24-06-2012, 02:57 PM (This post was last modified: 24-06-2012, 02:59 PM by mysterion.)
Hi guys, have a newbie question about free cash flow and would appreciate some help in the calculation of free cash flow.
From various sources, free cash flow is commonly explained as the amount of cash flow generated after the company has paid its expenses and reinvested money in the form of capital expenditures.
And so a convenient formula used to generate FCF would be FCF = Net Cash Flow from Operations (CFO) - Capital Expenditures.
However, in financial statements, dividends paid out to shareholders can be accounted for either under Operating Activities or Financing Activities.
So my burning question is whether dividends should be included in the calculation of free cash flow, i.e. whether should dividends be considered a form of "capital expenditure? After all, if a company has a history of dividend payments and investors have invested in the company for its consistent dividend payout, it cannot easily reduce or completely eliminate them.
This seems rather important to me because the impact of dividends in the FCF calculation can be rather large percentage wise for most companies.
IMO, FCF trend should be used to justify if dividend payment is sustainable.
So FCF should be Net Op CF - CAPEX without consideration for FCF
Instead, what's impt is in the distinction of CAPEX. In some companies, it is not restricted to just "Purchase of PP&E" and should include other items as well.
Payment of dividends should NOT be classified as OCF, but should be under Financing CF instead. I understand that some companies (e.g. SPH?) classify them as OCF, which I feel is misleading.
Capex consists of two types - M&A type capex (replacement of new machinery, amounts set aside for M&A of associates/subsidiaries) and maintenance capex which is necessary to ensure the machines/equipment are kept in working condition.
So FCF should be OCF minus normalized capex over the last few years, and should not include exceptional items (e.g. capex for a large acquisition which is unlikely to be repeated in subsequent years).
The company that classified dividends under operating cash flow is actually Goodpack Limited.
On another note, I understand that generally capex focuses on hard tangible assets like plant and machinery.
However what about companies that are not really reliant on tangible assets (e.g. software companies, service companies)?
Is it prudent to consider research and development costs as part of capex (especially if these costs have to be incurred to ensure that the company maintains its competitive edge)?
I think the first question to ask is why you are calculating free cash flow.
If you are calculating free cash flow for how much dividend a company can afford to pay, Free Cash Flow = OCF - Capex - Finance expense
If you are calculating free cash flow for how much capex a company can afford, Free Cash Flow = OCF - Finance Expense - Dividend
A company is generating cash for its growth (capex) or return to shareholders (dividends/share buyback, etc). Cash should not stay in the balance sheet for nothing.
(24-06-2012, 06:34 PM)Gregg Wrote: hi All, another newbie question, what is the working capital? usually it has to be deducted from operating cash flow become Net Op Cash Flow.
working capital often involves the 3 main items of inventory, trade receivables and trade payables.
To have a understanding of the working capital flow, when a company wants to sell a good it needs to own the good for sale. For retailers, the inventory comprises of items to be sold to the customer. For manufacturer, they involve the raw materials needed to produce a certain goods.
As the goods are not yet sold by the company, the company will not have the money to pay its supplier. This will then be booked under trade payable as it is not paid in cash yet.
When the company sold its product to the customers, it will then record a sale. Sometimes, it will collect cash upfront or it may allow the customer to buy on credit. In the case when the customer is buying on credit, it will be booked as trade receivables.
As the name of working capital suggest, it is something the company needs to maintain its operation. When inventory increases, trade receivables increase and trade payable decrease, working capital will be reduced as cash is being paid to hold on to inventory while it is not able to collect as much money back.
The main thing about cash flow statement is that it allows you to see the flow of cash in the company. A company reporting healthy profit might in fact be burning cash for capex and receivables and inventory. Cash flow is of course harder to manipulated though it is not entirely impossible. For income statement, all you need is to change the policy of recognition of revenue or to capitalise certain expenses and you get a higher profit.
