Hi guys, please could someone help me out with a couple of things please: Thank you so much!
FCF=EBIT(1-t) + (Depreciation & Amortisation) - CAPEX - Net Working Capital
What is the reasoning behind subtracting net working capital? Is it because it is a non-cash item?
THANK YOU!
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Since NWC is essential to operating the business, it's not really available as cash except in the case of total liquidation, but at that point, you're looking at a pretty small amount.
An increase from t-0 is a use of cash, and a decrease results in a greater free cash flow. At the end of the projection period, it's normalized for the terminal value. Remember, an increase (decrease) in an asset is a use (source) of cash and an increase (decrease) in a liability is a source (use) of cash.
The formula you have is the FCF to the firm; as you can see from the first part of the equation, you are showing earnings before interest and then taking out taxes.
When you ask about FCF from net income you are asking about FCF to equity, which includes taking out the interest. So long story short, to get FCF to equity you would replace the first part of your equation with net after tax income.
help with fcf and nwc (Originally Posted: 07/19/2017)
when calculating FCF, why do you just add/subtract back changes in networking capital without multiplying it by the tax rate first?
I understand the concept of NWC, increase in asset = decrease in cash flow, and increase in liability = increase in cash flow. However, a $100 increase in assets does not necessarily mean a 100 decrease in cash flow. For example, if A/R goes up by $100, assuming a 40% tax rate, cash only goes down by $40
Let's start with the numbers - revenue is up $100. All else held constant, this results in net income up $60 assuming a 40% tax rate. Moving to cash flow statement - net income is up $60 but change in working capital is a $100 outflow (increase in AR), resulting in a $40 decline in cash. Finally, the balance sheet - cash is down $40 but AR is up $100, netting to a $60 increase in assets. This is balanced by net income up $60, which flows directly into retained earnings within shareholders equity.
Going back to your first question, changes in operating assets and liabilities are not taxable events on their own. Think about this - say a company builds up an inventory balance in anticipation for an upcoming busy quarter. As it acquires more and more inventory, there is a cash outflow that shows up under CFO on the cash flow statement. However, there is no taxable event, as this increase in inventory on its own would not show up anywhere on the income statement.
Happy to go into more detail on this, but explaining the purpose of the cash flow statement and its function as "glue" that explains the disconnect between an income statement and balance sheet is one of the most critical concepts of financial accounting that you should be learning early on in introductory coursework.
"Going back to your first question, changes in operating assets and liabilities are not taxable events on their own. Think about this - say a company builds up an inventory balance in anticipation for an upcoming busy quarter. As it acquires more and more inventory, there is a cash outflow that shows up under CFO on the cash flow statement. However, there is no taxable event, as this increase in inventory on its own would not show up anywhere on the income statement."
I see, but wouldn't it still be wrong to straight up add NWC since as you stated in your explanation, cash flow is only down 40 dollars, not 100. So, let's say, A/R goes up $100 but nothing else changes, then your change in NWC would be 100, but it would be wrong to say cash flow changes by 100
^^ as previous poster mentioned, NWC items are not taxable
okay, so I get they might not be taxable, but isn't it still wrong to just add it without adjusting? In my example, cash flow only changes by 40 not 100
That's not how it works. It's the net change in assets. If your inventory goes up 100 and northing else changes in quantity (could have sold $1T worth of products on credit but you also collected $1T so there's no change in AR), then change in NWC is 100 but despite assets going up, it's actually a net cash outlay. If you charge an extra 100 to payables compared to the previous period, then that's 100 that you didn't pay during the period so the increase in liabilities is actually an increase in cash.
You would never account for taxes because it's completely outside of the P&L. If you pay $20 for dinner, you're out $20. The restaurant cares that your meal cost $6 to make, $3 in labor, and $2 in general costs, but you don't see or care how your experience impacted their income tax.
Could you stick with my example of an increase in A/R of $100? According to BIWS, increase in $100 A/R means decrease in cash flow of $40 not $100
Effect on all three statements=/=change in NWC.
FWIW, this is kind of a bad question. If they're implying that the +100 AR corresponds with +100 in revenue then you'd eventually get to +60 NI with a 40% tax rate. I just personally think that's a bad assumption to assume that revenue goes up but it is what it is.
To finish out the effect on all 3 statements, that'd be +60 to cash from NI and -100 by the increase in AR to get a -40 net change in cash. So then on the BS, cash goes down by 40, AR goes up by 100 for net +60 on assets and then +60 SE from NI to balance it out.
