###### Financial Reporting Quality Vs. Qualit ...

Financial reporting quality relates to the quality of the information contained in financial... **Read More**

The cash flow statement can be used to compute financial ratios which measure a company’s profitability, performance, and financial strength.

Other cash flow measures such as free cash flow to the firm, and free cash flow to equity, can also be instrumental in the valuation of a company and its equity securities. Generally speaking, free cash flow refers to the excess of operating cash flow over capital expenditures.

Free Cash Flow to the Firm (FCFF) is the cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made the required investments in fixed capital and working capital. It is computed according to the following equation:

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

Where:

NI = Net income;

NCC = Non-cash charges;

Int = Interest expense;

FCInv = Capital expenditures; and

WCInv = Working capital expenditures.

Alternatively, it may be computed as:

FCFF = CFO + Int(1 – Tax rate) – FCInv

Where CFO represents cash flow from operating activities in the case where the interest paid is included as an operating activity.

Free Cash Flow to Equity (FCFE) refers to the cash flow that is available to a company’s common stockholders after the company has paid all its operating expenses and borrowing costs and made the required investments in fixed capital and working capital. It is computed according to the following equation:

FCFE = CFO – FCInv + Net borrowing

If net borrowing is negative, this means that a company’s debt repayments have exceeded its receipt of borrowed funds. In this case:

FCFE = CFO – FCInv – Net debt repayment

A positive FCFE implies that a company has more operating cash flow than it needs to cover capital expenditures and the repayment of debt. Therefore, such a company has cash available for distribution to shareholders.

Several ratios can be computed using the cash flow from the operating activities segment of a cash flow statement. Data gathered from the computation can be used to compare the performance and prospects of different companies within the same industry or across industries. These ratios fall into two categories: cash flow performance (profitability) ratios, and cash flow coverage (solvency) ratios.

These ratios are summarized in the following table:

$$\begin{array}{c|c|c} \textbf{Performance Ratio} & \quad \quad \quad \textbf{Calculation} \quad \quad \quad & \textbf{Indication} \\ \hline \text{Cash flow to revenue} & \cfrac {\text{CFO}}{\text{Net revenue}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text {per dollar of revenue} \end{array} \\ \hline \text{Cash return on assets} & \cfrac { \text{CFO} }{ \text{Average total assets}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text {per dollar of} \\ \text{asset investment} \end{array} \\ \hline \text{Cash return on equity} & \cfrac { \text{CFO} }{\begin{array}[t]{c} \text{Average shareholder’s} \\ \text{equity} \end{array}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text{per dollar of} \\ \text{owner investment} \end{array} \\ \hline \text{Cash to income} & \cfrac {\text{CFO}}{\text{Operating income}} & \begin{array}[t]{c} \text{Cash generated from} \\ \text{operations} \end{array} \\ \hline \text{Cash flow per share} & \cfrac {\text{CFO-Pref. dividends}}{\begin{array}[t]{c} \text{Number of common} \\ \text{shares outstanding} \end{array}} & \begin{array}[t]{c} \text{Operating cash flow on a} \\ \text{per share basis} \end{array}\\ \hline \text{Debt payment} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash paid for} \\ \text{long term debt payment} \end{array}} & \begin{array}[t]{c} \text{Ability to pay debts} \\ \text{with operating cash flows} \end{array} \\ \hline \text{Dividend payment} & \cfrac {\text{CFO}}{\text{Dividends paid}} & \begin{array}[t]{c} \text{Ability to pay dividends} \\ \text{with operating cash flows} \end{array} \\ \hline \text{Investing and financing} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash outflows for} \\ \text{Inv. and Fin. activities} \end{array}} & \begin{array}[t]{c} \text{Ability to acquire assets,} \\ \text{pay debts, and make} \\ \text{distributions to owners} \end{array} \\ \hline \text{Debt coverage} & \cfrac {\text{CFO}}{\text{Total debt}} & \begin{array}[t]{c} \text{Financial risk and} \\ \text{financial leverage} \end{array} \\ \hline \text{Interest coverage} & \cfrac { \begin{array}[t]{c} \text{CFO + Interest paid} \\ \text{+ Taxes paid} \end{array}}{\text{Interest paid}} & \begin{array}[t]{c} \text{Ability to meet} \\ \text{interest obligations} \end{array} \\ \hline \text{Reinvestment} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash paid for} \\ \text{long term assets} \end{array}} & \begin{array}[t]{c} \text{Ability to acquire} \\ \text{assets with} \\ \text{operating cash flows} \end{array} \\ \end{array} $$

Question 1Which of the following statements accurately describes free cash flow to the firm (FCFF)?

- Cash flow that is available to a company’s suppliers of debt capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital.
- Cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital.
- Cash flow that is available to a company’s common stockholders after the company has paid all its operating expenses and borrowing costs and made necessary investments in fixed and working capital.

SolutionThe correct answer is

B.Free cash flow to the firm (FCFF) is the cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital. Option B describes free cash flow to equity (FCFE). Option C is partially correct, but inaccurately excludes suppliers of equity capital in its definition.

Question 2U&U Ltd. reported the following information in its latest financial reports:

Beginning borrowing balance: $200,000

Ending borrowing balance: $250,000

Cash from operations: $500,000

Fixed capital investment: $100,000

U&U’s free cash flow to equity (FCFE) is

closest to:

- $50,000
- $150,000
- $550,000

SolutionThe correct answer is

C.

$$\text{FCFE =

Cash from operations

– Fixed capital investment

+ Net borrowing}$$Where:

$$\begin{align}\text{Net borrowing}& = \text{Ending borrowing balance – Beginning borrowing balance}\\ & = $250,000 – $200,000 = $50,000\\ \Rightarrow \text{FCFE} &= $500,000 – $100,000 + $50,000 = $450,000 \end{align}$$