The Asset Approach to Valuing a BusinessDecember 17, 2018
The accrual accounting method allows companies to count their chickens before they hatch by considering credit as part of a company’s income. “Accounts receivable” and “settlement due from customers” can appear as line items in the assets portion of a company’s balance sheet, but these items do not represent completed transactions, for which payment has still to be received. They do not, therefore, count as cash.
However, it must be noted that the opposite can also be true. A company may be receiving massive inflows of cash, but only because it is selling off its long-term assets. A company that is selling itself for parts, may be building up liquidity, but it is limiting its potential for growth in the long term, and perhaps setting itself up to fail. In the same vein, a company may be taking in cash by issuing bonds and taking on unsustainable levels of debt. For these reasons it is necessary to view a company’s cash flow statement, balance sheet and income statement together.
Cash flow statement
The cash flow statement provides a precise reflection of whether a company’s income is languishing by the level of debts owed to it. Poor cash flow management often linked to the collection of debtors amounts, is not a sustainable situation in the long term for any business.
Even very profitable companies, as measured by their net incomes, can become insolvent if they do not have the cash and cash-equivalents to settle short-term liabilities. If a company’s profit is tied up in accounts receivable, prepaid expenses and inventory, it may not have the liquidity to survive a downturn in its business or a lawsuit. Cash flow determines the quality of a company’s income; if net cash flow is less than net income, that could be a cause for concern.
Cash flow statements are divided into three categories: operating cash flow, investing cash flow and financing cash flow. Operating cash flows are those related to a company’s operations, that is, its day-to-day business. Investing cash flows relate to its investments in businesses through acquisition; in long-term assets, such as towers for a telecom provider; and in securities. Financing cash flows relate to a company’s investors and creditors: dividends paid to stockholders would be recorded here, as would cash proceeds from issuing bonds.
Free cash flow
Free cash flow is defined as a company’s operating cash flow minus capital expenditures. This is, the money that can be used to pay dividends, buy back stock, pay off debt and expand the business.
Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Negative free cash flow is not necessarily an indication of a poorly managed company, but is a fundamental focus point as young executives invest a lot of their cash into their new ventures, which leads to very low levels of free cash flow.
If a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments.
Note while free cash flow doesn’t receive as much media coverage as earnings do, it is considered by some experts to be a better indicator of a company’s financial health.
Unlevered free cash flow
Free cash flow that does not take into account the interest payments that a company must make on its outstanding debt. It is more likely to be reported by companies that are highly levered, who want to give investors an idea of how assets are performing without subtracting interest payments.
Levered free cash flow
The amount of cash available to stockholders after interest payments on debt are made. A company with a large amount of debt will have to spend more money on interest payments, which in turn, will limit the amount of money that can be sent to stockholders in the form of dividends.
Free cash flow for the firm
A measurement of a firm’s profitability. It is calculated by taking operating cash flows and subtracting expenses, taxes, changes in working capital and changes from investments. Positive values indicate that a firm is profitable (it has money left over after expenses).
Free cash flow yield
An indicator of the return expected per share. It equals free cash flow per share divided by the current market price per share (or equivalently, the company’s overall cash flow divided by its market capitalization). This is similar to earnings yield, except it considers cash flow instead of earnings, and is used primarily by individuals who believe cash flow to be a more accurate indicator than earnings.
Free cash flow per share
Organization’s free cash flow divided by the number of shares outstanding. A measurement indicating an organization’s flexibility in various financial matters such as servicing debt, paying dividends and ability to perform other transactions.
Cash flow to capital expenditures
Cash flow to capital expenditures, or operations cash flow / capital expenditures, is the ratio used to determine an organization’s capability to use free cash flow to obtain long-term assets.
Higher cash flow expenditure to capital expenditure is a sign of that the company is able to finance itself and will probably grow.
Owner earnings run rate
Estimate of the annual free cash flow or the owner’s earnings based on the values of the same over a smaller time period like a few quarters. Calculation of an annual free cash flow using extrapolation is possible only if the cash flow remains the same for all the smaller intervals that a year is divided into. This eliminates its use for use in firms where it differs for different seasons or there is an extraordinary item to be considered.