So -40 in cash flow, yes, but with change in NWC we only care about the change in CA and CL.
NWC refers to the money you have tied up in order to run your business operations as usual. maybe there is an economic event, maybe your customer base changed,so your NWC needs change too. NWC accounts are only balance sheet ones, so tax rate is not applicable at all. inventory and accounts payable are examples of NWC accounts. if any of them increase, there are no tax implications as no expenses were incurred. if you had an increase in depreciation expense for example, then the tax rate comes into play.
in my example, I am using A/R. An increase in A/R does have tax implications since it increases revenue which increases taxable income.
Free Cash Flow without working capital (Originally Posted: 08/06/2008)
I'm calculating FCF per segment... only issue is that current assets and current liabilities aren't stated per segment.... I do have total assets per segment though...
If I calculate change in WC for the entire company, and use each segment's assets to weight the change in working capital per segment... does that make any sense?
How could I calculate FCF per segment otherwise? What I have is: Revenue per segment, EBITDA per segment, Assets per segement, D&A per segment, CapEx per segment... and obviously all figures as an aggregate for the whole firm. No relevant segment specific details in MD&A or footnotes.
Unless each segment has a different waterfall (tax, equity holders, debt covenants etc) why not just do it company as a whole? Cash is cash.
ended up doing WC as a % of incremental change in revenue
Typically I do it based on historic days of AR/AP and investory turnover, because say a B2B division would have very different AR characteristcs than the consumer retail division but I think that's close enough and as per my previous message don't see how it would impact valuation by allocating a total WC from the corporate to the division level unless differing waterfalls as mentinoed above applies.
Elan - agree with your approach to approximate segment WC by revenue. it's likely the best you can do given available info.
Why do you do NWC for FCF calc (Originally Posted: 07/17/2013)
Hi guys,
This maybe kind of a dumb question, so apologies in advance. Can someone explain the actual concept of why you have to add/subtract net NWC to calculate FCF? I understand it's a rule and done in the cash ops section of a CF. But I am just having a hard time connecting this concept to the actual running of a business. You would think that the expenses in the income statement throughout the year would cover the differences in NWC. For example, I am thinking like COGS already taking into account for the difference of inventory. So isn't it kind of double counting? Obviously, I know my reasoning is faulty, but can someone explain why?
Thanks a lot in advance.
I don't think you've actually tried to think about this...
If my inventory is increasing, what is happening to my cash? If my accounts payable are decreasing, what is happening to my cash?
You also need to reread your accounting textbook; I don't think you completely understand the relationship between COGS and inventory.
Changes in inventory aren't reflected in the income statement, but you've gotta pay for that inventory somehow, right...
Similarly, just collecting X amount of money that's owed to you in A/R or paying out some amount that you've already got in your A/P isn't going to hit your I/S.
Therefore - subtract from or add to FCFF, where applicable.
In fact, I can see where OP's misunderstanding comes from (for ease of thought, I will reduce the notion of NWC to just inventory in the following):
Yes, COGS show how inventory is decreased and yes, you've paid for that in cash earlier on. And IF you were looking at a non-growing, steady-state company that does exactly the same thing every single day, you wouldn't need to account for the CHANGES in NWC (note it's the change, not the total level), as there wouldn't be any change. Purchases would always equal COGS and would therefore be recognized already. Yet, things aren't like that and the level of NWC in the company goes up and down (and may be manipulated in the short term, especially during M&A situation). Since thus, the long-term, no-growth relation of "COGS = inventory purchases" usually doesn't hold over any specific period in time, you need to account for the variation in the level of NWC (the change in it).
You might also think about it this way: CF accounts for cash leaving the firm. So you're looking for total inventory purchases. COGS isn't actually cash going out, but inventory used up and equals only the downward side of changes in NWC. Only if COGS are refilled through purchases (i.e. NWC remains contant), you actually have cash out equal to COGS. I you don't refill, there's not cash out (and your adding back of the reduction in NWC to CF accounts for that). Thus: NWC net cash-out = COGS - changes in NWC; you're actually looking for the left side, but derive the right side from the income statement and balance sheets
Hope this helps.
If you buy $10 worth of inventory in a quarter and sell nothing your CoGS is $0 but you still had a $10 cash outflow for inventory. CoGS isn't accrued until you sell the inventory.
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