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Cash flows: The health parameter

Apr 18, 2001

A rupee today has more intrinsic value than a rupee tomorrow. Why is it so? If you have Rs 100 today, you can deposit this money in the bank, which fetches you interest from that day one itself. That is precisely the reason why cash flows and money management are all about attaining maximum returns. It is fine if a company earns adequate profits and commands better market share. But, if your company is not generating enough cash, which it can utilise for its expansion plans, it is losing on many fronts. From a shareholders perspective, the company could distribute a part of its free cash as dividend to the shareholders, who are entitled to every rupee that the company earns. From a company’s perspective, one, this will enable them to plough back money for further expansion plans and secondly it can buy back shares, which will enhance shareholder value.

Having said that, negative cash flow does not necessarily mean that the company is not doing well. Normally, for green field projects, cash flows tend to be in the negative territory as they build assets during the initial phase. There is always a lag time between investments and returns. So, cash flows from such capital expenditure would start flowing in probably after three or four years (this period is higher for capital-intensive companies like steel, cement and automobiles).

But how do I calculate free cash flow? A simpler method of calculating a company’s free cash flow is to add depreciation to the net profits and deduct capital expenditure and dividend. An in-depth methodology would be to adjust a company’s increase or decrease in net working capital (current assets less current liabilities) to the above figure. Free cash flow increases if the company manages to unlock efficiency by reducing the required working capital.

Calculating FCF
(Rs m) FY00
Net Profit 973
Add: Depreciation 348
Less:
Change in NWC (145)
Capex 300
Dividend 401
Free cash flow 765
Asian Paints reported a net profit of Rs 973 m in FY00. The depreciation, capital expenditure and dividend payout were Rs 348 m, 300 m and Rs 401 m respectively. The change in net working capital (NWC) was negative Rs 145. The free cash flow (FCF) is calculated as follows:

Let us take a simple example. Assuming that a company spends Rs 100 as capital expenditure in April 2000. The company has projected cash flows or returns from such investments as follows: Rs 20 in April 2001, Rs 35 in April 2002, Rs 50 in April 2003 and Rs 70 in April 2004. Assuming a discount rate of 15%, the net present value of these future cash flows is Rs 117 (present value factor is determined by dividing 1/(1+15%) in FY01E, 0.87/(1+15%) in FY02E and so on). Multiplying actual cash flow by PV factor would give you PV of the cash flows. Effectively, this means that earning Rs 20 in FY01, Rs 35 in FY02, Rs 50 in FY03 and Rs 70 in FY04 is equivalent to Rs 117 today.

Simple cash flow calculation
(Rs) FY00 FY01E FY02E FY03E FY04E Total
Cash Outflow 100          
Cash Inflow - 20 35 50 70 175
Discount rate 15.0%          
Present Value factor 1.00 0.87 0.76 0.66 0.57  
PV of cash flow   17 26 33 40 117

The debate then arises as to what rate should one discount the cash flows. But generally, the cost of capital of the company is a widely used hurdle rate because this takes care of a company’s debt and equity obligation like interest and dividend respectively. (Generally speaking, if the return on capital employed is higher than a company’s cost of capital, it is apparent that the company is managing its cash flows efficiently).

Let us consider a practical example: Mahanagar Telephone Nigam Limited has ventured into the cellular business for which it needed to incur capital expenditure for setting up infrastructure. The company has set this up at a cost of Rs 3,660 m through which it will be able to serve 0.8 m subscribers. As per the internal estimates, the company would net Rs 2,000 m as revenues in the first year of inception itself. But at the earnings level, the company is expected to report a loss in the first year, primarily on account of capital costs incurred in setting up the necessary infrastructure. Assuming that the company’s cost of capital is 17%, when we discount the projected cash flows from the cellular business, we get the net present value, which when divided by the number of shares, we get the fair value of the share. Remember, a company is not valued for what it has achieved but for what it has planned to do in the future i.e. growth prospects.

It is precisely the reason why cash flow analysis is ranked high by many of the value investors. So, the next time you plan to invest in a company, ascertain cash flows, as they are the health parameter of any company.


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