31 August 2012

Free Cash Flow To Equity (FCFE) - A Simple Explanation

According to the formula, FCFE = Operating Cash Flow - Capex + Net Borrowing.

Let us analyze the above formula first.

Operating Cash Flow is calculated as the net cash flow from the operation activities. You may find a more comprehensive cash flow from the sample below:

Source: Breadtalk Annual Report 2011
This sample starts from "Profit Before Taxation", so it must be computed with the tax paid later. You can see a lot of non-cash items to be adjusted here, such as:
  • Depreciation of PPE
  • Impairment Loss
  • Interest Income/Expenses
  • PPE Write Off 
  • Gain on Disposal of PPE
  • Shares Based Payment Expenses
  • Shares of Result of Joint Ventures
  • Translation Difference
  • Write off of Inventories
  • Write down of Inventories
  • Impairment of Receivables
  • Impairment of amount due from an associate
After we computed the above items, we will get "Operating Cash Flows before Working Capital Changes".We then compute the working capital changes which includes but not only:
  • (Increase)/Decrease in Trade Receivables / Inventories / Prepayments / Deposits
  • Increase/(Decrease) in Payables & Other Liabilities
We will get the figure "Cash Flow Generated from Operations", but we have to deduct "Tax Paid" from this figure to get the last figure "Net Cash Flows from Operating Activities"

Why Operating Cash Flow is important? This is the figure where we can forecast whether the business model of the company is sustainable in long run or not. Sometimes, the net profit can be manipulated by including a lot of non-cash items such as Depreciation/Amortization (to avoid additional tax or to increase more net profit). We can analyze how aggressive the management is in dealing with those non-cash items as some of the items are in management discretion.

Not only that, you may find some companies would increase their equity / debt financing due to the increase of working capital. A simple formula for working capital changes is shown as below:

"Net Increase in Trade Receivables + Net Increase in Inventory - Net Increase in Trade Payables"

The company can improve its operation efficiency by better managing its working capital to avoid any wastage. For example, when a company is growing, it will incur a lot of inventories or trade receivables. But at the same time it risks facing problem/additional cost for storing inventories or making provision for bad debt. In doing so, management may find a balance way to grow its business while managing working capital well.


Next we go to CAPEX (Capital Expenditures) which you can find "Purchase of PPE" from "Cash Flows from Investing Activities" below:

Source: Breadtalk Annual Report 2011


Why CAPEX is important? When a company is expanding its business, it will utilize the cash to increase its working capital as well as fix assets. CAPEX is equivalent to Purchase of Fix Assets in order to support its current business and it will consume the cash flow. A Cash Consuming business model might not be a good idea to invest in. For example, a lot of aviation companies would like to purchase a big airplanes to boost its business. In a good time, it might be seen as a good idea when everything is looking good and it is the only way to increase business by having a lot of jet planes.

You can find out that different sectors could have a different type of CAPEX needs. For examples, in industry sectors, you may find the companies need to increase or at least maintains its factories to support the production of the goods. For some sectors such as service industry or healthcare industry, it may not utilize high CAPEX to grow its revenue, as most of the cash would be spent to increase competency of the staffs which we cannot see it from the financial reports.

Net Operating Cash Flow - CAPEX = Free Cash Flow. The company can decide to return the excess cash as dividend to shareholders or they can purchase the shares from open market. Or they may save the cash and purchase more fixed assets to grow its business. It all under management's decision to do so. A question rise here, "what happen if the Free Cash Flow cannot support the current business? "

The company can only increase the cash flow through financing outside, such as rise the debt borrowings or equity borrowings. The most expensive cost is the Equity rising, following by the debt borrowings and lastly from retain earnings. So it is wise if the company can retain the earnings while expanding and not to rely on external financing activities, unless necessary.  Equity financing will dilute the EPS while debt financing may increase the cost of debt in long run or have a negative impact on its credit ratings. 

I hope you can understand a little bit on what I wrote above. Feel free to give me a comment here. Thanks.

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