ANALYSIS OF COMPANY CASH FLOWS

It has been a standard practice of financial managers to use financial statements, more
specifically accrual based ones (Statement of Financial Position and Income Statement), in analyzing
company financial condition and their results of operations, and it is important to remember that the
main concern of any financial manager would be the company’s cash flows. As a review, we already
know that Cash Flow Statements present cash flowing into and out of the company from their operating
activities, investing activities, and financing activities.

It is pivotal to systematically and consistently examine company cash flows, as this would help
management determine as to how much the entity is worth. One way by which cash flow may be
tracked is by the use of Free Cash Flow (FCF).

FREE CASH FLOW (FCF)

Free Cash Flow pertains to the residual amount of cash flows after using cash to pay or cover the
company’s cost and expenses from operation and those used to pay for company investments (current
or short-term investments and noncurrent or long-term investments). It can be said that FCF is the
amount of cash a business entity generates after deducting the entity’s capital expenditures like
acquisition of land, building, or equipment, in accounting these items are aptly categorized in an account
called “Property, Plant, and Equipment.”

There are assertions that stock exchanges are very much delving and focused on company
earnings while giving very little concern on the actual cash generated by the company. Company
earnings are subjected to a number of accounting-related tactics and ploys that may render them
“contaminated.” However, this is not the case with cash flow, it is more difficult to forge company cash
flow; because of this, some investor believe that FCF provides a better view of the company’s ability to
generate cash and ultimately provide an “uncontaminated” version of company income.

There are times that the FCF can be negative. This however, should not be automatically viewed
as something bad. Negative cash flows may mean that the company is making significantly large amount
of investments. If aid investment yield higher return, the strategy may prove to be more beneficial for
the company in the future.

The residual cash (FCF) after capital expenditures can now be used for expansion, payment of
dividends, payment of debt, and other disbursement necessary for the entity’s operation. The basal
formula created from this narrative description of FCF would be:

FCF = Total Cash Available – Operating Costs and Expenses – Investment Costs

Based on this formula, we can say that we need to do two things to arrive at the FCF:

1. Determine the cash flow from company’s operation or operating activities cash flow (OACF)

OACF = Company Net Income Before Taxes – Taxes + Depreciation +

Amortization + Depletion
  Depreciation, amortization, and depletion are added back because these were deducted the
company’s net income and yet they entail no cash outflow. In essence, by doing these, we are
converting the company’s net income (which is accrual-based) into a “pure cash-based” net
income.

2. Compute the cash flows from the company’s investing activities or investing activities cash flows
(IACF). The cash flows from investment can be represented by the ∆ as a change symbol.

∆PPE – pertains to changes in the entity’s fixed asset or property, plant, and equipment account.
The changes in this account would mean acquisition or disposal of fixed assets. The acquisition
and disposal is categorized as an investment activity, because as we know, acquisition of land,
building, and other properties is an investment. This may also include other long-term assets like
intangibles.

∆CA – Refers to changes in the entity’s current asset account. This would indicate changes in short-
term investment.

∆AP – Refer to changes in the entity’s account payable.

∆AE – Refers the changes in entity’s accrued expenses.

It is important to emphasize that these items, specifically the changes in AP and AE are
considered as spontaneous current liabilities. This means that they come to exist spontaneously
with changes in sales. These two items are subtracted from the total changes in current assets to
get the remaining changes in short-term investments.
All these changes can be computed by examining a two-dated or comparative statement of
financial position of a company and deducting the amount of the two periods for the company’s
PPE, CA AP, and AE.
The difference (result of subtracting the amounts from the two periods) can be applied on
the improved formula of the FCF below.

FCF = OACF - ∆PPE – (∆CA - ∆AP - ∆AE)

Using the figures taken from Riel Corporation’s comparative financial statements, we can
compute the company’s FCF for 2020 as follows (in the Philippine peso):
Assume the company’s operating expenses include depreciation of ₱10,000.

Step 1: Compute OACF

OACF = Net Income – Taxes + Depreciation

OACF = 178,507 – 62,477 + 10,000 (assumed figure)
= 126,030
Step 2: Compute IACF
∆PPE = 143,254 – 173,981
= -30,727
∆CA = 870,828 – 792,309
= 78,519
∆AP & ∆AE = 238,000 – 208,703
= 29,297
FCF = 126,030- (-30,727) – (78,519 – 29,297) = 46,081

This FCF would mean that Riel Corporation ha ₱46,081 as free cash flow, which the entity
can use to pay investors who give them equity and debt financing (Smart 2011)