Understanding finance

CASHING UP

John Royden, Head of Research

Cash is king. That’s what you get taught on finance courses. But what is frequently less clear is how the beans get counted and what people actually mean when they talk about cashflow.

Accountants provide us with something that they call Cashflow from Operations, which is pretty much what the widget machines produce in terms of net cash, after paying interest and tax. This is set out in the Consolidated Statement of Cashflows.

But this misses out how much was spent on capital expenditure, or capex (new widget machines and money spent maintaining existing ones). That detail can be found in the accountant’s Cashflow from Investing.

So as financial analysts, we subtract capex from Cashflow from Operations to give us what we call, Free Cashflow (“FCF”). 

Debt investors (banks and bond holders) or creditors are actually interested in how much cash there is to pay their interest and capital repayments on the debt. So creditors make an adjustment to FCF by adding back net interest after tax. This is called FCFF, or Free Cashflow to the Firm, and is often used to determine the riskiness and then the price or interest rate applicable to the debt.

Lastly, equity investors want to know what cash is going to be available for reinvestment and then for their dividends and, finally share repurchases. So shareholders take FCF, deduct preference share dividends and also changes in debt to understand their historic cashflows. Using the same basis they predict their cashflows out into the future as well. This is called FCFE, or Free Cashflow to Equity, and it is this that forms the starting point for many company valuations.

My advice is, when you are reading financial reports penned by analysts, just be certain to be sure exactly which cashflows are being talked about.

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