Analysing a company's finances reveals the overall well-being of the business and its economic health and helps predict the company's future. Thus, analysing a business's financial performance indicates whether it has the potential to boost its profits and operations or not.
There are multiple ways of measuring the economic performance of a business, FCF or Free Cash Flow being one of them. If financial modelling and analysis intrigue you, this blog is for you. Jump into this piece to learn more about Free Cash Flow and its component, Discounted Cash Flow.
What is Cash Flow?
Cash flow indicates the overall movement of money in a specific financial year regarding the decline or increment of money in an organisation. Working, funding and contributing are the three ways to ensure smooth money flow.
Understanding Free Cash Flow
Every business has its daily operations and expenses, like taxes, payroll, rent, inventory costs, and so on. Free Cash Flow measures the remnants of a business beyond its day-to-day expenses. It's an effective measure of profit which ignores all non-cash expenses. It only considers the cash, which supports business operations and helps maintain stocks and assets.
Free Cash Flow = Operating cash flow - capital expenditures
Various Approaches to FCC
FCF calculation takes two main approaches:
- Revenue approach: In this straightforward approach, first, all revenues are added, and then the expenses, like cash, interest payment, taxes, loans etc., are deducted.
- Net profit approach: This approach begins with a company's net profit, measured after calculating taxes and costs. Add the non-cash elements to your net profit and deduct any significant expenses incurred and interest payments.
Understanding Discounted Cash Flow
DCF, or Discounted Cash Flow, is an evaluation method which estimates investment value based on predicted cash flows. DCF attempts to evaluate an investment today based on predictions about the ability of the investment to create money in the future. Thus, DCF is an ideal tool for budgeting.
There are three steps encompassing DCF calculation. First, forecasting cash flow expectations from the investment and second, choosing a discount rate based on the total cost of bearing the investment. And last, with a financial calculator, discounting the predicted cash flow towards the current day valuation.
What are the benefits of Free Cash Flow?
Free Cash Flow removes any guesswork that usually comes with other similar tools. Here are the benefits of FCF:
Offers accurate, detailed stock value
Investors are engaged in daily stock comparisons. However, most valuations are relative, have ease of use and aren't always accurate. FCF offers the investors accuracy, with detailed stock value and hence helps in better decision making.
In investment, there's no tool to avoid uncertainty absolutely. FCF works to substantially reduce uncertainty by separating fruitful stocks from those potentially attracting loss. It helps investors to reduce their overall investment risks.
A chance to look into a company's future
If the investors wish to predict a company's growth, they must estimate backward from the current asset price with the cash flow model. It gives an idea of the company's actual value.
What are the drawbacks of Free Cash Flow?
Like any other tool, FCF also comes with its share of shortcomings. Here are its drawbacks:
Not beneficial for long-term investors
Short-term investors can benefit from FCF, but FCF does not fit long-term investors. Many uncertainties and mishaps can occur over 15-20 years, and FCF is ill-adapted to accommodate those.
May indicate a lack of investment
Higher FCF values can indicate that the business needs to invest more effectively. On the contrary, extremely low FCF values can indicate a company's extreme expansion and growth.
What are the benefits of Discounted Cash Flow?
Using precise numbers is one top benefit of using Discounted Cash Flow. It is highly objective rather than subjective. Here are the benefits:
DCF uses specific numbers, which makes it a highly detailed tool. Such specific values include growth rate, cash flow predictions, etc.
No use of comparables
DCF doesn't work by using comparables. It doesn't use market value comparisons, unlike other businesses.
Suitable for long-term investors
For long-term investing, DCF is ideal since it examines long-term values. It examines any project earning or investment through its entire economic life.
Accommodates sensitivity analysis
DCF allows the experts to examine how any change in the investment assumptions can affect the final value.
What are the drawbacks of Discounted Cash Flow?
To be precise, DCF demands that users collect significant data, making it time-consuming. Here are some other drawbacks of the tool:
Difficult to create accurate projections
Projecting cash flow for the next 10 or 15 years is challenging. This analysis is susceptible to various variables, and any minute change in the prediction can have immensely different results.
Discounted Cash Flow requires multiple data, and the formula itself can be tricky to understand. Thus, it can complicate the entire calculation and require extensive expertise to deduce results correctly.
External factors are excluded
Future prediction is tough, especially in wobbly times. This was particularly proven during the covid times. Thus, often predictions do not generate accurate evaluations.
Both free cash flow and discounted cash flow are widely used financial tools. While free cash flow is more suitable for calculating business valuations, discounted cash flow offers insight into whether an investment has long-term worth. A financial analysis course can aid prospective financial sector employees in mastering these tools and gaining industry-relevant knowledge.
If you want to bolster your knowledge about financial modelling and the associated tools, you can check out the financial analysis course offered by Imarticus. The Financial Analysis Prodegree, offered in collaboration with KPMG, runs for 120 hours and offers industry certification. This skill-building programme is available for learners as a part-time course, where you can learn crucial and job-relevant skills for a career in financial analysis, financial modelling, equity research, financial valuation, and much more. Learn from top industry experts and give your CV the necessary boost.