This article is a continuation of my article on importance of free cash flows and how they serve as an important guideline for investors to make their decisions. I have been asked by a few folks to elaborate on how to deduce this from the publicly available information and this article is an exercise to cover that.

## Quick Recap

Basically, the investment and valuation theory has on very important foundation: the better the Free Cash Flows to Equity are, the more valuable the company is. The free cash flow to equity is an indicator of earnings that the owner has from the operations. At its very basic level, it is calculated as:

FCFE = Profit After Tax – Reinvestment Needs – Total Debt Repayments

In the above statement, we see that profit is a measure of how much the company earned due to the income and expenses of the previous financial year and how much of that earning has gone towards repayment of loans and/or reinvestments which will give benefit in the future years. The equation combines both the profit and loss statement and the balance sheet.

## The Thing About ‘Publicly Available Information’

We should remember that just because a piece of information is available publicly, it does not mean that it is not relevant for a lay investor. Conversely, we should also know that any piece is information that is important to an investor like me IS AVAILABLE PUBLICLY. All ** we need to know is where to look, and in what detail**.

## FCFE is Necessary, But Not Sufficient

In the article below, I am mentioning how each aspect of free cash flows can be computed from the information that all of us can access, and where to access that information from. The illustration below should form the basic homework for any lay investor, who wishes to know if the company that he/she is considering to investing has the sound fundamentals or not. **One should also remember that this step is necessary but not sufficient to gauge the health of the company**. There are other factors too, which when brought into consideration change the perception of the numbers we obtain from the calculation below.

## Company Under Consideration

I am mentioning the analysis below for **Precision Wires**. I had done the analysis for this company about a month and a half ago in this article. Then, I had concluded that the company is fundamentally sound, based on its cash flows.

After I’ve illustrated how I calculated the free cash flows for this company below, I will mention what enhancements I do in my calculations, and how that changes the analysis.

* <<All nos. below are in Rs. Cr. >>*

## Step 1: Take profit

Any company reports profit or loss at the end of the year. This is its statement of how it has fared in the year. As an investor, we have no reason to doubt that this should be our basic starting point.

What are we considering |
Which Parameter to look at |
Where Do we get it |

Profit/Loss of the company | Profit After Tax (i.e. the parameter that is left after all obligations, except dividends, are met) | Websites like www.moneycontrol.com keep a database of company performance. One can query for the company (Precision Wires in this case) and the go to the “Financials” link and then “Profit & Loss” link within that. |

For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/profit-loss/PWI#PWI

When we go here, we see the following values:

Expression | Mar ‘07 | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Reported Net Profit (or pat) |
16.78 | 17.25 | 1.16 | 22.62 | 31 |

Once we have the above value, we need to look at the reinvestment needs and debt repayments.

## Step 2.1: Reinvestment Needs – Capital Expenditures

Next we need to find out the true nature of Capital Expenditures the company made in this year. The first step will be to find out how much the assets have changed between the last year and the present. Once that figure is found out, we will find out how much depreciation was for the present year, and remove this amount from the amount of change in assets. This is because depreciation is a non-cash amount for which the company enjoys tax exemption, and it cushions the capital expenditures to some extent.

What are we considering |
Which Parameter to look at |
Where Do we get it |

Change in Value of Assets | Gross Block of Assets, Cumulative Depreciation on the Gross Block and Capital Work in Progress | On Moneycontrol, one can query for the company (Precision Wires in this case) and the go to the “Financials” link and then “Balance Sheet” link within that. |

Depreciation for present year | Depreciation | On Moneycontrol, one can query for the company (Precision Wires in this case) and the go to the “Financials” link and then “Profit & Loss” link within that. |

For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/balance-sheet/PWI#PWI (for Gross Block/Cumulative Depreciation/Capital Work In Progress) and http://www.moneycontrol.com/financials/precisionwiresindia/profit-loss/PWI#PWI (for depreciation)

When we go here, we see the following values:

Expression | Mar ‘07 | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Gross Block |
158.45 | 168.65 | 180.55 | 197.67 | 229.24 |

Cumulative Depreciation |
40.84 | 49.73 | 59.89 | 70.21 | 81.40 |

Capital Work In Progress |
3.31 | 12.72 | 14.03 | 4.56 | 5.08 |

Depreciation |
7.51 | 9 | 10.32 | 10.88 | 12.25 |

Now, once we see the above values, we can calculate the total capital expenditure as:

Capital Expenditure for the present period = { (Gross Block for present year – Cumulative Depreciation for present year) – (Gross Block for previous year – Cumulative Depreciation for previous year) + (Capital WIP for preset year – Capital WIP for previous year) } – Depreciation charged to Profit/loss for present year

In the light of this calculation, we see that the final expenditure of capital nature for the previous 4 years is:

Expression | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Capital Expenditure |
1.72 | -7.27 | -13.55 | 8.65 |

## Step 2.2: Reinvestment Needs – Non-Cash Working Capital

Next we need to find out the expenses due to non-cash working capital changes in the year under consideration. This information relates to how the working capital assets (current assets) changed in the year, but this information can be best obtained from the Cash Flow Statement of the company.

What are we considering |
Which Parameter to look at |
Where Do we get it |

Change in Value of Non-Cash working capital | Trade and other receivables, Inventories, Trade and other payables, Loans and Advances | On Moneycontrol, when one queries for the company (Precision Wires in this case) and the goes to the “Financials” link and then to “Cash Flow” link within that, one sees that the whole Cash Flow statement is compressed into Cash flow from operations, Investing and Financing activities. The information we need is a part of “operating activities” but is not depicted. |

So to get this information, we go to the company website and look at the annual report.

