In the last post we covered the analysis of the common size cash flow statement. Today, in the last post in the cash flow series, we will cover various types of cash flow ratios, like free cash flow ratios – FCFF and FCFE, performance ratios and coverage ratios and their relevance in analyzing the performance of a firm. So let’s begin….
Free Cash Flow to Firm (FCFF)
Free cash flow is the cash flow available to the firm after meeting its capital expenditures. Free cash flow to firm, also known as FCFF, is one of the free cash flow ratios that measures the free cash flow available to debt holders and equity holders. Free cash flow to firm or FCFF can be calculated starting with either net income or operating cash flow (CFO).
If we calculate FCFF starting with net income, we add back interest expense (net of tax) to the net income. We need to add it back as it was originally deducted from revenue as part of expenses to arrive at net income. (Click here to see the post covering the basics and format of the income statement)
Since interest is paid to debt holders, it should therefore be part of the free cash flow to the firm available for distribution to them and hence we add it back too.
Similarly, non cash expenses such as depreciation and amortization are also added back to net income to arrive at the free cash flow to the firm.
The FCFF formula reads as;
FCFF = Net Income + non-cash charges + interest expense (1-tax) – Fixed capital expenditures – working capital expenditures
Fixed capital expenditure in the FCFF formula is the net of purchase and sale of fixed assets.
When calculating FCFF beginning with CFO, it is not necessary to adjust for non cash charges and changes in working capital as they have already been adjusted while calculating CFO.
The FCFF formula with CFO is given as;
FCFF = CFO +Interest expense (1 – tax) – Fixed capital expenditures
In case of firms following IFRS, if interest expense has been classified as a financing cash flow, no adjustment for interest expense needs to be made in the FCFF formula. It needs to be adjusted only if it has been classified as an operating cash flow.
Free cash flow to equity (FCFE)
Free cash flow to equity or FCFE as it is known, is another of the free cash flow ratios that measures the cash flow available for distribution to equity owners as dividends after paying off debt holders. The FCFE formula is given as;
FCFE = CFO – Fixed capital expenditures + net borrowing
In the FCFE formula we do not deduct interest expense as it has already been adjusted to arrive at CFO in case it has been classified as an operating cash flow. Again, if it has been classified as a financing cash flow there is no case for adjustment from CFO.
Net borrowing in the FCFE formula is net of debt issued and debt repaid. Here it is added to arrive at FCFE as debt can also be sometimes issued for paying dividends to equity holders.
In case of firms following IFRS, if dividends paid has been adjusted from CFO, it needs to be added back to arrive at free cash flow to equity.
Other cash flow ratios
Other types of cash flow ratios include performance and coverage ratios. The performance ratios try to gauge the performance of the firm with respect to the operating cash flow, while coverage ratios measure how much of the debt and interest obligations can be covered with the cash generated from operations.
Performance cash flow ratios
Cash flow to revenue ratio
Cash flow to revenue ratio is a cash flow ratio that calculates the operating cash flow generated for per dollar of revenue and it is given as;
Operating cash flow / revenue
Cash return on assets ratio
Cash return on assets ratio measures the operating cash flow generated by putting assets financed by all capital sources to use and it is given as;
CFO/ average total assets
Cash return on equity ratio
Cash return on equity ratio is a cash flow ratio that measures the cash generated by assets financed by owner’s capital and is given by;
CFO / average total equity
Cash to income ratio
Cash to income is a cash flow ratio that measures the cash generated from the firm’s core operations and is given as;
Cash flow per share
Cash flow per share is a computation of Basic EPS calculated with CFO instead of net income and is given as;
CFO – preferred dividends / weighted average no. of common shares
In case of firms under IFRS, common dividends classified as operating cash flow should be added back to CFO to calculate cash flow per share as cash flow per share is a measure of how much cash flow is available for distribution to common shareholders.
Coverage cash flow ratios
Debt coverage ratio
Debt coverage ratio measures how much of the debt is covered by cash. Therefore it is a measure of financial risk and leverage and is given as;
CFO / total debt
Interest coverage ratio
Interest coverage ratio is a cash flow ratio that measures how of the interest obligations is covered by cash and is given as;
CFO + interest paid + taxes paid / interest paid
In case of firms under IFRS, if interest is classified as an operating cash flow, it needs to be added back. In case interest is classified as a financing cash flow there is no case for any adjustment to operating cash flow.
The reinvestment ratio measures how much of long term assets could be purchased with operating cash flow and is given as;
CFO / cash paid for long term assets
Debt Payment ratio
Debt payment ratio is a cash flow ratio that measures how much of the long term debt could be paid with the operating cash flow and is given as;
CFO / long term debt repaid with cash
Dividend payment ratio
Dividend payment ratio is a cash flow ratio that measures how much dividends could be paid from the operating cash flow and is given as;
CFO / dividends paid
Investing and financing activities
Investing and financing activities measures a firm’s ability to carry out investing activities and financing activities like repaying debt and paying dividends from the operating cash flow. It is given as;
CFO / cash outflows from investing and financing activities
That’s all in this post….with this we come to an end of the cash flow series….hope you found it useful…from the next post we start a new topic….financial analysis techniques….stay tuned….bye
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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