Cash Flow Analysis Blog #5 – FCFF, FCFE, and ratios
“Keep your eye on free cash flow.”
We proceeded with the cash flow analysis by calculating the Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE), metrics that are highly critical to companies’ shareholders and lenders. Using the following formulas:
*CFO = operating cash flow
The detailed calculations and underlying data can be observed in the second tab of the attached file. As summaries:
The good news to shareholders and lenders in our example company Caterpillar (CAT) is that its FCFF and FCFE over the past three years have been positive.
In making their investments, shareholders should be very interested in a firm’s performance ratios, specifically cash flow to revenue, cash returns on assets and on equity, and cash to income. For CAT, the picture is positive (though not perfect):
Without competitors’ data as a comparison, the 0% average return of savings accounts in the same historical period, and the 8% average market returns of a 60/40 portfolio of stocks and bonds; we can conclude that CAT has done well and above the market average. However, there is a declining trend in the measures against revenue and assets, a signal the CAT’s ability to generate cash is deteriorating.
In making loans to CAT, lenders should be very interested in the firm’s debt coverage and interest coverage ratios. For CAT, this picture is not good:
CAT’s operating cash flow is not enough to meet its debt obligation and it must find other ways of repaying its debt. CAT has been able to meet its interest obligation from its operating cash flow. However, in both metrics, there are declining trends on the ratios, further confirming the deteriorating cash generation ability of the company.
In conclusion, CAT was a healthy company. While its current financial performance is still positive, there are signs of deteriorating ability to generate cash. To confirm these findings further, a financial analyst should perform an earnings quality analysis – a topic that we will explore in the next blog post. This post concludes the 5 blog posts series on cash flow analysis.
Of course, all of these analyses are useless if the underlying data is unreliable. Garbage in, garbage out. This drives home the importance of getting financial data from reliable sources: SEC filings (such as what we have done here) or from the company’s website (audited financial). In future blog posts, we will explore how to detect financial reporting fraud by two popular methods, Piotrosky Score and Beinish Score.