One of the most important measures of cash flow for a lender doesn’t appear in a business’ statement of comprehensive income so it’s one that is not often used. If you can understand how a business generates its free cash flow, both historically and in the future, your lending decision is going to be so much better.
What is it?
It’s really simple. Free cash flow is the cash that a business generates that is available to the providers of capital as dividends and of debt after everything else has been paid.
How is it calculated?
The calculation isn’t difficult but you’ll almost certainly have to do it the old, low-tech way (i.e. with a calculator). You start with EBITDA because you want to include all revenues and to assume that all cash expenses have been paid, that’s why you add back the non-cash expenses of depreciation and amortisation.
Then you deduct the taxes that have been paid in cash. That means you ignore the tax figure on the statement of comprehensive income and use the tax paid amount from the statement of cash flows.
Next, because we know that revenues are not necessarily the same as cash, we deduct any additional investment in working capital as that would signify an outflow of cash and, therefore, a reduction in free cash flow. Again, you find that figure in the statement of cash flows, usually called “changes in net working capital”.
Finally, you need to deduct any capital expenditure that has been funded by the business itself. What we mean here is that if some capital expenditure has been funded through additional debt, we should assume that the debt has been raised to finance the capital expenditure and so we should ignore it for the purposes of this calculation as that transaction would have no effect on free cash flow. Normally, you could find the figure you need by looking at the investing activities section in the statement of cash flows and adjusting it for any additional long-term interest-bearing debt that appears in the financing activities section. A better way to get to this figure though is to ask the business to supply it as the directors/owners would be able to explain exactly how the capital expenditure was funded.
A point of caution. You will only deduct cash taxes paid, net changes in working capital and capital expenditure if the figures are in brackets in the statement of cash flows as that means that cash was paid out. If any of the figures are not in brackets it would indicate that cash flowed in from those sources so you would add those amounts to your EBITDA.
The result of the calculation is the free cash flow that the business generated in the past financial period (probably a year but not always) and that amount was available to pay dividends to shareholders and to repay capital on debt.
What do we do with it?
Okay, so now we know how much free cash flow the business generated. That’s all well and good but it’s a historical figure and, like all historical figures, it has limited value for a lender.
What lenders should want to know is what the future free cash flow will be. Calculating the figure for the past year is a useful way to understand what the drivers are that cause the business to generate and use cash, but we need to think about how those drivers will play out in the coming financial year at least, since that’s where lenders will get their debt repayment from.
The only way to do this is by discussion with the business’ directors/owners around what the EBITDA is likely to be (based on an understanding of the likely revenues) and how those revenues will affect the investment in working capital and fixed investment via capital expenditure. If you can get a view of future free cash flow you’ll obviously have better insight into the ability of the business to repay you.
One final point, note that the definition of free cash flow says that it is the amount of cash available to pay dividends and to repay debt. As a lender, you’re far more concerned about the last part of that definition so you might want to factor in the business’ dividend policy and calculate a free cash flow figure after dividends have been paid out – that way you’ll have a cash figure that is available only for the repayment of debt.