand how much the company actually earns, and how much cash it actually has left for free disposal. DP can be both positive and negative if the company spends more than it earns (for example, it has a large investment program). However, a negative DP does not necessarily indicate a bad situation. Current large capital expenditures may return many times greater profits in the future. A positive DP indicates the profitability of the business and its investment attractiveness.
