Calculating Free Cash Flow to Firm: Method 3: EBIT
In the previous articles, we learned about how to calculate the cash flow from operations if the cash flow statement or the income statement were given in the question paper. In many cases, these financial statements may not be given in full in the question paper.
Instead, some excerpts from these statements may be provided in the question paper. One such example is when Earnings before Interest and Taxes (EBIT) is provided. Hence, we have to begin our calculation with EBIT and derive the free cash flow to the firm based on the supplementary information. This article will describe this process in detail.
It is important to understand the logic behind the formulas. Mindless rote learning of the formula may cause the students to forget the formulas or get confused. If the concepts are clear, students can derive the formulas themselves as and when required.
Here is a step by step procedure to calculate the free cash flow to the firm from EBIT.Step 1: Add Back Depreciation:
Depreciation is a non cash expense. It has been reduced from the revenues to arrive at EBIT. Hence, to derive what the true cash flow of the firm is, we need to add back the depreciation amount. This is the standard procedure we use while preparing any cash flow statement.Step 2: Adjust EBIT for taxes
Step 2 is where things get slightly complicated. Now, notice the fact that we are working with EBIT which is earnings before interest and taxes. This means that we havent accounted for interest as well as taxes and their effects on the cash flow.
Interest does not have any effect on the cash flow. We havent subtracted it from EBIT and hence there is no need to add it back.
Taxes on the other hand are a different matter. They are a cash outflow which occurs at a later stage in the income statement. Hence, while deriving free cash flows to the firm we must adjust the EBIT for taxes. This is done by subtracting the tax amount from EBIT.
For example, the EBIT was $1000 and there was a 40% tax rate. At a later stage on the income statement, the company will pay 40% of this $1000 as cash flow. Hence, its EBIT will be reduced to $600. We therefore need to adjust the EBIT for taxes and make it a post tax EBIT number.Step 3: Subtract Fixed Capital and Working Capital Investment
Step 3 is the standard procedure we use to calculate free cash flow to the firm. Here, we will subtract our working capital and fixed capital investments from the amount derived by performing step 1 and step 2. The complications that may arise while doing so have been discussed in earlier articles.
These three steps can be summarized in the following formula:
The fourth method of calculating free cash flows is closely related to the third method. Here too we are being provided with excerpts from the income statement. Instead of being provided with the EBIT number, we are provided with the EBIDTA number.
EBITDA stands for Earnings before interest, tax, depreciation and amortization. As we can see this appears even further up on the income statement as compared to the EBIT number.
Here even the depreciation has not been subtracted. Hence there is a slight change in the step 1 that we followed above.Change in Step 1: Add Back Depreciation Tax Shield
Since the depreciation amount has not been deducted, there is no need to add it back. However, the depreciation amount does reduce the tax bill of the company. Hence, we need to add back the depreciation tax shield to find out the true free cash flow that will accrue to the firm.
Notice the difference. When we were given EBIT, we added back the entire depreciation amount. In this case we will only add back the tax shield provided by the depreciation.
For example, if the depreciation amount was $200 and the prevailing tax rate is 40%, we will add back only $80 i.e. ($200*0.4) and not the entire $200 as we did in the earlier case.
Apart from this, steps 2 and 3 need to be repeated exactly as they were in the above case.
This method can be summarized in the following formula:
The thumb rule in these cases is to adjust for any non cash changes above the income statement metric that you have been provided. All non cash changed below the metric must be ignored or only adjusted for taxation.
It is for this reason that we added back the entire depreciation amount in case of EBIT. (Depreciation appears above EBIT on the income statement) whereas we add only the depreciation tax shield in the case of EBIDTA (Depreciation appears after EBIDTA on the income statement)
Thus, we can derive free cash flow to the firm from a wide variety of metrics. We could use the cash flow statement, the income statement or even some selected information from the income statement.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Equity Valuation: Definition, Importance and Process
- Market Value, Intrinsic Value and Investment Value
- Applications of Equity Valuation
- Assumptions Used In Equity Valuation
- Qualitative Issues While Conducting Equity Valuation
- Intrinsic Value and Mispricing
- Absolute Valuation Models Vs Relative Valuation Models
- Choosing a Valuation Model
- Sum of the Parts Valuation
- Dividend Discount Model: Advantages
- Dividend Discount Model: Disadvantages
- Single Period Dividend Discount Model
- Two Period Dividend Discount Model
- Dividend Discount Generic Model
- Dividend Discount Model: Gordon Growth Rate
- Gordon Growth Model: Pros and Cons
- Valuing Preference Shares Using Dividend Discount Model
- Link between Present Value of Growth Opportunities (PVGO) and Dividend Valuation
- Dividend Discount Valuation: H Model
- Phases of Growth and Valuation Models
- Dividend Discount Model: Share Repurchase Programs
- Implied Dividend Growth Rate
- Sustainable Growth Rate: Concept
- Sustainable Growth Rate and the Du-Pont Analysis (PRAT Model)
- Spreadsheet Modeling: Dividend Discount Model
- Estimating Future Dividends
- Dividend Discount Models: Some Points to Consider
- Introduction: Concept of Free Cash Flow
- Why Is Free Cash Flow Approach Better Than Dividend Discount Models?
- Free Cash Flow to the Firm vs. Free Cash Flow to Equity
- Calculating Free Cash Flow to Firm: Method #1 (Contd): Treatment of Fixed Capital Expenditure
- Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
- Calculating Free Cash Flow to Firm: Method 3: EBIT
- Calculating Free Cash Flow to Equity
- Calculating Free Cash Flows: The Case of Preferred Shares
- Changes in Financing Policy: Effect on Free Cash Flow
- Single Stage FCFF Model
- Single Stage FCFF Model to Equity Valuation
- Variations in Cash Flow Models
- How to Value Companies like Netflix?
- Debt to Equity Swaps