Summary: Free Cash flows are the most important measurement of the operating earnings of a company. Calculating them is easy, provided an investor is willing to look at the right place for the information. 

In an earlier article, I had mentioned that that an investor has to invest in a company assuming that he/she is owning the company in the process and that business owners who are capable of sleeping well tonight are the ones will have a good day in office the next day. Also, I had mentioned that one of the most important aspects of judging the peace of mind of an owner is to evaluate Free Cash Flows. In this article, I am mentioning what Free Cash flows are and how they can be calculated.

Example Of A Small Factory Owner

 Suppose you are the owner of a small manufacturing firm in Central India. It is the end of the financial year and you are sitting with your CA talking about preparing accounts for tax payments. At the end of the exercise, your CA congratulates you that you have made record profits this year. You too know within yourself that you have exceeded the sales and profit targets you had set out for yourself at the beginning of the year. It seems CA is happy.

But you are tense. You do not share his optimism.

You know that you have made even stiffer targets for next year. Also, you know that you are operating at 80% capacity utilization for your factory and you will not be able to deliver much more unless you invest in capacity expansion. Since all this will be the challenge in the coming year, you have already started making arrangements for the same. You now are carrying record inventories with yourself and you have taken loan from the bank for capacity expansion. None of these activities show their impact the profit and loss statement.

You know you have spent more than you’ve earned this year. You know you haven’t made any money from your factory operations, no matter what the tax department says!

How Much An Owner Earns Dictates How Much A Shareholder Earns

When one is valuing the worth of ownership, one has to look at how much the ownership fetches in that firm. When asked, owner will say that, “Whatever profits I make, I have to first pay tax. Then I have to pay for for capital expenses and inventories. If the money I’ve got with me is sufficient, then I can chose to pay bank debt too. If I do not have enough money already, then I may have to borrow debt from bank. Only after all the obligations on these activities are taken care of will I earn my share of money.” The money that the owner earns is the residual operating earning of the firm.

Just like above, when valuing worth of a share, equity investors judge the value on the basis of the dividends they receive. One has to know that the company will be in a position to pay dividend only when it is earning money after all its obligations are met. If a company not making money on operations, then it is not a sound investment irrespective of whether it pays dividend or not. Free cash flows are the way to judge the earning capability of the company from its operations.

Basically, one can say that while valuing the equity of a company one has to look at earnings that are:

• After Tax
• Net of Reinvestment Needs Of the Company
• After Debt Repayment

Below, I am mentioning what are the obligations of a company in terms of its reinvestment needs and its debt repayments.

Reinvestment Needs

Ideally a firm has only 2 reinvestment needs:

• Capital Expenditure for utilization in many years and
• Working Capital for upcoming orders

As a lay investor, I always used to ask, “If the profit is obtained after all the expenses, then why do we need to look at anything else.” The answer to this is that Profit in a profit and loss statement is calculated after revenue is earned after selling good/services and expenses are paid only for those goods/services. If there have been any transactions that have happened (like inventory purchase or advance received) but revenue has not come out of them in the accounting period, then those transactions are not a part of profit calculations.

That is why we have to account for above two expenses over and above the profit calculations in order to understand how the money is flowing within the firm.

Net Debt Repayments

Here, we are not taking about interest payment. Those have been accounted for in the expenses after which profit is calculated. We talk about the new debt that is borrowed by the company and the old debt that is paid back by the company. Hence:

Net Debt Repayments = Old debt Repaid- New Debt Issued

Sometimes a company issues preferential shares. In such cases, the sales pitch is that such shares will have all the advantages of a stock and debt and none of their problems. That, like most promises of a better world, is a myth.

A Preference Stock is one where the stock holder is to be paid before the common stock, if the company decides to give dividend. So the company is obligated to pay the preference holders before the regular stock holders and at a fixed rate. So if the company is not making profit, then preference share holders will not be paid (unlike debt holders).

So from an ordinary shareholder point of view (which is our point of view) a preference shareholder is one who is like a debt holder. And hence when we look at debt repayments, we have to look at the amount of money going to preference share holders. Hence,

Total Debt Repayment = Debt Repaid as calculated above + Pref. Dividend Pad + Pref. Stock Issued.

The cash flow to equity, thus, has to be free from obligations that have to be prioritized above the needs of the owner. That’s why it is called: Free Cash Flow To Equity

Free Cash Flow To Equity

The free cash flow to equity is the earning that the owner has from the operations. At its very basic level, it is calculated as:

FCFE = Profit After Tax – Reinvestment Needs – Total Debt Repayments

Below is a table that contains which variable goes into the calculation and where we can find it in the financial reports:

Variable	Where to Get It From	What To Do With It	Remarks
PAT	Profit and Loss Statement	Starting Variable	The profit that has been reported by the company has to be altered to remove the impact of extraordinary expenses (like sale of land etc.)
Capital Expenses	Balance Sheet	Remove from PAT	Look at changes in Gross assets and Capital WIP between last year and this year and subtract the cumulative depreciation from that. One needs to also subtract the amount of assets that are impaired or written off.  The resultant value is Capex expense in this year.
Working Capital changes	Cash Flow Statement	Remove from PAT	Look at the amount of cash that is trapped in Trade Receivables, owed in Trade Payables and Inventory.  Also, we need to look at non-cash changes. The logic is explained later in the article.
Debt Repayment	Balance Sheet and Schedules To Balance sheet	Remove from PAT	The formula is calculated above. Include deferred tax liability in debt as well.

The resultant value you get is the Free Cash Flow To Equity

The Thing About Cash

Among all the variables in the above table, the only one related to cash is Working Capital and in that I have not considered changes in cash at all while calculating changes in working capital. The reason is that when you own the shares company, the cash owned by the company is owned by you immediately. The cash by itself does not contribute to the operating earnings of the company and since this measurement is about operating earnings, we have to ignore the cash.

In another article, I will mention what we do about the cash that we have ignored just now and how we consider that in our valuations.

Conclusion

Free Cash Flows are a measurement of the true operating income of a firm, and hence are of paramount importance while evaluating the health of the company. Calculating this is also simple if a investor knows where to look and is willing to look for the same. Only when one verifies that the company is having positive free cash flows, will one be able to understand if the company under consideration is a sound investment or now.