FSA and Free Cash Flows

This lecture drew attention to the practice of FSA (Financial Statement Analysis). FSA is a useful tool for drawing inferences about a firm, its operations, financing, and investment policies. We use FSA to try and form opinions about a firm/industry based on some level of time series and cross-sectional analysis. The lecture focused on several ratios including average collection period, inventory days, average payable period, and sales capacity (fixed assets). These ratios have direct implications for cash flows and value. For example, a firm that changes its credit policy from net 30 to net 60 - thereby making payment terms less stringent for customers, would expect net working capital to increase in the short term, and consequently free cash flows to fall. If inventory days were to increase, then due to increased amounts of cash tied up in inventory, cash flows for the immediate period would be lower. Creating a ratio analysis sets up a framework that requires the ultimate user to ask a series of questions of the numbers produced. These questions should include:

1) Is the analysis stable or trending?
1) What do any abnormal ratios represent?
2) Can they be explained in any way? Are they one off events?
4) If that is indeed the case, should you consider normalising figures for that one period?

One must also consider the appropriateness of particular ratios. That is, even though a lower inventory ratio is a preferable state for most firms, what are the implications on cash flows resulting from so called "black swan" events. Take Toyota, Apple, Sony and a range of other firms whose operations have been interupted by the Tsunami in Japan. If you are impartial to driving a Ford or Toyota and Toyota have a 3-month wait on their vehicles (because the company didn't have any reserves), then the just-in-time inventory model will inevitably produce lower sales, and cash flows for that company over the period.

The sales to fixed assets ratio is defined as sales / average PP&E (plant, property and equipment) which provides information about the capacity to generate sales (but not utilisation). One possible interpretation of a firm with low sales to fixed assets ratio relative to its industry participants is that the firm can probably expand sales without requiring further investment. While this is a fairly simple and intuitive definition that can be found in most textbooks, a more rigirous interpretation of the capacity needs of a firm needs to factor growth driven by an increase fixed assets from mergers and acquisitions (joint ventures, strategic alliances etc...). Only by factoring in claims on the true state of assets can we examine what level of capacity and degree of asset utilisation a firm employs.

A final note about FSA - FSA is only as good as the financial statements in which they are derived from. Ratio analysis needs to be extensive, and we should therefore not use the same group of ratios for analysing firms in different industries. You should employ multiple ratios for examining different line items in your financial statements to see whether a consistent conclusion can be gained from that aspect of the firm's operations. Otherwise, where similar ratios paint disimilar views about the firm, questions should be raised about the legitemacy of the firm's operations.

Free Cash Flows

The next part of our analysis moves to working out free-cash flows (FCF). Free cash flows represent the cash available for distribution to all stakeholders of the firm. FCFs are generally divided into two groups. FCFs to equity holders (FCFE) is the cash flow available to equity holders after all operating expenses have been paid and necessary investments in working capital (WC) and fixed capital (FI) have been made. FCF to the firm (FCFF) include cash flows to all the firm stakeholders (not just shareholders).

Why do we need separate the groups in this way? 

If you are a buyer interesting in acquiring a firm, then you care not only about the firm's equity position but also any debt owing. Therefore, FCFF are what you are interested in calculating. If you are an investor then calculating FCFF does not necessarily tell you whether a company is solvent. Therefore, FCFE will be more useful in this situation.

The free cash flow method derives from the traditional dividend discount model (DDM). The DDM model uses 'potential' dividends as opposed to free-cash model which estimates actual dividends to stakeholders. Where firms pay out all their cash flows as dividends then value derived from the DDM and free cash flow model should be equal.

Components of FCF

Deriving free cash flows from financial statements requires several adjustments. Many of these adjustments are fairly trivial. For example, reversing non-cash expenses like depreciation and ammortisation can be conducted by looking through the P&L statement and/or cash flow statement. Factoring other cash flows like capital expenditure can require greater thought. We normally consider any investment in PP&E (Plant, Property, and Equipment) to be an investment in fixed assets but this may or may not factor in any recent acquisitions made by the firm. Factoring in this type of investment is particularly important for companies in the technology, pharmaceutical, and mining industries since these industries rely extensively on acquisitions to promote future growth. When focusing on PPE and CAPEX we should remember that our assets will not have the same productive capacity year after year. If we did not invest a single dollar in our assets in 2011 for example, we would not expect in this year our assets would we worth what they were worth (or even produce what they did) in 2010. For this reason, CAPEX will represent the difference in net CAPEX between succesive years (2011-2010) plus any depreciation expense incurred in 2011.

Questions are often asked about working capital and which accounts to include. A finance versus accounting definition of working capital reveals that they are not quite the same. That is because the finance definition includes anything that ties up cash and is related to the operations of the firm. Unless there exists some rational reason, one should think twice about including accounts like cash, short term debt and the current portion of long-term debt.

After interest tax expense - When calculating EBIT(1-t), t in this equation should equal the marginal tax rate (i.e. 30% for an Australian firm). Even if the effective tax rate is lower than the marginal rate, the benefit of the interest tax shields will be captured in the cost of capital calculation. If we use the effective rate instead of the marginal rate then we are effectively double counting the taxation benefit of interest/debt.


Issues regarding FCF use (FCFE or FCFF)

1. As a firm increases its level of borrowing, its cash flows become more volatile. This is because debt holders demand a return whether or not a firm makes a profit, unlike equity holders. If we increase our borrowing then we would expect that FCFE will increase due to the influence over sales (and net income),CAPEX, and the change in net proceeds. As we increase our level of borrowing, however, what we will find is that the return required by both debt holders and equity holders will also rise. Therefore, although from an operating cash flow perspective debt may look like a solution to the value creation problem, any analysis must be tempered by a corresponding evaluation of how it impacts the cost of capital.

2. Practical problems associated with estimating FCFE can arise when debt ratios are expected to vary over time. With firm valuation models, changes in debt ratios are easier to incorporate into a valuation analysis because we are examining pre-debt cash flows and not needing on an annual basis to work out cash flows from net proceeds (P-NP). If leverage is expected to remain constant over time, then your choice between FCFE and FCFF is negligible.