Free cash flowFree cash flow

Cash Flow Cash Flow AnalysisAnalysis

Free Cash FlowFree Cash Flow

If cash flow after investing in long term If cash flow after investing in long term assets is not positive then the firm did not assets is not positive then the firm did not generate enough cash from operations to generate enough cash from operations to pursue long-term growth opportunities pursue long-term growth opportunities and must rely on external financing.and must rely on external financing.

These firms have less flexibility than firms These firms have less flexibility than firms that can generate the necessary funds that can generate the necessary funds internally.internally.

Cash flow after long term investments is Cash flow after long term investments is cash flow available to both debt and cash flow available to both debt and equity holders.equity holders.

Free Cash FlowFree Cash Flow

Payments to debt holders include Payments to debt holders include interest and principal payments.interest and principal payments.

Firms with negative free cash flow Firms with negative free cash flow after investments in long term assets after investments in long term assets must borrow additional funds to meet must borrow additional funds to meet their interest and principal payments.their interest and principal payments.

They can also reduce their investments They can also reduce their investments in working capital, long term in working capital, long term investments, or issue additional equity.investments, or issue additional equity.

Free Cash FlowFree Cash Flow

Cash flow after payments to Cash flow after payments to creditors is free cash flow available creditors is free cash flow available to owners.to owners.

Payments to equity holders include Payments to equity holders include dividends and stock repurchases.dividends and stock repurchases.

If firms pay dividends despite If firms pay dividends despite negative cash flows available to negative cash flows available to equity holders then they are equity holders then they are borrowing to pay dividends. This is borrowing to pay dividends. This is not sustainable in the long term.not sustainable in the long term.

SummarySummary

Examine cash flow from operations Examine cash flow from operations before investment in working capital to before investment in working capital to verify the company is able to generate verify the company is able to generate a cash surplus from its operations.a cash surplus from its operations.

Examine cash flow from operations Examine cash flow from operations before investment in long term assets before investment in long term assets to how the firms working capital is to how the firms working capital is being managed and to see if the being managed and to see if the company can invest in long-term assets company can invest in long-term assets for future growth.for future growth.

SummarySummary

Examine free cash flow to debt and Examine free cash flow to debt and equity holders to asses a firm’s ability to equity holders to asses a firm’s ability to meet its principal and interest payments.meet its principal and interest payments.

Examine free cash flow to equity holders Examine free cash flow to equity holders to asses a firm’s ability to sustain its to asses a firm’s ability to sustain its dividend policy.dividend policy.

All cash flow analysis must be done All cash flow analysis must be done taking into consideration the company’s taking into consideration the company’s business, its growth strategy, and its business, its growth strategy, and its financial policies.financial policies.

Analyzing Quality of Analyzing Quality of IncomeIncome

The Quality of Income Ratio is The Quality of Income Ratio is calculated ascalculated as

Cash Flow from Operations Cash Flow from Operations

Net IncomeNet Income

OROR

Cash Flow from OperationsCash Flow from Operations

Net Income + DepreciationNet Income + Depreciation This ratio should be > 1 for a healthy This ratio should be > 1 for a healthy

firm.firm.

Analyzing Quality of Analyzing Quality of IncomeIncome

If there are significant differences If there are significant differences between net income and operating cash between net income and operating cash flow ask the following questions:flow ask the following questions: What are the sources of the difference?What are the sources of the difference? Is it due to accounting policy?Is it due to accounting policy? Is it due to one-time events or on-going Is it due to one-time events or on-going

activities?activities? Is the relationship changing over time?Is the relationship changing over time?

If so, why? (see above for possible reasons).If so, why? (see above for possible reasons). Is it because of changes in business Is it because of changes in business

conditions or accounting policies and conditions or accounting policies and estimates?estimates?

Analyzing Quality of Analyzing Quality of IncomeIncome

What is the time lag between What is the time lag between recognition of revenues and expenses recognition of revenues and expenses and the receipt or payment of cash?and the receipt or payment of cash? What uncertainties are there regarding What uncertainties are there regarding

cash collection or cash payments (e.g. cash collection or cash payments (e.g. bad debts, contingent liabilities, etc.)bad debts, contingent liabilities, etc.)

Are the changes in working capital Are the changes in working capital accounts normal?accounts normal? If not, is there an adequate explanation If not, is there an adequate explanation

for the changes?for the changes?