Free Cash Flow and cash

[Asuka]

@busprof

Asuka - While S2000 magician would probably say it more cleanly, I’ll give it a shot: #1 is correct. But while you do net out the gain/loss from sale of FA (#2), the reason you do it is not “because if has been accounted for in FCINV” (i.e. the change in Gross FA). It’s because you are trying to calculate “Cash flow” by putting Net Income back to a cash basis. So you are adding back non cash epenses (like Depreciation) and deducting non-cash income (like the gain).

Maybe I shall say :

To calculate CFO, the gain/loss from sales of fixed assets shall be accounted for as CFI and the cash flow (the proceeds) from sales of fixed assets shall be accounted for in FCInv.

Am I right ?

[S2000magician]

@Asuka

@busprof

Asuka - While S2000 magician would probably say it more cleanly, I’ll give it a shot: #1 is correct. But while you do net out the gain/loss from sale of FA (#2), the reason you do it is not “because if has been accounted for in FCINV” (i.e. the change in Gross FA). It’s because you are trying to calculate “Cash flow” by putting Net Income back to a cash basis. So you are adding back non cash epenses (like Depreciation) and deducting non-cash income (like the gain).

Maybe I shall say :

To calculate CFO, the gain/loss from sales of fixed assets shall be accounted for as CFI and the cash flow (the proceeds) from sales of fixed assets shall be accounted for in FCInv.

Am I right ?

The gain or loss from the sale of fixed assets _ isn’t a cash flow _. _The amount received (proceeds) on the sale is the cash flow _ (included in FCInv, as you say), which (by itself) has no relationship to the gain or loss.

Notice the formulae: they’re saying NI + NCC – WCinv = CFO

We know (from the indirect method for CFO) that NI + NCC + losses – gains - WCInv = CFO, where gains and losses are nonoperating items that appear on the income statement (e.g., McDonald’s showing a loss when selling a french-fry-making machine).

The only way we can reconcile the FCFF formula with the indirect method for CFO is to assume that NI in the FCFF formula already has losses added back and gains subtracted out (or that they are, in fact, zero); more simply, that formula assumes that there are no gains/losses on the income statement. That’s the only thing that works.

Take my word for it, in the questions about FCFF, there will be no numbers given for gains/losses on the income statement; that’s not the purpose of testing you on this formula.

[S2000magician]

@busprof

Asuka - While S2000 magician would probably say it more cleanly, I’ll give it a shot: #1 is correct. But while you do net out the gain/loss from sale of FA (#2), the reason you do it is not “because if has been accounted for in FCINV” (i.e. the change in Gross FA). It’s because you are trying to calculate “Cash flow” by putting Net Income back to a cash basis. So you are adding back non cash epenses (like Depreciation) and deducting non-cash income (like the gain).

You flatter me.

Yes, #1 is correct, and #2 is almost correct, as I mentioned in the post above.

[Asuka]

S2000magician & busprof :

Thank you for your clarifications !

[S2000magician]

@Asuka

S2000magician . . . :

Thank you for your clarifications!

My pleasure.

[busprof]

S2000 has it right - the chance of the exam having a case where a question includes gain on a sale of an asset is extremely small. The exam tends to test the main part of a concept, and not the picayune technical aspects. So get the basic intuition down and you’ll be fine.

But his point about gain;loss not being included because it’s noncash is very important. It follows the same logic as for why we add back depreciation. Remember that NI is “accounting profit”, and we want “Cash flow”, so everything else is unwinding the differences between profit and cash.

For what it’s worth, this is probably one of the topics my students have the most diffuiculty with when they’re doing valuations. Calculating a present value is easy, but getting cash flows can be a bit tricky.

[S2000magician]

@busprof

Calculating a present value is easy, but getting cash flows can be a bit tricky.

Amen!

[Asuka]

@Phoeniyx

As discussed earlier, two popular formulations of FCFF are based on net income and CFO as base values. Therefore, it appears that what the company does with investing activities (except for fixed capital investment) and financial activities are not relevant. So conceivably, if a fruit company uses all of its cash in the books (including all the new positive operating cash flow in the current period) to buy a Casino in Vegas (for some odd reason) as an investing property, the FCFF will NOT catch that. So, even though in “reality” all the cash is completely tied down and there is no liquidity, FCFF can still show some positive value. S2000magician, Sorry I come back here because I am confused if the buying of a Casino in Vegas shall be accounted for in FCInv in case that casino is not the business being operated by the company, although I think the cash outflow of buying a casino shall be accounted for as CFI. Would you please clarify my confusion ? Thanks !

[S2000magician]

@Asuka

@Phoeniyx

As discussed earlier, two popular formulations of FCFF are based on net income and CFO as base values. Therefore, it appears that what the company does with investing activities (except for fixed capital investment) and financial activities are not relevant. So conceivably, if a fruit company uses all of its cash in the books (including all the new positive operating cash flow in the current period) to buy a Casino in Vegas (for some odd reason) as an investing property, the FCFF will NOT catch that. So, even though in “reality” all the cash is completely tied down and there is no liquidity, FCFF can still show some positive value.

S2000magician,

Sorry I come back here because I am confused if the buying of a Casino in Vegas shall be accounted for in FCInv in case that casino is not the business being operated by the company, although I think the cash outflow of buying a casino shall be accounted for as CFI.

If the company is in the casino-operating business, I could see that buying a casino would be considered FCInv. (However, remember what I said above about FCInv: it’s really supposed to be only the investment needed to maintain the current operations, not to expand. So if you’re calculating FCFF properly, then buying a new casino wouldn’t be deducted as FCInv (because it’s an expansion).) If the company is not in the casino-operating business, then it’s definitely not FCInv. In that case, you’re correct: the cash flow would be CFI.

Phoeniyx should have chosen a different example.

@Asuka

Thanks!

My pleasure.