For Precision Wires, the link is: http://www.precisionwires.com/Corporate/Finance/A/2010-11/2010-2011.PDF (Page 43 for cash flow of this year and last) and http://www.precisionwires.com/Corporate/Finance/A/2008-09/2008-2009.pdf (Page 41 for cash flow of this 2008and 2009).

Expression | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Sum of Cash flow generated (in Rs Cr.) from Trade and Other Receivables, Inventories, Trade and Other Payables, Loans and Advances, Other Current Assets |
-7.3 | 13.06 | -7.82 | -28.1 |

The +ve amount in the above table means that cash was generated from the operations (hampering FCFE) and negative amount means that the cash was released (helping FCFE)

## Step 2.3: Total Reinvestment Needs

The Total Reinvestment needs will be equal to what we calculated in 2.1 above (i.e money invested in fixed assets) – 2.2 Above (i.e. money released from current assets)

Expression | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Total Reinvestment Due to Asset Changes |
9.02 |
-20.33 |
-5.73 |
36.75 |

## Step 3: Total Debt Changes

The next step is to look at how much money has come to the company due to additional debt that is borrowed by the company, or has left the company due to debt being repaid by the company.

Before I proceed on this section, I have a confession to make. My original article on free cash flows that I’ve referenced above had a typo. In that article, I had mention a table on how to consider the various variables involved in the calculation. Unfortunately, I realize now that the 4^{th} row of that table (on debt) was missing and was pasted as free text below the table. This wiped out the total debt calculation from my table altogether. I have corrected it now.

What are we considering |
Which Parameter to look at |
Where Do we get it |

Debt Repayment | Total Secured and Unsecured Loans | On Moneycontrol, one can query for the company (Precision Wires in this case) and the go to the “Financials” link and then “Balance Sheet” link within that. |

For Precision Wires, the link is: http://www.moneycontrol.com/financials/precisionwiresindia/balance-sheet/PWI#PWI

Apart from the debt, one can also look at deferred tax liability as another component of debt. Money control does not depict this for all companies, but this information can be obtained in the Annual Report under the balance sheet section, just below the debt amount. The calculation below on debt can be replicated for deferred tax.

Expression | Mar ‘07 | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Total Secured + Unsecured loans |
84.83 |
76.61 |
62.75 |
56.59 |
75.09 |

Now, once we see the above values, we can calculate the total debt repayment or borrowed as:

Debt Borrowed in the present period = (debt outstanding at the end of present year – debt outstanding at the end of last year)

In the light of this calculation, we see that the final debt raised in the previous 4 years is:

Expression | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Debt Raised |
-8.22 |
-13.86 |
-6.16 |
18.50 |

In the above table, a +ve amount means that the companied has borrowed the amount on the whole (which helps FCFE) and the negative amount means that the company has paid debt on the whole (which reduces FCFE).

## Step 4: Final Free Cash Flows

The final free cash flow calculation, as a result, is: Results from Step 1 – Results from Step 2.3 + Results from Step 3.

Expression | Mar ‘08 | Mar ‘09 | Mar ‘10 | Mar ‘11 |

Free Cash Flow |
0.01 |
7.63 |
22.19 |
12.75 |

## Analysis, Inference and Enhancements

Based on the above basic calculation, we see that in 2011 the free cash flows of the firm were much less than the actual profit that was reported by the company. This was exactly opposite of what happened in Mar09. This means that the actual performance of the company was lesser than what it reported this FY, and 2 years ago the company gave a lot of reasons for Cheer to the investors.

Above is just one basic inference that one can draw from the free cash flow calculation. The analysis, however, has a lot of caveats. One can look at these caveats, decide if they are important, and then enhance these calculations to arrive at updated free cash flow nos. It is precisely because of these caveats and the subsequent enhancements, the numbers I arrived at in my analysis of Precision Wires were slightly different from what we’ve calculated above in this article.

The numbers arrived above are very close to the numbers I reported in “**Latest FCFE before Normalization of Debt and Capex**” value in my analysis.

What are the caveats, and their corresponding enhancements that need to be incorporated in the calculation?

Caveat |
Enhancement |

We have used PAT blindly. A lot of times PAT includes extraordinary income, like income obtained after a plot of land is sold. | PAT has to be altered by removing all extraordinary items. Luckily, for Precision Wires there were not many. But we won’t be so lucky all the time.
If such extraordinary items recur frequently over years, it is better to average them out. |

The company pays debt in some years and borrows in others. | Changing debt sign has a huge impact on FCFE. So it is better to average the debt changes out over a period of time and then use that for calculations. |

Working Capital investments and Capital Expenditure investments change sign on a year on year basis | Like debt, it is better to average the Capital Expenditure items. One can link working capital changes to changes in annual turnover to come up with an average estimate for change in working capital |

Deferred Tax liability is not considered | One can assume that deferred tax liability is actually a debt obligation. If one agrees to this assumption, then treatment can be made on exactly the same lines as debt. |

Preference capital raised is ignored | If there are preference capital issues, they have to be treated the same way as debt. |

## Conclusion

Calculating free cash flow is important and easy for an investor, provided one knows how to calculate it and where to get the information from. The simplicity of calculation should not fool the investor into believing that he/she is missing something. The only thing that one needs to be careful about is that one needs to understand what each and every variable means, how it is relevant to the whole business and hence to the whole calculation, and how to control those variations.

## Recent Comments