Financial Statements and Cash Flow FIN 4310(2) (copy)

What is free cash flow?

The amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations

Calculated by subtracting the net investment in operating capital from the net operating profit after taxes

Why is FCF important?

A company’s value depends on the amount of FCF it can generate, because investors value companies based on their ability to generate cash flow

FCF represents the cash available for distribution to all investors after necessary investments to support operations have been made

What are the five uses of FCF?

1. Pay interest on debt.

2. Pay back principal on debt.

3. Pay dividends.

4. Buy back stock.

5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

Formula to calculate FCF

NOPAT - Net investment in operating capital

Formula to calculate NOPAT

EBIT(1-Tax)

Formula to calculate Net Investment in Operating Capital

Total net operating capital this year - Total net operating capital last year

Formula to calculate Total Net Operating Capital (Operating Capital)

Net operating working capital + operating long-term assets

Formula to calculate Net Operating Working Capital (NOWC)

Operating current assets - Operating current liabilities

What are operating current assets?

The current assets needed to support operations

These include cash, inventory, receivables

These exclude short-term investments because these are not a part of operations

What are operating current liabilities?

The current liabilities resulting as a normal part of operations

These include accounts payable and accruals

These exclude notes payable because this is a source of financing and not a part of operations

Operating Profitability Ratio (OP)

The amount of operating profit generated by a dollar of sales

NOPAT / Sales

Capital Requirement Ratio (CR)

The amount of operating capital required to generate a dollar of sale

Total operating capital / Sales

Return on Invested Capital (ROIC)

It tells us how effectively a company is using its capital to generate profits.

NOPAT / Avg total operating capital

What does it mean if the ROIC is less than the WACC?

Investors did not get the return they require, growth did not add value

High growth usually causes negative FCF (due to investment in capital) but that’s ok if ROIC > WACC

Economic Value Added (EVA)

Tells us the amount of value a company has created or destroyed for its shareholders.

NOPAT-(WACC)(Capital)

Weighted Average Cost of Capital

Tells us the minimum return that a company needs to generate in order to create value for its investors.

It is the average rate of return that a company must earn on its investments to satisfy both its equity and debt holders.

If a company's return on invested capital (ROIC) is less than its WACC, it indicates that the company is not generating enough value for its investors.

Market Value Added (MVA)

Tells us the difference between the market value of a firm and its book value

MV of the firm - BV of the firm

If the market value of debt is close to the book value of debt, then MVA is

MV of equity - BV of equity

Market Value (MV)

(# shares of stock)(price per share) + Value of debt

Book Value

Total common equity + Value of debt