Mergers & Acquisitions, Part 4: Why is the Free Cash Flow important?

Last time I have discussed which methods exist to value a firm and this time I give you a small introduction in what the free cash flow is and why is it important for the valuation of the firm based on the internal data.
So, let us now focus on the internal method. My intention is to highlight the main aspects of this method, which are usually taken for granted and sometimes are paid less attention to.

First of all for the ones that are interested in technical and detailed information on calculating the value of the firm I suggest you take a look here.

Now I want to focus your attention on why do we work with the free cash flows for determining the value of a firm and not with the profits the company is making when trying to determine its value.

Cash flow creates a great deal of confusion to many especially those who are new to the subject of corporate finance. People tend to think that profit is the key for measuring value creation in a company or a project, not least because such concept is widely known. On the other hand, while many have heard of the proverb “cash is king”, few can explain its significance.

The importance of cash flow, or more precisely, cash, is that it is countable. In a single year, how much cash you have left after everything is paid for and collected is how much money you have made. You know exactly how much money you have earned (or lost). In contrast, profit, put it simply, is the difference between revenues and costs. This means that unpaid bills (accounts payable) and uncollected amount (accounts receivable) are not taken into consideration. Also profit tends to leave a bit of room for creative accounting or manipulation.

Free Cash Flow (FCF) refers to the money that is leftover after all the bills to suppliers have been paid, all the outstanding amount of money that buyers owed us have been collected and all the money needed for investments have been paid for. What is left must therefore be distributable among all the investors, whether they are shareholders or debt holders. In a nutshell, the remaining portion must be the value that a project or company has created! Therefore, the “free” in FCF refers to the fact that the cash flow is free from any obligations.

FCF is made up of three components.

  • Cash flow from operation (CFO), also called operating cash flow, refers to the cash flows that are generated by the on-going operation of a project or a company. CFO is calculated by the following: EBIT * (1-t) + Depriciation + Amortisation, where t stands for taxrate.

If you take a second to think about EBIT, it is effectively all the benefits that a project or a company has created before distributing to all three stakeholders – the debt holders (in the form of interests), the government (in the form of taxes) and the shareholders (in the form of profit). Since the government is only a stakeholder and not an investor, EBIT*(1-t), reflects the benefits created that are distributable to the only investors of the firm – the debt holders and the shareholders. To complete the calculation of CFO, it is needed to add depreciation and amortization, because here we are concerned to when the money is paid and not how we are administrating it.

  • As for capital expenditure or CAPEX, it is less about calculation but more about figuring out what the amount should be, whether it is a cash inflow or cash outflow and when it occurs. CAPEX is sometimes simply called investments. It usually refers to one-time major cash outflow (e.g. buying new equipment) or cash inflow (e.g. sale of equipment or receiving subsidy).
  • Change in net working capital (∆NWC) is easily the most difficult aspect of FCF calculation. Working capital is money that is necessary for keeping the operation going. However, it is only money that got tied up in the operation, without which you will not be able to reach the end of the project to obtain the expected Net Present Value.

Usually, as the business expands (i.e. increasing revenues), the demand for working capital will go up. An important consideration of working capital is that since working capital is simply capital that is working for the operation; you will be able to recover all the outstanding working capital at the end of the project.

Once you have obtained all components as stated above, you can do the following:

FCF = CFO – CAPEX – ∆NWC.

It is needed to offer a gentle reminder that when dealing with FCF and its components, you should pay particular attention as to whether the number represents a cash inflow or cash outflow.
Obviously you now have to discount all your future FCF in order to get the present value of a firm.

The main point that I wanted to make with this part of my blog is that as a company you still can go down if you do not generate enough cash flow to cover all your expenses even if you are making profit!

Next time I will discuss some of the elements of the external methods! Stay tuned!