###### Ratios Used in Equity Analysis and Cre ...

Equity analysis involves the evaluation of a company’s equity to determine its relative... **Read More**

Recall that it is important for operating cash flows to adequately cover capital expenditures. The surplus of operating cash flow after accounting for capital expenditures is called free cash flow.

In company valuation aspects, such as assessing a company’s overall value or its equity securities, an analyst might consider utilizing additional cash flow metrics such as free cash flow to the firm (FCFF) or free cash flow to equity (FCFE).

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

$$ FCFF=NI+NCC+\text{Int}\left(1-\text{Tax rate}\right)-\text{FCInv}-\text{WCInv} $$

Where:

\(NI\) = Net income;

\(NCC\) = Non-cash charges;

\(\text{Int}\) = Interest expense;

\(\text{FCInv}\) = Capital expenditures; and

\(\text{WCInv}\) = Working capital expenditures.

Alternatively, it may be computed as:

$$ FCFF=CFO+Int\left(1-\text{Tax rate}\right)-\text{FCInv} $$

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

If interest paid is categorized under financing activities, then there is no need to adjust cash flow from operations (CFO) for interest adjusted for taxes, i.e., Int(1 – Tax rate).

Additionally, according to IFRS guidelines, if interest and dividends received are reported under investing activities, these amounts should be added back to the CFO when calculating free cash flow to the firm (FCFF). Furthermore, if dividends paid are deducted in the operating section, they should be reinstated to CFO for the accurate computation of FCFF.

Free Cash Flow to Equity (FCFE) refers to the cash flow available to a company’s common stockholders after it 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:

$$ FCFE=CFO-\text{FCInv}+\text{Net borrowing} $$

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

$$ FCFE=CFO-\text{FCInv}-\text{Net debt repayment} $$

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

**Example: Calculating FCFF and FCFE from Cash Flow Statement**

Consider the following direct cash flow statement for a hypothetical company, KTDA, for the year ended 31 December 2023

$$\begin{array}{lc} \hline \text{ Cash flow from operating activities: } & \\ \hline \text{ Cash received from customers} & \$25,417,000 \\ \text{ Cash paid to suppliers} & \$11,214,00,000 \\ \text{Cash paid to employees} & \$(4,190,000) \\ \text{ Cash paid for other operating expenses} & \$(3,889,000) \\ \text{ Cash paid for interest} & \$(260,000) \\ \text{ Cash paid for income tax} & \$1,505,000 \\ \text{Net cash provided by operating activities} & \underline{\$4,573,000} \\ \hline \textbf{Cash flow from investing activities:} & \\ \hline \text{Cash received from sale of equipment} & \$220,000 \\ \text{Cash paid for purchase of equipment} & \underline{\$(1,000,000)} \\ \text{Net cash used for investing activities} & \$(780,000) \\ \hline \textbf{Cash flow from financing activities:} & \\ \hline \text{Cash paid to retire long-term debt} & \$(500,000) \\ \text{Cash paid to retire common stock} & \$(500,000) \\ \text{Cash paid for dividends} & \$(2,720,000) \\ \text{Net cash used for financing activities} & \$(3,720,000) \\ \hline \text{Net Increase in cash} & \$ 73,000 \\ \text{Cash balance, 31 December 2022} & \$1,254,000 \\ \text{Cash balance, 31 December 2023} & \$1,327,000 \\ \hline \end{array}$$

We wish to calculate FCFF and FCFE from the above Cash Flow Statement, assuming a tax rate of 30%.

**Solution**

FCFF is calculated as shown in the table below:

$$ \begin{array}{lr} \hline \text{CFO} & \text{USD4,573,000} \\ \text{Plus: Interest paid times (1 – income tax rate)} & \text{(USD260,000 [1 – 0.30])} \\ & \text{USD182,000} \\ \text{Less: Net investments in fixed}& \\ \text{capital (USD1,000,000 – USD220,000)} &\text{(USD780,000)}\\ \hline \text{FCFF} & \text{USD3,975,000} \\ \hline \end{array} $$

Note that net fixed capital investment is calculated from the cash flow from investing activities. We use the data for payments for the purchase of equipment (USD1,000,000) and proceeds from the sale of equipment (USD220,000).

Lastly, FCFE is calculated as follows:

$$\begin{array}{lr} \hline \text{CFO} & \text{USD4,573,000} \\ \text{Less: Net investments in fixed}&\\ \text{capital (USD1,000,000 – USD220,000)} & \text{(USD780,000)} \\ \text{Less: Debt repayment (USD500,000)} & \text{(USD500,000)} \\ \hline \text{FCFE} & \text{USD3,293,000} \\ \hline \end{array} $$

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{align}&\begin{array}{lcc} &\textbf{Performance Ratios}&&\\ \hline \end{array}\\& \begin{array}{l|c|c}{\textbf{Performance} \\ \textbf{Ratio}} & \textbf{Calculation} & \textbf{Indication} \\ \hline

