Slide 1SCF BasicsSCFSCFSCFSCFFree Cash FlowFCFNet IncomeAccrual AccountingAccrual AccountingAccrual AccountingTax AccrualsOff Income Statement FlowsInterestTaxes For The All Equity FirmAfter Tax InterestFCFThe Statement of Cash Flow & Valuation Cash FlowCorporate Finance: MBAC 6060Professor Jaime ZenderSCF BasicsSCF is a summary of a company’s transactions for a given period that effect the cash account.This statement provides information about the firm’s ability to generate cash and the effectiveness of its cash management. Where is cash coming from and going?It is derived from the income statement for the period and (at least) the two balance sheets surrounding the period.Cash is the “life blood” of the firm so the SCF can be an important diagnostic tool and provide insight into which financial ratios should be calculated to assess the strengths and weaknesses of the firm.Cash flow information is increasingly viewed as a (the) crucial piece of information for assessing the firm and its financial health by outside audiences.SCFThe generic structure of the SCF is:Cash provided (used) by operating activities.Basic running of the business, how fast cash comes in versus how fast it goes out. Tells us about how past investments are generating cash.Cash provided (used) by investing activities.Acquisition/sale of new assets.Cash provided (used) by financing activities.Raising new capital/retiring old, significant sources/uses of cash.Increase (decrease) in cash.Cash – beginning of the period.Cash – end of the period.Let’s look at each category in a bit more detail.SCFOperating Activities:Start with: Net Income (from Operations)Add: Depreciation & AmortizationAdd: Change in Deferred Income Tax*Subtract: Change in NWC (exclude Cash and interest bearing liabilities)Total to find: Total Cash from OperationsSCFInvesting Activities:Acquisitions of fixed assets are (generally) cash outflows.Sales of fixed assets (net of any tax implications) are (generally) cash inflows.Acquisitions of financial assets are outflows.Sales/Maturities of financial assets are inflows.The net is Cash from Investing Activities.SCFFinancing Activities:Subtract the amount of long-term or short-term debt retired.Add the amounts of newly issued long-term or short-term debt.Subtract total amount of dividends paid.Subtract the amount of stock repurchases.Add the amount of new stock issues.Total is cash flow from financing activities.Free Cash FlowWhile the SCF is a good diagnostic tool, it does not present information in a form useful for valuation purposes. Here we do not focus on the change in the cash account as is done on the SCF. Cash on hand is really just another asset.Recall our basic valuation equation. We need forecasts of all future cash flow expected to be generated by the current ownership of a firm (asset). We want to introduce Free Cash Flow (FCF).The cash flow that would be generated by a firm and be available to be dispersed to its claimants if the firm were all equity financed.It is important to note that free cash flow is on an enterprise level. In other words, we use it to value a firm.FCFThe most theoretically correct cash flow figure to use in DCF valuation is Free Cash Flow.FCF:Start with: Net Income (from Operations)Add back: Depreciation & AmortizationSubtract: Change in NWC*Add: Change in deferred income taxSubtract: Net Capital ExpendituresAdd: After tax interest = (1-Tc)InterestNote: this is really free cash flow from operations, we are ignoring any non-operating cash flows not contained in Net Cap Ex.Net IncomeNet income is not a measure of cash flow, any kind of cash flow (it was specifically designed not to be), so automatically we know we have to make adjustments.Accrual accounting.Off income statement expenses.Interest.Net income is, however, a reasonable place to start. It captures, in an accounting sense, what existing assets are generating.Accrual AccountingThe most obvious problem with using net income to understand cash flow is that non-cash expenses are deducted.The largest (commonly) are depreciation and amortization. In order to help turn net income into free cash flow we have to add these expenses back into net income.Accrual AccountingRevenue is booked when sales are made. This is true regardless of whether the sale is for cash or credit.To find cash flow we want to reflect any and only cash flows (pretty obvious).We could count only cash sales but what would that miss?It’s the timing of credit sales that are the problem.We correct by subtracting (why subtract?) the change in accounts receivable.Accrual AccountingExpenses work the same way.Expenses are booked even if we only record an accounts payable rather than an actual cash outflow.We correct by adding the change in accounts payable.The shortcut we use to deal with lots of these corrections at once is to subt ract the change in NWC (almost). Why do we subtract this change?Tax AccrualsThere are three tax accrual accounts that tell us what is the difference between “allowance for income taxes” in the public books and actual cash taxes on the tax books.Prepaid taxes is a short term asset account, taxes payable is a short term liability, and deferred taxes is a long term liability (occasionally you see a 4th, deferred tax assets).We can change “book” taxes to “cash” taxes by adding the change in the asset account and subtracting the changes in the liability accounts to “allowance for income taxes.”However, in most instances taxes paid is not the goal, rather it is free cash flow. The two short term accounts are dealt with when we look at the change in NWC so we only have to add the change in deferred taxes to net income.Off Income Statement FlowsAn expense we want to take out of free cash flow that isn’t reflected on the income statement is net capital expenditures.We added back the reflection of past expenditures that appears on the income statement (depreciation) but we want to make sure that all valuable investments are made so that free cash flow is what is left after accounting for investments necessary for the efficient operation of the firm.We find this value for the last period from the statement of cash flow in the investment cash flow section once we ignore the financial asset transactions.This can be estimated by the change in gross fixed assets over the