Here's a satire written by Benjamin graham on how to increase profit of the company
(24-06-2012, 06:34 PM)Gregg Wrote: hi All, another newbie question, what is the working capital? usually it has to be deducted from operating cash flow become Net Op Cash Flow.
working capital often involves the 3 main items of inventory, trade receivables and trade payables.
To have a understanding of the working capital flow, when a company wants to sell a good it needs to own the good for sale. For retailers, the inventory comprises of items to be sold to the customer. For manufacturer, they involve the raw materials needed to produce a certain goods.
As the goods are not yet sold by the company, the company will not have the money to pay its supplier. This will then be booked under trade payable as it is not paid in cash yet.
When the company sold its product to the customers, it will then record a sale. Sometimes, it will collect cash upfront or it may allow the customer to buy on credit. In the case when the customer is buying on credit, it will be booked as trade receivables.
As the name of working capital suggest, it is something the company needs to maintain its operation. When inventory increases, trade receivables increase and trade payable decrease, working capital will be reduced as cash is being paid to hold on to inventory while it is not able to collect as much money back.
The main thing about cash flow statement is that it allows you to see the flow of cash in the company. A company reporting healthy profit might in fact be burning cash for capex and receivables and inventory. Cash flow is of course harder to manipulated though it is not entirely impossible. For income statement, all you need is to change the policy of recognition of revenue or to capitalise certain expenses and you get a higher profit.
Here's a satire written by Benjamin graham on how to increase profit of the company
(24-06-2012, 06:30 PM)mysterion Wrote: Thanks dzwm87 and Musicwhiz for your comments!
The company that classified dividends under operating cash flow is actually Goodpack Limited.
On another note, I understand that generally capex focuses on hard tangible assets like plant and machinery.
However what about companies that are not really reliant on tangible assets (e.g. software companies, service companies)?
Is it prudent to consider research and development costs as part of capex (especially if these costs have to be incurred to ensure that the company maintains its competitive edge)?
For a simple rule of thumb, I will consider CAPEX to be the expenditure needed to run the daily operations. Purchase of PP&E is the simplest common form of CAPEX since a business requires buying of new machinery or office equipment, etc to continue business operations. Depending on the business nature of the company, it is then up to the investor discretion to determine what other items need to be added to "CAPEX".
Take China Minzhong, an agricultural business, for example. What their business entails is to lease farmlands from farmers, purchase the vegetables from them and sell it to their customers. Thus farmland leasing, along with other farmland improvement, is a big parcel of their business operations. If you dig deeper into their business, you realise they normally pay a lump sum of "leasing rights" to the farmers. Thus, prepayment for land rights is also another form of CAPEX. In all, it is the understanding of the business nature which allows you to distinguish what CAPEX exactly comprises of. If R&D is a core of their operations, then it is part of CAPEX. If it involved software company, then are there any recurring licensing rights which they need to purchase? If it is, I will include them as CAPEX. Generally, the key is to ensure a conservative measure of CAPEX expenses. You do not want to be too generous or stringent with its distinction as you may understate or overstate the company's ability to generate FCF
Hi, reviving this old thread (better than making a new one )
I'm wondering how does FCF compute for real estate developers.
In an earlier post by Shanrui_91, working capital includes inventory. In the context of real estate developers, that would mean purchase of land?
For a more practical example, I'm looking at Ho Bee AR2010 (chose that because the net cash from operating activities was -107 mil).
Profit for the year was $317 Mil
Under the changes in working capital there is "Development properties" is ($210 Mil)
Should that ($210 Mil) be considered as inventory? It's one of the main reason why the net cash is negative.
Reason I'm asking is because I'm trying to understand how to use FCF to compute DCF.
If I just use the "Net cash from operating activities", that would make computation difficult because over the years, it fluctuates between positive and negative.
I'm assuming that's because in some years, they use the cash to purchase land for development hence resulting in a negative cash flow.
Or does this mean to say, it's very hard to apply DCF valuation to real estate developers and so, just stay away from that form of computation?
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