{\text{Cash flow} \\ \text{to revenue}} & \frac{\text{CFO}}{\text{Net revenue}} & {\text{Operating cash} \\ \text{generated per dollar} \\ \text{of revenue.}} \\ \hline

{\text{Cash return} \\ \text{on assets}} & \frac{\text{CFO}}{\text{Average total assets}} & {\text{Operating cash} \\ \text{generated per} \\ \text{dollar of asset} \\ \text{investment.}} \\ \hline

{\text{Cash return} \\ \text{on equity}} & \frac{\text{CFO}}{\text{Average shareholder}^\prime \text{s equity}} & {\text{Operating cash} \\ \text{generated per} \\ \text{dollar of} \\ \text{owner investment.}} \\ \hline {\text{Cash to income}} & \frac{\text{CFO}}{\text{Operating income}} & {\text{Cash generated} \\ \text{from operations.}} \\ \hline {\text{Cash flow} \\ \text{per share}} & \frac{CFO-\text{Pref Dividends}}{\text{Number of common shares outstanding}} & {\text{Operating cash} \\ \text{flow on a per-share} \\ \text{basis.}} \\ \hline\end{array} \end{align}$$

$$\begin{align}&\begin{array}{lcc}\textbf{Coverage Ratios}&&\\ \hline \end{array}\\& \begin{array} {l|c|c}{\textbf{Coverage} \\ \textbf{Ratio}} & \textbf{Calculation} & \textbf{Indication} \\ \hline\text{Debt payment} & \frac{\text{CFO}}{\text{Cash paid for long-term debt payment}} & {\text{Ability to pay} \\ \text{debts with} \\ \text{operating cash} \\ \text{flows.}} \\ \hline

\text{Dividend payment} & \frac{\text{CFO}}{\text{Dividend paid}} & {\text{Ability to pay} \\ \text{dividends with} \\ \text{operating cash} \\ \text{flows.}} \\ \hline

{\text{Investing and} \\ \text{financing} } & \frac{\text{CFO}}{\text{Cash outflows for Inv. and Fin. activities}} & {\text{Ability to} \\ \text{acquire assets,} \\ \text{pay debts, and} \\ \text{make distributions} \\ \text{to owners.}} \\ \hline

\text{Debt coverage} & \frac{\text{CFO}}{\text{Total debt}} & {\text{Financial risk} \\ \text{and financial} \\ \text{leverage.}} \\ \hline

\text{Interest coverage} & \frac{\text{CFO}+\text{Interest Paid}+\text{Taxes Paid}}{\text{Interest paid}} & {\text{Ability to meet} \\ \text{interest obligations.}} \\ \hline

\text{Reinvestment} & \frac{\text{CFO}}{\text{Cash paid for long-term assets}} & {\text{Ability to acquire} \\ \text{assets with} \\ \text{operating cash} \\ \text{flows.}} \\

\end{array} \end{align}$$

**Example: Calculating the Performance Ratio from a Financial Statement**

An analyst analyzes the financial statements of a company. Some of the information from the financial statements of the company is given below (in thousands):

$$\begin{array}{l|l} \text{Revenue (net)} & \$25,456 \\ \hline \text{Cost of goods sold} & \$11,345 \\ \hline

\text{Gross profit} & \$14,111 \\ \hline\text{Cash paid to retire long-term debt} & \$(500) \\ \hline\text{Net cash provided by operating activities} & \underline{\$4,573} \\\hline \text{Cash paid to retire common stock} & \$(500) \\ \hline\text{Cash paid for dividends} & \$(2,720) \\ \end{array}$$

Assuming that the company does not have short-term debt, the debt repayment ratio is *closest to:*

- 4.60
- 9.15
- 9.28

**Solution**

The correct answer is **B**.

The debt repayment ratio is calculated as follows:

$$\begin{align} \text{Debt repayment}&=\frac{\text{CFO}}{\text{Cash paid for long-term debt payment}}\\ &=\frac{\$4,573}{\$500)}\\&=9.15\end{align}$$

## Question 1

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

- Cash flow 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 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 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 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.

B is incorrect.It describes free cash flow to equity (FCFE).

C is incorrect.It inaccurately excludes suppliers of equity capital in its definition.## Question 2

U&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
- $450,000

SolutionThe correct answer is

C.$$ \begin{align*} FCFE & =\text{Cash from operations}-\text{Fixed capital investment} \\ & +\text{Net borrowing} \end{align*} $$

Where:

Net borrowing=Ending borrowing balance-Beginning borrowing balance

Net borrowing=$250,000-$200,00=$50,000

\(\Rightarrow\)FCFE=$500,00-$100,000+$50,000=$450,000

$$ \begin{align*} \text{Net borrowing} \Rightarrow FCFE &=\text{Ending borrowing balance} \\ & – \text{Beginning borrowing balance} \\

&=\$250,000-\$200,000 \\ & =\$50,000=\$500,000-\$100,000+\$50,000 \\ &=\$450,000 \end{align*} $$